3 things to know about target-date funds

(Money magazine) -- The ease of investing in a target-date fund doesn't mean you should just set it and forget it.

As discussed in our companion article, The truth behind target date funds, these all-in-one retirement portfolios have a wide variety of strategies, stock bets and costs. So be on the lookout for these three things:

1. You can find yourself taking more risk than you should

Even after the losses of 2008, the three biggest target-date providers -- Fidelity, T. Rowe Price and Vanguard -- have at least half their holdings in equities within a few years of retirement.

None follow the old rule of thumb (promoted by Vanguard founder John Bogle) that you should hold your age in bonds and the rest in equities. That's hardly scientific, but it lines up with what many investors expect.

According to a survey commissioned by the Securities and Exchange Commission, more than half of target-fund owners believe a fund will hold less than 40% in stocks at the target date.

Funds in general may have an incentive to favor equities. If risk usually pays off in better performance, that can make the fund easier to sell. Still, the big providers haven't been pure performance chasers: None swung to big bond stakes after the crash.

The managers of those funds also make a case for equities that isn't so easy to dismiss. With traditional pensions disappearing, the 401(k) has to solve a big problem: how to make a finite -- and, for most Americans, tiny -- nest egg provide a decent income for a possibly very long retirement.

For a mutual fund, the high potential return from equities is the main tool at hand to solve that problem, even if it's a far from perfect one. (What's more, says Jerome Clark, manager of the T. Rowe Price target-date funds, stocks look like an even better value relative to bonds now.)

In designing a target-date fund's "glide path" -- the schedule it follows for gradually reducing its equity stake -- firms typically run simulations to determine the range of possible risk and return, with a focus on finding a strategy that offers you the best chance of not outliving your money. When you focus on that risk of a shortfall, you get a counterintuitive result: Portfolio mixes that are volatile appear safer, and the ones that are less volatile look risky.

This is especially true for people who haven't saved enough or who make big withdrawals at retirement. For example, T. Rowe Price calculates that a retiree who takes out an initial 6% of savings in year one, and then increases that amount annually by the rate of inflation, has less than a 50% chance of making the money last 30 years with 20% in equity and 80% in bonds. Raise the equity exposure to 60%, though, and the chance of the money's lasting rises to over 60%.

The problem is that a riskier portfolio always carries the possibility of a huge loss. Things that don't happen 99% of the time can still happen.

In 2007, Vanguard published research on glide path design showing what a hypothetical target-date fund, with strategies similar to Vanguard's, could do. It declined by an annual 16% or more in 1% of their market performance simulations. The real Vanguard 2010 fund lost 26% from March 2008 through February 2009.

Doesn't investing over decades shelter you from short-term risk? Not necessarily.

Over long time frames the probability of losing money goes down, "but the magnitude of what you can lose increases," explains Moshe Milevsky, professor of finance at York University in Toronto.

Young investors can have more in equities, says Milevsky, because they can offset stock volatility with their "human capital" -- that is, the income they can earn over a career. Once you've stopped working and begin spending assets, you lose some of your ability to simply ride out market volatility. Hitting a bear market early on is especially damaging.

John Ameriks, head of Vanguard's investment counseling and research group, agrees that retirees' falling human capital calls for taking less risk. Still, Social Security is a form of human capital, and your ability to earn doesn't go to zero when you turn 65.

"We're seeing people step out, only to come back in a consulting role," says Ameriks. That's why Vanguard's glide path doesn't hit its lowest risk until 72. Though that makes sense, it also suggests that if you are set on not working, or know you can't, after 65, Vanguard's glide path may be too bullish for you.

Managers of more conservative target-date funds focus on what can happen right around the target. "We're trying to avoid material setbacks closer to retirement," says Jim Lauder, co-manager of the Wells Fargo target series, whose 2015 fund has less than a third of assets in stocks.

Imagine you lose 30% of $1 million as you retire. If you were planning to turn that into an income-producing annuity, your earnings would have fallen from $69,000 a year to $49,000.

What to do: Adjust your aim. No matter what model a target-date manager is using, it's only that: a model. In real life, if your savings are just about enough to produce the income you need, you might want to focus on preserving capital. With a bigger cushion, a pension, or plans to keep working, it could make sense to stay aggressive.

"Target-date funds don't rebalance relative to your goal, just relative to stocks and bonds," says Zvi Bodie, a professor of finance at Boston University who advocates a safety-focused retirement strategy. (He's also a paid speaker for Dimensional Fund Advisors, which sells a competing 401(k) product.)

The 2008 crash provided a vivid example of how hard a target-date fund can fall. So check how a fund for people five years older than you did in 2008. That's roughly what you could expect to experience if the same thing happened today.

Ask yourself if that's a loss you could handle -- both psychologically and in terms of your plans. If the risk seems too great, scale back: Buy a more conservative target-date fund in your plan -- one with an earlier retirement date in its name -- or add a bond fund to your portfolio.

2. Although there's a variety of investing strategies, you usually get one choice

Even among the target-date managers who think retirees can bear a fair amount of market risk, there's a wide variety of glide paths.

T. Rowe Price holds about 64% in stocks near retirement; Fidelity is closer to 50%.

Differences become even more pronounced later. The Vanguard glide path settles down to 30% seven years after retirement, but T. Rowe Price doesn't get to that point for 20 years, and then keeps cutting back on stocks until hitting 20% at the 30-year mark.

