Why Target Funds Aren't Broken

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In a perfect world, everyone would take enough interest in their personal finances to manage their money and avoid any nasty surprises. But unless that pipe dream actually comes to pass, you'll continue to see a tug of war between providers of financial solutions designed to make things simpler and critics who argue that such solutions have too many flaws.

One example of a particularly controversial investment is the target-date retirement fund. Target funds offer an easy one-step way for people to put money aside for their retirement. But the way they invest doesn't match up with what some of their investors intuitively believe, which led to some nasty surprises during the market meltdown four years ago. That bad experience has some pundits arguing that target funds are more dangerous than they are valuable. But coming to that conclusion either gives investors too little credit for knowing what they're investing in, or lets those investors off the hook too easily for not doing the slightest bit of digging into the workings of their funds.

A simple solution
Target funds operate on two basic premises. First, the funds use a basic asset allocation strategy to divide money across different types of assets, typically including stocks, bonds, and sometimes some alternatives like real estate investment trusts or commodities. Second, target funds follow an age-based risk model, whereby the funds seek to cut back on risk as their specific target date approaches.

That all should seem simple enough. In a nutshell, when you still have a long time horizon left before retirement, your portfolio is pretty aggressive. Yet as you approach retirement, the fund shifts to a more conservative approach, making more of an effort to preserve capital and focusing less on growing that capital.

Where things got tricky four years ago, however, was in the different philosophies that target funds took with respect to asset allocations during retirement. Some investors expected that their target-fund investments would include very little stock exposure on or after the fund's target date, believing that since the goal had been reached, capital preservation was the only important factor. Yet many fund companies took a longer-term approach, arguing that with many retirees living 20-30 years past their retirement age, sticking their entire nest eggs in bonds or cash would make it run out a lot faster than if the funds took advantage of the historically greater returns available from stocks.

During the bull market in the mid-2000s, target-fund investors didn't mind that higher-than-expected stock exposure. But when the bottom fell out of the market in 2008, retirees and near-retirees were shocked to discover what they could have known all along: that they owned more stocks than they thought.

Retirees need stocks
It's easy to conclude that target funds were too aggressively invested. But that thinking relies only on hindsight and focuses too closely on the years when the stock market was at its worst. Since then, target funds that didn't reduce their stock allocations have mostly recovered from the downturn.

Moreover, bond yields have fallen so far that stocks are now taking their place as lucrative income providers. IBM (NYSE: IBM  ) , Microsoft (Nasdaq: MSFT  ) , and Wal-Mart (NYSE: WMT  ) have been able to convince corporate bond investors to pay 1% or less on their short-term debt, even as their shares offer far higher yields through dividends. Some even are dabbling in the high yields that European giants Telefonica (NYSE: TEF  ) and Total (NYSE: TOT  ) pay right now, even with substantial doubt about troubled economies on the continent.

Income, though, isn't the main argument for retirees owning stocks. As much as retirees may prefer to minimize risk, few of them have enough assets to warrant doing so. Rather, they need continued growth in their assets to cover living expenses years down the road. Stocks have a better chance of doing that even when bond yields are reasonably normal -- let alone at their current rock-bottom levels.

Don't miss the target
Target funds certainly have their quirks, and it's important to know exactly how your target fund invests over time. But casting them off as fundamentally flawed is short-sighted. If you understand their limitations and benefits, then target funds can serve you well.

Target funds aren't the only way to invest for retirement, though. Let me invite you to read The Motley Fool's special report on investing for retirement and learn how you can add individual stocks to create a retirement saving strategy you can prosper from. Just click here and start reading your free copy right now.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

Fool contributor Dan Caplinger knows if it isn't broken, don't fix it. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of IBM and Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft and Total, as well as creating a diagonal call position in Wal-Mart, a bull call spread position on Microsoft, and a synthetic long position in IBM. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't break you.

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  • Report this Comment On June 25, 2012, at 10:35 AM, FutureMonkey wrote:

    Targeted funds have the advantage of being immune to emotional responses to boom/bust cycles. Fear and Greed are psychological traps that can harm many investors long term performance if the investor is prone to action in response to short-term events or whatever Cramer said on Mad Money last night.

    Nice for steady eddy, dollar cost average investing in a MPT with rebalancing either at regular (not too frequent) intervals.

    Even with Target Date portfolio's with heavy equity exposure for retirees, if the targeted portfolio was rebalanced properly, the investor should be better off now than a person that didn't rebalance between asset classes or worse, panicked and bailed out of equities. Anybody that was still putting money in (close to retirement age, but not retired) probably came out of the last 5 years like a bandit!

    To me it isn't the asset class balance that gives me pause. Targeted funds have the disadvantage of charging high management fee's for something you probably can be doing on your own. That extra 1.5% bleeds quite a bit of return. People see 1.5% and they see a small number, but they reallly should be seeing the fee bleeding 20% off their return. (inflation adjusted CAGR for the market over most 20-30 year period is 7%)

    So a person needs to ask themselves if handing 20% of their return over to a manager each year is better than the risk of making a poor decision based on tendency to make emotional decisions.


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