Target-date funds: 3 risks to consider

Their popularity is skyrocketing, but investors should pay close attention to fees and focus.

By InvestingAnswers May 22, 2013 2:33PM

 copyright Tom Grill, CorbisBy Michael Vodicka

Steve Jobs once famously commented that simplicity is genius.

That attitude helped Apple Inc. (AAPL) redefine the personal electronics space and create an entire new ecosystem surrounding its products and services.

But now, a few years after Jobs passing, it looks like the financial services industry is taking a few pointers from the late and great founder of Apple.

One of the mutual fund industry's simplest product offerings is gaining popularity with investors. The growing trend has been fueled by the Pension Protection Act of 2006, which approved their use as a default option for 401(k) plan sponsors, who are allowed to automatically select them for participants who have not selected on their own.

I'm talking about target-date funds.

A target-date fund is much like a mutual fund in that it provides diversification with a mix of different assets. But unlike a mutual fund, the target-date fund continues to rebalance and reallocate its investment mix as the investor moves closer to retirement.

These target date-funds have become popular with investors for one very good reason: They are simple.

For most 401(k) investors, it's just easier to identify with a target retirement date than it is to sift through rows of small-cap mutual fund offerings and then think about rebalancing on a yearly basis.

A target-date fund also enables the 401(k) investor to one-stop shop and set up a dynamic investment plan that will evolve in the long run. With target-date funds automatically adjusting asset allocation as the investor moves closer to retirement, investors no longer have to worry about rebalancing their portfolios.

As you can see, target-date funds are easy to understand and provide a number of benefits that regular mutual funds don't. That's why 25% of 401(k) assets were being held in target-date funds at the end of 2012.

But as with any investment, investors need to understand how to evaluate a target date-fund and be aware of potential risks.

Risk No. 1: Excessive fees
If you take a look at any group of mutual funds, you are likely to see a wide range in fees and expenses. Some mutual funds carry expense ratios above 2%, while others in value territory fall safely below 1%.

Target-date funds are exactly the same, carrying different expense ratios. In fact, the difference can be significant. In value territory, there is Vanguard, with an average expense ratio of .18%. T. Rowe Price target funds are more expensive, carrying an average expense ratio of .70% with Fidelity clocking in at .60%.

That means the offering from T. Rowe Price is 250% more expensive than Vanguard. Picking up an extra 50 basis points annually, with no risk and then reinvesting that over 30 years can have a big impact on your portfolio.

For a $100,000 portfolio, that is $500 annual savings in expenses. Taking that $500 and contributing it back into your portfolio would grow to $28,118 after 30 years, carrying a modest 3.5% return compounded annually.

Risk No. 2: Overly aggressive asset allocation
The defining characteristic of a target-date fund is its classification of investors by age. By rebalancing asset allocation (its mix of stocks and bonds) according to age, the target-date fund reduces portfolio risk as investors get closer to retirement. This is called glide path.

But there is a big difference between target-date funds here as well. Some target-date funds are more aggressive than others, carrying different mixes of stocks at bonds at various stages of the investment cycle.

For example, the Fidelity ClearPath 2045 and Vanguard Target Retirement 2045, two target-date funds with the same target date, have different asset mixes. The Fidelity ClearPath 2045 carries an 84% allocation to equity for 2013, while the Vanguard Target Retirement 2045 carries 90% exposure to equity. This is an important detail that distinguishes one target-date fund from another.

Risk No. 3: Too much focus on either international or domestic stocks
But it's not just asset allocation that can differ from one target-date fund to another. Target-date funds are also unique in how they choose to invest. Some are focused on domestic stocks, while others are more international. And that can have a big effect on the performance of a fund.

For example, Vanguard Target Retirement 2045's largest allocation is 63% for 2013 in Total Stock Market Index. The Fidelity ClearPath 2045's largest allocation is 53% to Canadian Equity. Those are two very different core-equity strategies that target-date investors should be aware of.

The Investing Answer: Target-date funds continue to gain popularity with investors. Not only are they easy to pick based on a target retirement date, they also eliminate the need for investors to rebalance annually with an evolving mix of investments. But even though these relatively new instruments are gaining popularity, there is still risk involved when choosing between two different funds. Be aware of those differences and you'll get the target-date fund that fits best.

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