A Perfect Solution, or a Flawed One?

A few years ago, I learned of a brilliant solution for the average American investor: the target-date mutual fund. Here was the main problem it addressed: Few people have the time or skills to study stocks, bonds, and funds and to shift assets from one to another according to our changing needs as we age.

Enter target-date funds. The idea was that if you planned to retire in 2030, you'd buy into a "2030" fund. So when 2030 is far away, the fund would own mostly stocks. But as 2030 approaches, a greater percentage of assets would go into bonds. And the fund manager takes care of all the money moves for the investor.

Take an example: The Vanguard Target Retirement 2025 (VTTVX) fund. Target-date funds often invest in a bunch of funds from the family's lineup. So this fund recently had 61% of its assets in Vanguard's Total Stock fund, 23% in one of its bond index funds, 8% in its European Stock fund, 4% in its Pacific Stock fund, and 3% in its Emerging Markets fund. That gives you exposure to lots of different types of companies:

Source: Morningstar.

Seems perfect, right? Well, not so fast. The idea sounds great in theory, but in actuality, it's a bit more complicated. In fact, a recent problem has the Securities and Exchange Commission and the Department of Labor both looking into reforming and setting standards for the target-date niche.

The problem? Some target funds proved to be riskier than their investors thought -- even funds with nearby target dates. For example, in 2008, when the overall stock market dropped by nearly 40%, 2010 target-date funds, whose shareholders are assumed to be just a year or two from retirement, lost between 4% and 40%. Now, sure, they won't all invest exactly alike, but sheesh -- that's quite a surprising range!

Nitty-gritty
Check out these allocations for 2025 funds:

Source: Morningstar.
*Plus a sales load of up to 5.75%.
**Plus a sales load of up to 4.25%.

You can see a wide range of allocations, fees, and returns. Clearly, these funds all purport to do the same thing -- invest for you and your retirement around 2025 -- but they're doing so in different ways and with different degrees of success. The difference in fees is starkest. You can pay very little, such as less than a fifth of a percent with Vanguard ($9 out of $5,000), or quite a bit, such as Putnam's 1.23% ($62 out of $5,000, plus a load of up to $288).

What to do
The lesson is to take a close look at any fund you buy into, and monitor it at least a little, over time. You don't want it straying so that it no longer invests in a way that makes you comfortable. You also want to make sure you're not volunteering much more in fees than you need to. By keeping a focus on target funds and how they fit into your overall portfolio, you'll make sure you don't get any nasty surprises down the road.

Learn more:

• Rescue Your 401(k)!
• Where Smart Investors Put Their Money
• These No-Brainer Investments Could Fail You