Is Your 401(k) Riskier Than You Think?

What you need to know about target-date funds before you invest.

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Understand "to" vs. "through." All target-date funds have an associated retirement target year, but some manage to a fund's target date and others manage through the target date. When a fund is managed to the target date, it reaches its final asset allocation at the target year, while funds managed through the target date will continue to evolve after reaching the target year. "To" funds generally assume investors will cash out and move money elsewhere, either rolling over funds to a 401(k) or purchasing an annuity, while "through" funds continue to evolve to generate income for investors in retirement.

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These two approaches have differing impacts on the resulting glide path, most apparent nearest to the target date. "What you see with different glide paths between competitors is that the widest dispersion in equity allocation happens at the retirement date due to the difference between "to" and "through" managers," Viston says.

According to a March 2011 Morningstar survey of 41 target-date funds, "to" and "through" funds have nearly identical stock allocations 40 or more years from retirement—about 90 percent—but as the retirement date approaches, differences start to crop up. "To" target date funds generally move more rapidly to the lower final equity allocation, while "through" funds have a more gradual arc in equity reduction. At the target date, "through" funds averaged around 49 percent in stocks, while "to" funds had only 33 percent. (The report does note that some "through" funds eventually end up at a lower equity allocation than "to" funds, but it takes longer to arrive at that point.)

Currently, more funds use the "through" paradigm, but Charlson says one approach isn't necessarily better than the other; it depends on an investor's unique situation and financial goals. Because "through" funds have higher equity allocations for a longer period of time, they tend to court more market risk and might expose investors to short-term losses if market upsets like 2008 occur close to the target date. "To" funds, on the other hand, might not have enough equity exposure to generate the level of income retirees need. "One may fit a particular risk profile or investor profile better than the other, depending on your views or intentions during retirement," Charlson adds.

Look under the hood. Despite being considered by many as one-size-fits-all investments, not all target-date funds are created equally. "[Target-date funds] are a different vehicle—they're not your average stock mutual fund or bond mutual fund," Endress says. "They're much more complex, even though they are simple from a turnkey standpoint. When you actually look at the components across the different fund families out there, there are a lot of differences."

After the devastation wreaked by the financial crisis on U.S. stocks and bonds alike, some firms have tweaked target-date fund holdings to include more non-traditional asset classes such as real estate, foreign debt, and bank loans. Not only does this provide broader diversification, many of these asset classes have less correlation to U.S. equity and bond markets. "We've definitely seen some shifts," says Charlson. "It's not an overwhelming or universal trend, but it's definitely there. There's a movement towards greater risk control."

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While changes have been incremental thus far, Endress notes that recent pressure from regulators and investors might signal more significant changes for target-date funds in the future. "I think we'll see more things come out in terms of regulations moving forward," he says. "[Fund companies] are still trying to find a standardized way to communicate these products and make it simple for investors to understand the differences a little bit more than they do today."

Twitter: @mmhandley