Target-date Mutual Funds

By Katherine Reynolds Lewis
c.2007 Newhouse News Service
Graphic by Monica Seaberry

Americans love one-stop shopping. You can buy groceries, pick new prescription glasses, gas up the car and have dinner — all without leaving your favorite big-box retailer.

In retirement planning, target-date mutual funds offer the same convenience. These products, also known as life-cycle funds, blend stocks and bonds and systematically reduce the proportion of stocks as retirement — the target date — draws closer.

And while financial advisers recommend rebalancing your portfolio at least once a year to ensure the mix of assets still fits your goals, if all your savings are in a target-date fund, you can be less disciplined. Not only is your shopping complete, you never have to return to the store.

"It makes things a lot simpler: Paperwork is simpler, managing your money is simpler,'' said Susan Black, director of financial planning at eMoney Advisor Inc., a Conshohocken, Pa.-based software company.


What's more, you can get started with limited savings, because you create a balanced set of investments when you purchase shares in just one mutual fund.

The recent college graduate who doesn't yet qualify for the company pension plan, or a mid-career worker who wants to supplement an employer-provided 401(k), can invest in target-date funds through an individual retirement account. While IRAs typically require a $2,500 initial investment, some fund companies waive the minimum if you set up an automatic monthly contribution — as little as $50 for T. Rowe Price Associates and $200 for Fidelity Investments.

"These are the first products that have a 40-year time horizon that are meant to be consumed by the general investing population,'' said Chip Castille, a managing director at Barclays Global Investors in San Francisco, which pioneered target-date funds.

Investors have come running. In 2007, target-date funds held $152 billion in assets, up from $116 billion in 2006 and more than double the $71 billion in 2005, according to Chicago-based research firm Morningstar Inc. The number of funds exploded to 220 in 2007 from just 39 five years earlier.

The market bust early this decade helped the funds gain steam, said Greg Carlson, a Morningstar analyst. Investors' "confidence was shaken in their ability to build their own portfolio and they're looking for something more broadly diversified with more stability,'' Carlson said.

But because the funds are extremely long-term investments, it's vital to do your homework. Some mutual fund companies are more conservative than others in their recipe of stocks and bonds, and some have high fees that can eat into your nest egg.

First, look at how the proportion of stocks to bonds changes over time, a concept called the equity glide path, Carlson said.

If you're planning to retire in 2040, your portfolio would have 83 percent stocks under Principal Funds' strategy, compared to 92 percent stocks under T. Rowe Price. Once retirement is well under way, Principal gradually lowers the stock weighting to 20 percent, compared with Barclays' 35 percent.

You may think more stocks mean more risk, that the more conservative fund is the best choice. But you face greater, less obvious risks, such as outliving your assets or inflation shrinking the value of your savings.

That makes a substantial stock investment mandatory, since stocks on average give far higher returns than bonds.

"When you look at longer time periods, the volatility of stocks is actually very small,'' said Jerome Clark, Baltimore-based manager of T. Rowe Price's Retirement Funds. "Investors are not only living longer, they're also living more active lives. ... You need to assure yourself that you have enough equity exposure even in retirement.''

Target-date funds are designed so that if you're retiring in 2030 you simply invest in the retirement fund corresponding to that date. But if you want a little more stock exposure, you could instead pick the 2035 fund.

"No one says you have to pick the fund that specifically relates to your retirement age, if your risk tolerance is higher,'' said Ellen Rinaldi, a principal at Vanguard, based in Valley Forge, Pa.

Another factor in choosing a fund is to look at the underlying investments. Most target-date funds invest in other mutual funds, usually run by the same company.

"A shop where there's a lot of manager turnover or they're weak in some areas, those are going to be less attractive,'' said Morningstar's Carlson.

Some mutual fund companies load up the target-date products with too many funds, leading to over-diversification, said Richard Davies, a senior managing director at AllianceBernstein in New York.

"Too many portfolios can be a warning sign that you're not getting anything other than extra fees and complexity,'' Davies said. "The investor should ask, 'Are the underlying funds there because they're the best the company had to offer?'''

Some funds stick to stocks and bonds, and some dip into other asset classes — such as AllianceBernstein investing in real estate. Principal uses preferred securities, real-estate investment trusts and inflation-protected Treasuries in addition to traditional bonds, large and small cap stocks, and foreign equities, said David Reichart, a Principal vice president in Des Moines, Iowa.

Some companies offer funds targeted at retirement dates in five-year intervals; others only go every 10 years.

Last but not least, look at the funds' fees, or expense ratios — the percentage of assets spent running the fund.

"Two of the best target-date labs out there are T. Rowe Price, because they tend to do a lot of things well and the costs are certainly reasonable, and Vanguard, because they're very cheap,'' Carlson said.

Vanguard's expense ratios are 0.21 percent or less, compared with an average of 0.69 percent at T. Rowe Price and as much as 0.82 percent at Fidelity Investments.

Target-date funds aren't for everyone. If you want to actively manage your retirement portfolio — or pay someone to do so — you'll have a greater selection of investments than are available in a target-date fund.

But given that many investors fail to rebalance their portfolios or change their initial fund allocation, target-date funds are a better option than ignoring your retirement portfolio.

"Only one in six participants in 401(k) plans ever change their allocation,'' said Adam Bold, executive chairman of the Mutual Fund Store, based in Overland Park, Kan.

"We can do a better job of asset allocation and fund selection than a lifestyle fund, but if you're not going to use a service like (ours) you're much better off to be in a target-date or life-cycle fund than to let it sit in a fund that used to be good.''

And in the end, the most important decision that can put you on track for retirement is to save money, regardless of where you put it, said Jonathan Shelon, co-manager of the Fidelity Freedom Funds in Boston.

"Saving early and often is key to helping investors reach their retirement goals,'' Shelon said.

(Katherine Reynolds Lewis can be contacted at katherine.lewis(at)newhouse.com)

This story was originally published Tuesday, June 19, 2007.