Understand the risk with these retirement funds

October 23, 2010 | By Walter Hamilton. Los Angeles Times

Individual investors have yanked billions from the stock market this year but are still steadily pumping money into a type of retirement vehicle that relies heavily on equity holdings.

Even through the financial crisis, Americans kept investing in the products, known as target-date mutual funds, despite surprisingly sharp losses during the downturn.

Thanks to the continuing flow of cash from investors, target-date funds held $288 billion in assets on Sept. 30, nearly five times as much as five years ago, according to research firm Morningstar Inc.

Meanwhile, managers of the funds have responded to their steep bear-market declines and the rash of criticism that followed by adjusting their portfolios to make them less volatile.

But critics say the funds remain riskier than many investors realize. And the recent tweaks, such as cutting stock allocations for people close to retirement or adding commodities to the portfolios, have only increased the complexity of a sector that already had significant differences among fund families.

The changes, experts say, have made it even more important for investors to do their own research.

You’re going to own this fund for 20, 30, 40 years, said Morningstar analyst Laura Lutton. You’ve got to have a lot of faith in the organization behind the target-date funds, and some fund companies are more shareholder-focused than others.

The appeal of target-date funds is simple: Investors stash retirement savings in a fund pegged to their expected retirement date. As that date approaches, the portfolio gradually becomes more conservative, with the percentage allocated to stocks going down and the bond portion going up.

Many experts recommend the funds for people who lack the time or expertise to assemble and regularly adjust their own retirement portfolios. Target-date funds are considered such a universally suitable investment that the government allows employers to make them a default destination for employees’ 401(k) contributions.

But the funds suffered bruising losses in the bear market. For example, funds for people who planned to retire by this year fell an average of 27 percent between October 2007 and March 2009, according to Morningstar.

Although that was much better than the 57 percent loss in the Standard & Poor’s 500 stock index during the same stretch, the losses blindsided investors who may have assumed the bulk of their money was stowed in safer bond or money-market funds.

Since then, managers have ratcheted back on equities in some target-date funds. Los Angeles-based American Funds as late last year reduced the stock allocation of its fund with a 2010 target date to 30 percent from 40 percent. Its funds with target dates of 2015 and 2020 went to 45 percent equities from 55 percent.

But industrywide, the equity exposure of funds designed for people retiring five years from now ranges widely, from 21 percent to 76 percent. The average is 51 percent.

Some critics say even a 50 percent stock allocation is too high for people who have little time to recoup losses.

Investors nearing retirement should consider moving out of target-date funds and into safer alternatives, said Joe Nagengast, principal of Target Date Analytics, a research and investment management firm in Marina del Rey, Calif.

Up until about age 50, they should be fine, he said. But starting at 50 or 55 they need to start paying attention and start looking around for diversification or professional assistance.

Others, however, say the fact many people live for decades after retiring means it’s legitimate for investors approaching or in retirement to have a significant portion of their portfolio in stocks.

If I’m looking for a fund that’s going to be paying out for another 20 years, that 50 percent equity allocation is perfectly reasonable, said Lou Harvey, president of Dalbar Inc. a financial research firm in Boston.

But Harvey says fund companies have misled investors into thinking that a fund becomes a conservative investment at its target date when that’s not the case.

The Securities and Exchange Commission has proposed requiring funds to prominently display the asset allocation they plan to have at their target dates. The disclosure for example, 40 percent equity, 50 percent fixed income, 10 percent cash would come right after the fund’s name in all marketing materials.

The proposal hasn’t been embraced by the fund industry or many independent experts. Investors would be better served, Morningstar contends, if fund managers gave more information about the expected riskiness of a fund’s portfolio at all stages of its life.

The need for better information may increase as some target-date funds diversify beyond stocks and bonds.