Whoops! Target Funds May Miss Your Mark

Instant portfolios are not one size fits all. Approach them with care.

Retirement Guide 2008

Target-date funds are supposed to make saving for retirement easier by offering a one-shot, premixed portfolio of funds that grows more conservative as the years pass. All investors need to do is select an anticipated retirement date and voilà! Instant retirement portfolio.

That sounds deliciously simple, but a peek inside these funds reveals holdings that run the gamut from straightforward blends of stock and bond funds to more exotic asset classes. No doubt, target-date sponsors all have their own ideas about what asset classes offer the best returns with the least amount of risk.

How about a 2040 portfolio that invests in, among other things, Japan, Malaysia, small companies, transportation, utilities, and real estate investment trusts? It's from Foliofn, a Vienna, Va., brokerage that uses exchange-traded funds to glide investors down the retirement path. The idea is to create a truly diversified portfolio containing elements that zig when the broad market zags, says Geoff Considine, a strategic adviser to the firm. "It's striking how many of the existing target-date solutions simply track the S&P 500," he says. "Some ignore whole asset classes, like commodities. The premise here is to diversify the way pension plans diversify."

Since their debut about a decade ago, target-date funds have exploded in popularity: In 2007, almost 80 percent of large 401(k) sponsors offered target-date funds as an investment option, up from 60 percent in 2006, according to consulting firm Greenwich Associates. In the early days, the funds tended to rely on four asset classes: large and small U.S. stocks, developed international markets, and bonds. "As the industry is maturing, we're now seeing diversification into more and more asset classes," says Joe Nagengast, president of Turnstone Advisory Group, which studies target-date funds.

The new wave of add-ons includes real estate, commodities, emerging markets, and inflation-linked bonds. In the past year, for example, TIAA-CREF added underlying funds that invest in high-yield bonds and "enhanced" international indexes—which are based on computer-driven stock-picking models—to its target-date funds. Since 2006, Barclays Global Investors has added REITs (both domestic and global), treasury inflation-protected securities (TIPS), emerging markets, and international small companies. The result, says Kristi Mitchem, head of the firm's defined-contribution business, is a mini-version of a pension fund that allows retail investors to "sit alongside the largest and most sophisticated [institutional] investors in the world."

For investors who feel boxed in by the one-size-fits-all design of target-date funds, some companies, including Old Mutual Capital, offer conservative, moderate, and aggressive versions for each target date. Eaton Vance puts investors in the driver's seat by allowing them to build their own. Through its Supplemental Retirement Account—designed for those who have already maxed out their tax-deferred savings—investors can select holdings from a menu of tax-efficient funds, choose a target date, and specify starting and ending asset allocations.

But not all target-date funds are getting creative. Vanguard's Target Retirement funds contain a no-frills mix of U.S. and international stocks, as well as bonds. Investors nearing retirement also have exposure to TIPS. "Our philosophy for a core holding is to make it very simple to the consumer," says Ann Combs, a principal of institutional strategic consulting at Vanguard. She says investors still get exposure to asset classes such as real estate through the stock market.

Nagengast says investors should closely examine the holdings of target-date offerings. For comparison, he recommends checking out several versions of the 2010 target-date funds. "Because these funds are just two years from the target date, they're very revealing about how the manager is adjusting over time," Nagengast says. "One of the biggest cautions is that some fund companies put too much emphasis on high growth potential, to the dismissal of risk."