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What’s Up With Target-Date Funds? | Coastal Financial Advisors - Providing Fee Only, Unbiased Advice. NAPFA member.

What’s Up With Target-Date Funds?

Dennis O’Brien discusses the risk of investing in target-date funds in a story examining the hearings being conducted by the Securities and Exchange Commission and the Department of Labor on these investment vehicles.

 What’s Up With Target-Date Funds?


Posted 06/23/2009 05:10 PM ET

 The latest financial scapegoat? Target-date funds. At a joint hearing by the Securities and Exchange Commission and Department of Labor last week, critics beat up on the increasingly popular mutual funds.

 The catalyst was that most target-date funds — like much of the fund industry — lost ground last year.  The problem was that some people were shocked by that.

 “Some people think these funds are risk-free,” said Dennis O’Brien, president of Coastal Financial Advisers, of Farmingdale, N.J. “They don’t understand that these are investments. They can lose ground, especially during short periods.”

 In the worst-case scenario, the SEC and DOL could restrict how target-date funds invest. The DOL will take public comments until July 18. After that it will indicate what action, if any, it plans.

 “There is no denying that 2008 was the second-worst market ever for equities,” Francis Kinniry, a principal in Vanguard’s Investment Strategy Group, told IBD before the hearings. “Everyone should take a deep break and use a much longer lens than one year. The market has rebounded (about 34% off its March 6 intraday) low. That should influence the eventual outcome here.”

 A bigger problem for target-date funds is how fund families market them, said O’Brien, who is a financial adviser to individual clients and consultant who helps corporate clients set up and run 401(k) plans.

 “Not enough fund groups clearly explain how these funds are run and how they differ from each other,” O’Brien said. “Not enough of them explain their risks or their costs.”

 The stakes are rising. Target-date funds have grown a lot. As of May 31 they held $181.8 billion in assets. That was 3.06% of all fund assets and up from $152.8 billion on Dec. 31. It was also well up from $7.2 billion at the end of 1999, or 0.16% percent of all fund assets.

 The funds have become a staple of 401(k) plans, especially since 2007. Late that year the DOL gave incentives to plans that use them as default investment options for workers who are automatically enrolled.

 Proliferating Portfolios

Target date funds are in more than 33% of all 401(k) plans, says the Profit Sharing/401(k) Council of America. That’s up from 25% in 2005.  The funds generally invest in other mutual funds. A parent fund’s ratio of bonds and cash to stock typically grows as the target date nears.  That’s meant to better preserve the fund’s principal. The target date is usually near a shareholder’s intended retirement. Target-date funds overall averaged a 32.96% loss in 2008, according to Morningstar. The S&P 500 lost 37%. U.S. diversified stock funds averaged a nearly 39% loss.

 As might be expected, target-date funds with the longest investment horizons generally did worse. Last year funds with a target date of 2050 or later averaged a 39% loss. The $10 million JPMorgan SmartRetirement 2050 fell 33.53%, marking the best of the long-range funds.

 Funds with target dates from 2000 through 2010 fared best, averaging a setback of 22.46%.

 Among funds with the shortest views, $32 million DWS Target 2010 took top performance honors with a 3.61% loss. The $20 million Oppenheimer Transition 2010 was the cellar dweller with a 41.84% plunge.

 Too many shareholders do not understand how target-date funds differ, O’Brien says. First, there are two broad varieties.

 In addition to the type known as target-date funds, there are lifecycle funds. These portfolios do not shift their asset mix over time.  Instead, as he ages a shareholder is supposed to hop from one with an aggressive investment strategy — usually with more stocks — to one with a moderate strategy. As he nears retirement, he shifts to one with a conservative tack, with more bonds and cash.

 Different Approach

Second, many shareholders do not realize that funds with the same target date or in the same lifecycle category often invest differently.

 They can have different ratios of stocks, bonds and cash. Drilling down, they can also have different types of stocks and bonds.

 “A fund with all blue chips tends to perform differently from one with a mix of large caps, small caps and emerging markets,” O’Brien said.

 Also, only some funds stop making strategic moves when they reach their target date. Some shareholders cash out. Others want ongoing growth or income.

 “Some fund families do a better job than others of explaining things,” O’Brien said. “Shareholders can look up information at fund Web sites. They can also check through their 401(k) plans.”

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