For investors who would rather give professionals the keys to their portfolio, target-date funds are a simple solution. Investors select funds with a horizon date, which should generally match up with the year they turn 65, then leave the fund selection, allocation, and rebalancing up to the fund company.
"All of the heavy lifting is done by the fund companies, from the selection of the underlying funds to create a diversified portfolio to the managing of the glide path—essentially shifting the asset allocation over time so that it becomes more conservative as the investor approaches retirement," says Morningstar senior mutual fund analyst Josh Charlson. That's the general idea, but investors should be aware that allocation strategies can vary significantly among fund companies.
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Misconceptions. The biggest benefit of buying a target-date fund is that investors don't have to track their investments as meticulously as if they managed them on their own. Still, investors need to pay attention to each fund's planned allocation strategy. "One misconception might be that just because people enter them as default investments or because they're one-stop-shopping kind of investments, that you don't have to pay attention to how they're constructed or what's going on with them year after year so you need to exercise due diligence," Charlson says.
Investors should also be aware that once the fund hits its target date, its allocation doesn't suddenly change to all bonds or cash. "There's a new philosophy, and I don't know if it's grasped totally by the advisors or investors these days ... You need to continue to have some equity exposure even after you're retired just for capital appreciation purposes—to keep you above water as you grow older and have those funds continue to grow," says Dale Carbaugh, senior mutual fund analyst at Raymond James.
During the 2008's bear market, many investors in target-date funds pegged to 2010 were badly burned because of some funds' large allocation to stocks (in some cases, 50 to 60 percent of total assets). T. Rowe Price Retirement 2010 lost almost 27 percent in 2008, which was a difficult pill to swallow for many investors. (By comparison, the S&P 500 index lost 37 percent in 2008, and the Barclays Capital U.S. Aggregate Bond index returned 5 percent.) The average target-date fund with a 2010 horizon lost 25 percent in 2008, according to Morningstar, before rebounding 22 percent in 2009.
[See How to Build a Strong Do-It-Yourself Retirement Portfolio.]
Cost. Fidelity, Vanguard, and T. Rowe Price hold more than three-fourths of the total assets invested in all target-date funds. Of the big three, Vanguard offers the cheapest funds, in part because the Vanguard Target Retirement Series is made up entirely of index funds, which are generally cheaper than actively managed funds.
As of the end of 2009, Vanguard's average annual fees for its series of target-date funds were 0.19 percent, followed by the Fidelity Freedom series (0.69 percent), and T. Rowe Price (0.73 percent), according to Morningstar. Fidelity and T. Rowe Price offer some index funds in their target-date series—and Fidelity has a separate series devoted to indexing—but their offerings are generally made up of actively managed funds, which rely on managers to pick investments that they believe will outperform others.
In early May, the Securities and Exchange Commission weighed in on the benefits and drawbacks of target-date funds. In a statement, the SEC said, "Keep in mind that a fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time."
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