Is Your Target-Date Fund Missing the Target?

Investing on cruise control is easy, but it may be riskier than you think. .

The appeal of target-date funds is supposed to be "set it and forget it." Plug in your expected retirement date and a few investing parameters, and let the algorithms take over.

But recently, some analysts have questioned the wisdom of a total hands-off strategy. It's smarter, they say, to keep your hands on the wheel even if your investment strategy is mainly on cruise control.

Many people just trust the fund options selected by their employers, says Richard Davies, head of defined contribution at investment management and research firm AB (formerly known as AllianceBernstein). But it's smart to understand the underpinnings of your target-date fund, partly so you can see if you need a different strategy to reach your goals, and partly so you can have an intelligent conversation with the committee that chooses the fund on behalf of employees at your workplace, Davies says.

New research from AB indicates that managers of target-date funds need to focus less on the "glide path" – the investment transition that gradually shifts assets from growth (usually stocks) to income (usually bonds) as the retirement "target date" nears. A better focus, Davies says, is how well the funds make the most of various types of asset classes, including funds that are not owned by the plan sponsor.

The emerging term "open architecture" challenges plan sponsors to make best-in-class choices from a spectrum of investment options instead of defaulting to its own funds. "The investors that have done the best are taking advantage of diversified asset classes," Davies says. Diversification is important not only for growth, but also for limiting the volatility of the portfolios, he adds.

Kevin Coppola, president of Kenilworth, Illinois-based Compass Investors, a financial analysis firm, says target-date funds hew to a middle-of-the-road approach that somewhat insulates investors from both downturns and upturns.

"These things are landlocked within a particular investment return," he says. "Target-date funds are not going to deliver a pot of gold."

One basic question to ask yourself: Do you have the right target date?

Many people realize only a few years from their assumed retirement date that they need to keep working. But that's too late to adjust target-date funds that have already been transitioning for years to bonds, analysts say. Instead of trying to manage the fund by moving the target date, set up a separate growth portfolio intended to carry you well into your retirement, they recommend.

"If you're debating about the target date, then go for the longer one," says Rob Austin, director of retirement research for Aon Hewitt. "If you expect to live longer, then bet on that and have your portfolio reflect that."

With the financial headaches of the 2008 financial crisis still fresh in many investors' minds, some may prefer investment vehicles they can steer, especially if they are concerned about market corrections. "If you're worried about making hands-on decisions if there's an economic shock, you probably don't want this kind of cruise control," Austin says.

And after the fund hits the target, then what?

Target-date funds largely sunset risk as you transition to retirement, and that means with little growth in the fund, your buying power will soon start to erode, Coppola points out.

"It doesn't work beyond your retirement target. You have to have some money in riskier categories to support your retirement. You can create an index-based target-date fund with about half an hour a year and have more control over the mix," Coppola says. Most people with long life expectancies "need meaningful equity exposure until they're age 80," Davies adds.

"For people who believe they can't [manage their own portfolios], a target-date fund is a panacea, but they need to understand what the pot of gold will look like and how big or small it will be," Coppola explains. "Run some numbers to find out where you will be, based on your current rates and expected lifestyle."

He and other analysts agree that target-date funds are complemented by market-focused investments that diversify both the asset mix and the investment philosophy.

"If you want a passive investment, understand that the results may not be what you need," Coppola says. "Autopilot comes with a cost, and it may be more than you have been led to believe. If you still want to use a target-date fund, then put some of your money into it, and also take a portion of your portfolio and invest it responsively to what the market is doing. Create your own safety net that will break through the investment return barrier that you'll be locked into in the fund."