Why Target-Date Funds Make Sense for Younger Investors

Investing on autopilot comes with a few bumps, including expenses and international risk.

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Even as financial market turmoil rattled investors, studies show that younger participants stuck with mutual funds—most notably target-date funds, an outlet for the "set it and forget it" crowd. The funds' growing presence in workplace retirement plans, where some novice investors simply tick off a box, is fueling popularity.

The strategy is designed to offer a convenient way to invest for a person expecting to retire at or around a particular date. A target-date fund pursues a long-term investment strategy, using a mix of asset classes (or asset allocation) that the fund provider adjusts to become more conservative over time, according to the Investment Company Institute (ICI).

[See top-rated Retirement Income funds ranked by U.S. News Mutual Fund Score.]

"Across the board, we are finding that target-date allows investors to be more comfortable," said Paul Zemsky, chief investor officer of multi-asset strategies at ING Investment Management. "Investors tend to stick with their plan. They don't chase the top and sell at the bottom. They just generally behave like better investors."

An Employee Benefit Research Institute (EBRI) and ICI study showed that growing use of target-date funds may play a role in keeping younger participants invested in stocks even during a stretch of bear markets. The study found that 7 in 10 401(k) plans included target-date funds in their investment lineup at the end of 2010, and that recently hired plan participants in their 20s had 35 percent of their account balances in target-date funds, up from 31 percent in 2009 and 16 percent in 2006.

There's more evidence: Target-date funds had the highest net new inflows, at $31 billion, in 2011, the leader among Morningstar-tracked categories.

Investor resolve, however, was tested again in 2011, when eight of the nine target-date funds tracked by Morningstar declined, based on average fund performance for the year. Losses nearing 4 percent in some cases compared with the S&P 500's flat year (or 2 percent gain including dividends), but target-date funds shined compared with the double-digit beating of 2008—a year that brought these "lifecycle" investments under Capitol Hill scrutiny.

[See Is Your 401(k) Riskier Than You Think?]

Lawmaker grumbling centered in large part on an apparent lack of disclosure of the exposure to stocks and high-yield bonds in funds designed for soon-to-be retirees.

It's evidence that as with any investment, returns are not guaranteed. And in slim years for market returns, even modest expenses can bite. The funds have evolved, Morningstar analysts note, becoming more diversified. More international equity exposure can open up greater opportunity, but also greater risk. This diversification can also skew direct comparisons of target-date returns to U.S. index performance. Automatic rebalancing is generally a good thing, but some critics say it doesn't guarantee precision "best-in-class" asset-picking. Even so, the formula remains popular with investors just starting to plan for retirement.

Target-date funds were given a huge boost by the Pension Protection Act of 2006, which allowed for their inclusion as default options in 401(k) plans, according to Annuity Digest.

Investment firms continue to respond to demand. Earlier this year, Vanguard rolled out its Target Retirement 2060 Fund, which gradually increases investments in bonds and money market funds to help provide income and reduce volatility as the target year approaches. For example, the initial allocation tends to be 63 percent in the Vanguard Total Stock Market Index Fund; 27 percent in the Vanguard Total International Stock Index Fund; and 10 percent in the Vanguard Total Bond Market II Index Fund. The fund also charges a relatively low 0.18 percent in fees and expenses, which is 67 percent below the average cost for funds with similar holdings.

[See 5 Considerations for Investing in Target-Date Funds.]

"The 2060 Fund is designed with young investors in mind," said Vanguard CEO Bill McNabb in the fund's announcement. "Granted, if you're just entering the workforce, you may not be thinking about retirement savings, but even setting aside a small amount today in a low-cost, balanced portfolio can make a difference down the road." The fund has a low $1,000 minimum investment.