The truth behind target-date funds

(Money magazine) -- Target-date mutual funds had all the makings of a classic bull market folly.

In the boom years right before the 2008 financial crisis, Congress passed a law that not only encouraged employers to automatically sign up workers to a 401(k) plan but also allowed them to pick the investment if the employee didn't go to the trouble.

On the very short list of approved default investments were target-date funds, which typically offer a premixed portfolio of stock and bond mutual funds that becomes more conservative as employees age. (The "target date" refers to the year that fund investors expect to retire.)

Around that time, Fidelity and Vanguard, two of the largest target-date managers, changed their long-term strategies so that investors would hold more equities later in life.

Then came the crash. Vanguard Target Retirement 2010 and Fidelity Freedom 2010, funds for investors just a few years from retirement, lost about 26% and 29% of their value, respectively, over a 12-month stretch; one small fund run by OppenheimerFunds fell almost 45%.

Congress and regulators launched hearings. News stories warned of a risky new class of mutual funds. It looked as if a hubristic money-management industry had overreached.

A funny thing happened next: Money kept pouring in.

Since the beginning of 2008, target-date funds have added more than $177 billion in net new cash, bringing them to a total of $380 billion in assets.

"It's a freight train going down the tracks," says Brooks Herman, head of research at BrightScope, a company that rates 401(k) plans. "Imagine if these things had gotten good press."

The market recovery since 2009 has surely helped, but stock funds overall have continued to hemorrhage cash, while target-dates are reshaping Americans' 401(k)s.

If you don't own a target-date fund now, chances are you will soon. Besides auto-enrollment, the design of many 401(k) plans nudges you to actively pick the funds. Your plan might group fund choices into logical tiers (simplest and so on), and drive take-up of target-dates by putting them in the first tier.

By 2020, the investment consultancy Casey Quirk projects, target-date funds could account for half of all assets in workplace retirement accounts.

And the funds reach beyond 401(k)s: Fund giant T. Rowe Price, for example, puts target-dates front and center on its IRA rollover website. Click on your birth date and see which fund to buy.

The boom in these funds has been an unambiguous win for fund companies. How that happened is partly a story of Washington influence and partly a story of how an industry got wise to the lessons of behavioral finance, the study of how psychological biases skew investment decisions.

It's also the case that target-date funds address a real need: Even savvy savers who would never leave it to their employer to sign them up for a 401(k) could use some guidance. The employers who design the 401(k) menu and the fund managers who set the asset allocations are, together, many Americans' de facto financial planners.

The open question, though, is whether target-date funds can truly fill that need for financial advice. While there's much to be said for taking a set-it-and-forget-it approach -- it beats constantly trying to time the market -- you should think carefully before handing over the keys to whichever fund company your employer picked out for you.

In this story, you'll learn how target-date managers are making crucial decisions that could determine how much wealth you have in retirement.

Many target-date funds still take significant market risk in the years leading up to and after retirement. Holding a lot in equities during what may be a 30-year or longer retirement can be a reasonable choice, but this "stocks for the long run" thinking isn't watertight.

Even the pros who run the funds have a wide range of views: Funds with a 2015 target may hold as much as 63% or as little as 20% in stocks. These supposedly simple funds can also have a lot going on inside them, with some managers making their own market-timing calls, adding commodities or dipping into hedge-fund-like strategies. Costs range from razor-thin to expensive.

Once you understand the differences among these funds and the risks they expect you to be able to handle, you may still find that a target-date fund is a useful tool. (And you'll see how to make even better use of it.)

But the fund industry doesn't expect most target-date users to take that kind of care -- it is a product largely built around the unusual proposition that the customer isn't always right.

THE IDEA THAT STUCK

That belief isn't totally unfounded. The shift from traditional pensions toward 401(k)s was initially heralded as a chance for people to take control of their retirement.

By the early 2000s, however, the evidence had piled up that savers were struggling. Much of the research came from the emerging field of behavioral finance.

In a 2001 paper, economists Shlomo Benartzi and Richard Thaler found that many 401(k) investors practiced "naive diversification": They would spread their bets among whatever options were offered, so if the plan had lots of stock funds, they'd have lots of stocks.

Other researchers found that investors were prone to inertia. They tended not to change their holdings over time, ending up with the same risky portfolio at 60 that they had picked at 45. And they were saving too little, in part out of sheer procrastination.

Some large companies aimed to turn that inertia in the other direction, making contributions to a 401(k) automatic, with the choice of opting out. All of this made it inevitable that employers would have to make investment choices.

"With automatic enrollment, you have to decide what to do with the money," says David Wray of the Plan Sponsor Council of America, a trade association of employers offering 401(k)s. Fund companies cooked up a solution. Fidelity launched its target-date funds in 1996; Vanguard got going in 2003, and T. Rowe in 2002. (Together, the three now control 75% of the market.)

The final push for target-dates came with the new law in 2006. It was a small provision, championed by the fund industry's trade association, tucked into a big bill regulating traditional pension plans. Although some companies were already auto-enrolling people, the law offered them legal protections by spelling out the rules.

The Labor Department's regulations that followed created new default options, including balanced funds with a set stock/bond mix and customized accounts as well as target-dates. But target-dates are what stuck.

This automation of the 401(k) may be the most important real-world application of behavioral finance.

"It's not the biggest change. It's the only change," says Benartzi, who now runs a behavioral research group for Allianz Global Investors, a target-date manager.

Default investing had something for everyone. Employers liked that it got their employees signed up. Policy wonks hoped it would give lower-income workers a better shot at saving. And of course the mutual fund industry knew it was a heck of a sales tool.

Just in time. In contrast to the roaring 1990s, few fund managers are household names these days. So for the companies that sell their expertise as stock pickers, target-date funds have been an important bright spot.

"This is a very strategically important product to the firm," says Jerome Clark, manager of the T. Rowe Price target-date funds, which invest only in other T. Rowe portfolios.

Clark's funds were responsible for $7.5 billion of the $11 billion in new mutual fund assets the company took in last year. And once people are in a target-date fund, they seem more likely to stay put than other fund investors.

"It's very, very 'sticky' money," says BrightScope's Herman. The inertia that target-date funds help correct also keeps investors in place.

Not surprisingly, executives at the large target-date managers have enthusiastically embraced the language of behavioral finance.

Christopher Sharpe, co-manager of the $147 billion Fidelity Freedom target-date funds, invokes the term "alpha"; if a fund can get more return without adding risk, it's said to have delivered alpha. The Freedom funds, Sharpe says, can bring investors "behavioral alpha, if you will." That means the fund is likely to beat the not-so-bright things you might do instead.

And in fact, by some measures, investors are doing a better job allocating their money since target-dates took off. Extreme bets of 100% stocks or no stocks are becoming less common in 401(k) plans, fund companies say.

The quick start that target-date funds can give to investors, especially beginners, is why Vanguard and T. Rowe Price target funds are on the MONEY 70 recommended list

More: 3 things to know about target-date funds