In a few decades you'll know who made the smartest bet. But the bet you end up making will depend on which funds your company uses in its plan, notes Boston College economist Pierluigi Balduzzi, who has studied the funds.

As a result of the hearings that followed the 2008 crash, the SEC and the Labor Department have proposed rules to require target-date funds to spell out the risk they are taking. Yet the whole point of target-date funds is that they are supposed to make decision-making easier by narrowing your options to one choice.

Asked if it might make sense to buy a fund with an earlier target date if you want less risk, T. Rowe Price's Clark says it would, but that he doesn't see it happening often. "Most folks don't know what their risk tolerance is, and most are not going to take the action because of inertia," he says. "Throw in one decision and you may lose them."

What to do: Take back the wheel. In your early and mid-career, going on autopilot with whatever your company offers can work out fine. Most target-date funds have a similar high-equity strategy for young investors. With many years of 401(k) contributions ahead, you can recover from even large market dips.

Late in your career, though, you need a real financial plan. Robert Pozen, a former president of Fidelity's fund-management group, has argued that all these precisely plotted glide paths may suggest to investors that target-date funds are more sophisticated and customized than they really are.

He'd rather see investors defaulted into a 60% stock/40% bond balanced fund, and then encouraged to decide based on their own situations how much to hold in stocks late in their careers.

"You have to make one important financial decision in your entire life, and that's between the ages of 50 and 60," says Pozen. You can consult a financial planner for this, or your company may offer an advice service or tools that can help.

For example, Financial Engines provides 401(k) plans with sophisticated online simulators that show the effects of different portfolio mixes, savings rate, and retirement dates. If your company doesn't offer such a service, you can pay $39 for three months of access at financialengines.com.

3. High costs can wipe out any edge you get from a pro tinkering with your mix

For all of the fund industry's talk about behavioral blind spots, most of the business has been silent on another common investment error: the belief that you can easily find managers who can beat the market.

Some target-date funds -- most notably Vanguard's -- use just three or four index funds. Many others seek an edge by combining a number of the firm's own actively managed funds.

Fidelity, for example, owns 23 other Fidelity funds in its 2020 target portfolio. That's partly because it offers more asset classes, such as commodities and real estate. It also has 10 U.S. stock funds, nine of which are actively managed.

Fidelity's managers say that having so many funds means they can find the best ideas within each distinct slice of the market. But it's tough enough to find one market-beating manager, much less nine.

Smaller firms are becoming even more complex. Putnam's target-date lineup, which is conservative, with a low exposure to stocks, takes an exotic turn by investing in so-called absolute-return funds, which can invest in almost anything, including bets on a stock to decline.

There's a chance such strategies could improve performance. (Christopher Davis, an analyst at Morningstar, says it's not easy to tell which target-date managers are adding value, in part because of funds' differing glide paths.)

It's a sure bet, however, that active strategies will add costs. Vanguard's indexed offerings charge management fees of 0.18% a year; T. Rowe Price and the main Fidelity Freedom series cost about 0.7%. Some of the smaller fund groups cost 1% or more.

Sounds small, but a study by Towers Watson found that for an 8% saver earning $75,000 a year, the lifetime difference between a 0.2% and a 1% target-date fund could add up to almost nine years of retirement income.

The target-date business exists very much under the umbrella of government. You can invest outside a 401(k), but the tax and employer-matching incentives mean you'd probably be crazy not to contribute.

Given that and Uncle Sam's willingness to bless target funds as default investments, why not go further and say that the funds should resemble, say, the low-cost plan federal workers get?

Rep. George Miller (D-Calif.) has proposed requiring plans to offer at least one index fund. But in general, lawmakers and regulators have been reluctant to single out index funds or cheap funds as better.

"I don't think it's appropriate for the government to substitute for the judgment of the fiduciary [the employer]," says Bradford Campbell, a former deputy secretary of labor who helped craft the default rules.

What to do: Build a cheaper model. Constructing your own portfolio of a stock fund, a bond fund, and an international fund can be worth the trouble if your plan offers an actively managed target fund charging 0.7% a year and a menu of index funds at 0.2%.

And don't get hung up on a fancy glide path. A 2008 study by researchers at the Boston College Center for Retirement Research found that paying an extra 0.2% in fees wiped out the advantage of having an optimal glide path, vs. holding the same mix all along.

You have other weapons -- use them

Target-date funds are an improvement over the pick-your-poison mess that the 401(k) used to be.

Still, it's an awkward world: The choices aren't quite yours, but all the risks are.

One thing you can do is make sure that your success doesn't rest only on asset allocation. As Stuart Ritter, a senior financial planner at T. Rowe Price points out, the amount you save is one of the biggest determinants of retirement success.

Critics of aggressive target-date funds say investors should focus on saving more, not on late-in-the-game stock bets.

"To say you didn't save enough and therefore you have to take more risk, it doesn't follow," says Joe Nagengast of Target Date Analytics, a firm that sells its own glide paths for custom 401(k) plans.

But at T. Rowe Price, at least, the thinking is that most people will live with some market risk.

"I've yet to hear someone say, 'I got out of the stock market and doubled the amount I'm saving, so my wife and I never go on any vacations,' " says Ritter.

He's right. The choices are hard. They're also, much more than any glide path, what a real financial plan is about.