CHICAGO A torrent of money flowing into target-date funds suggests many retirement investors may be ignoring the risks of this key category.
These funds now represent the second-most-popular allocation after U.S. large-stock funds within defined-contribution plans like 401(k) accounts, according to pension consultant Callan Associates. Target-date assets have climbed above $500 billion, attracting $16 billion in the first two months of 2013 alone, according to Strategic Insight.
Target-date funds combine several mutual funds within one package and are managed so that they move to less risky postures as their shareholders move closer to retirement. That movement - usually from stocks to bonds - is called the fund's "glide path." The funds take aim at specific future dates, and investors are expected to buy the fund that matches their own retirement date.
Investors may find themselves automatically invested in these funds: Target-date funds are approved by the U.S. Department of Labor as a default choice in 401(k)s, so some plan managers use them whenever they automatically enroll employees.
All that might suggest the funds are fairly risk-free. But while diversification strategies can reduce risk, they don't eliminate it. Some target-date funds are much more volatile than others, depending upon their allocation. Their internal risks are poorly understood, fund expenses are high and they yield varying results. Here's what investors may be missing:
The premise behind most of the glide paths is that bonds are safer than stocks. But when interest rates rise, bond prices fall, so bond funds within target-date funds are likely to lose money. And sooner or later, either a recovering economy or improving job situation will compel the Federal Reserve to raise interest rates. A legion of market observers are warning of a decline in the bond market, which is said to be nearing the end of a 30-year bull run.
Then there's inflation. If consumer prices begin to rise more rapidly, that could hit your target-date bond holdings too. Does yours have a stake in Treasury inflation-protected securities (TIPS), which pay a premium if the cost-of-living increases? Many funds lack sufficient protection against this enemy of bond holders.
While many investors may think target-date funds reduce risk over time, they still have large exposures to the stock market. That helps retirement investors keep their portfolios growing over the long term but also leaves them vulnerable to a market sell-off. For example, the T. Rowe Price 2020 fund performed poorly in 2008, with a 33 percent loss.
That fund keeps 69 percent of its portfolio in stocks and more than 26 percent stake in bonds, with the remainder in cash, and it is almost as volatile as a broad-market S&P 500 Index fund. During bull markets, though, that aggressive stance has paid off for fund holders: It's up 8 percent year to date through May 6.
Other target market funds are less aggressive. The Schwab 2020 fund, with the lowest volatility in this group at just over 13, has a lower stake in stocks, at 58 percent with the remainder in bonds and cash. It lost 26 percent in 2008. It's up 7.5 percent year to date through May 6.
Target-date fund holders pay dearly for convenience, shelling out as much for a group of mostly passive funds as they would for an actively managed fund.
Expenses for funds with target dates ranging from 2016-2020 averaged 0.71 percent, just slightly lower than the 0.78 percent average for more than 300 U.S. active stock funds tracked by Morningstar. Furthermore, higher-priced target-date funds do not deliver better performance than the lower-priced ones, according to a study by Marc Fandetti, principal of the Meketa Investment Group in Westwood, Massachusetts.
As is often the case, the Vanguard Retirement 2020 (VTWNX) fund is a low-cost option. It charges 0.16 percent annually. Through last year the fund held 63 percent in stocks, 33 percent in bonds and the remainder in cash. It lost 27 percent in 2008 and is up 7.76 percent year to date through May 6.
Instead of the prepackaged solution, consider owning separate stock and bond index funds, so you can adjust your own allocation between them to reflect your risk tolerance.
Are you close to retirement and concerned about inflation? Look at funds that invest in real estate investment trusts (REITs), dividend-paying stocks, commodities or precious metals.
"Hedge your urgent needs," says Zvi Bodie, a finance professor at Boston University and staunch critic of premixed funds of funds. "Only risk wealth that you can afford to lose. The providers of target are not offering guarantees."
(The author is a Reuters columnist and the opinions expressed are his own.)
(Follow us @ReutersMoney or here Editing by Linda Stern and Prudence Crowther)