7 Tips for Picking a Target-Date Fund

Some target-date funds are riskier than others, here’s how to choose the right one.

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Many retirement savers think they can put their investment choices on cruise control if they use a target-date fund. These funds offer a mix of stocks, bonds, and cash that the fund manager automatically adjusts to become more conservative over time, based on the retirement date the participant selects. But it's best to take a look under the hood before stashing your nest egg in a target-date fund. Here are some tips for finding a target-date fund that is right for you.

Evaluate your risk tolerance. Many target-date fund investors, including those near retirement age, recently suffered large losses. Long-term investors with a retirement date between 2050 and 2055 had a median return of negative 47.5 percent between October 2007 and February 2009, according to a recent Watson Wyatt analysis of 72 target-date funds. Those on the verge of retirement didn't fare that much better. Investors interested in retiring in 2010 had a median return of negative 31.9 percent. But losses varied considerably among funds because of the large differences in stock market exposure. Funds with a target date between 2050 and 2055 were invested between 51 percent to 95 percent in equities, Watson Wyatt found. Those with a retirement date of 2010 had between 32 and 80 percent of the fund exposed to the stock market. Instead of assuming that the target-date fund has the appropriate amount of stock market exposure for your age, individual investors should make sure that their fund carries a level of risk they are comfortable taking on.

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Consider the investment strategy of the fund. It's not just the level of stock market exposure you should pay attention to. The underlying investments also play a role in your returns. For example, target-date funds with larger allocations to developing and emerging international markets suffered greater losses than those invested more heavily in the U.S. stock market, according to recent Vanguard research. Target-date funds with higher exposure to bonds and especially U.S. government bonds performed better in 2008. However, when the market is growing quickly, the riskier funds could potentially exhibit higher returns.

Examine how the fund changes over time. The combination of stocks, bonds, and cash in a target-date fund changes over the investor's lifetime. Different fund managers have various strategies for how quickly the asset allocation is shifted from equities into bonds and cash. The fund's prospectus will generally contain an illustration of the glide path the fund manager plans to follow between now and the target retirement date. Make sure that strategy fits with your retirement and investing goals.

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Aim for low costs. High fund expenses can eat away at your returns over time. Fees vary from fund to fund and can change over time as the asset allocation is shifted from sometimes pricey equities to low-cost bond funds. Target-date fund expense ratios generally vary between 0.2 percent and 1.5 percent, according to Eric Endress, an investment analyst with CBIZ Financial Solutions in Cleveland. He says that, ideally, investors should seek out a target-date fund with expenses of 1 percent or less. Passively managed funds made up largely of index funds also generally have lower costs. "Consider whether or not the higher fees associated with an actively managed fund are warranted over the long term," says Jodi DiCenzo, a certified financial planner and the president of Behavioral Research Associates, an investor research firm in Evanston, Ill.

Pick the correct retirement age. Most people choose a target date near when they actually plan to retire. But some investors tinker with their stated retirement age to get a more desirable asset allocation. Investors can pick a younger age if they want less risk in the fund or can take on more risk and potentially higher rewards by picking an older age. "You could adjust the allocation by changing the retirement date that gives you the allocation you want but isn't necessarily the retirement date you plan on retiring on," says Mark Ruloff, director of asset allocation at Watson Wyatt. Some investors also choose risky or conservative investments outside the target-date fund to insure that their overall portfolio has the desired level of risk. "An individual that wants to be in the target-date fund for part of their portfolio but also wants to be more conservative can put some percentage in a bond portfolio or a Treasury Inflation Protected Security portfolio to get a more conservative stance," Ruloff says. Conversely, investors could also put a percentage of their nest egg in various equity funds to counteract a conservative target-date fund.