08/07/2009 05:12 am ET | Updated May 25, 2011

Target Date Funds Face Heat and Probable Reforms

Target date funds need to sharpen up their aim.

These funds, which offer a way to put your 401(k) investing on cruise control, are taking a lot of heat due to the large losses suffered by some close-to-retirement investors in the market crash. At a Washington hearing last month, regulators threatened to impose new regulations and controls on these fast-growing investment products.

Target funds are good at addressing a basic problem with 401(k) investing -- namely, that many people just don't want to, or can't, manage their own portfolios. That fact is reflected in asset allocations that often are shockingly inappropriate for investors' ages.

Nearly one in four investors approaching retirement age (56-65) had more than 90 percent of their account balances in equities at the end of 2007, and more than two in five had more than 70 percent in stocks, according to the Center for Retirement Research at Boston College. Those concentrations are far too high for older investors, who don't have nearly as much time as younger investors to recoup their losses before the funds are needed.

With a target fund, you simply pick a fund targeted for the year you expect to retire; the fund manager adjusts the asset mix as the target year approaches, reducing the percentage of equities and increasing fixed-income investments to make the overall mix more conservative.

In a broad sense, target date funds offer an opportunity for investors to improve their asset allocations. The Employee Benefits Research Institute compared the equity percentages held by all 401(k) participants at the end of 2007 to the theoretical mix those same investors would have had if they were invested 100 percent in target date funds, which automatically adjust portfolio holdings for age-appropriate balance. The finding: 40 percent of investors would have had at least a 20 percent decrease in their equity concentrations.

But here's the rub: The PPA doesn't set any definitions for appropriate equity exposure levels by age group, so fund managers have been free to manage the investment mix as they see fit. As a result, target date funds have come under fire since the crash because many of the funds tailored for investors near retirement age racked up significant losses. Morningstar Inc. reported that target funds with dates between 2000 and 2010 lost 22.5 percent in 2008, and funds with target dates between 2011 and 2015 lost 28 percent. But those are broad averages; some funds with dates as early as 2010 lost as much as 50 percent of their value in 2008.

Clearly, many older investors thought they were buying more protection from market risk than that when they bought target date funds.

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