Target date funds are popular

One part of the investing universe is growing rapidly: target date funds.

A target date fund automatically resets an employee's retirement portfolio according to a preset formula. The basic idea is that younger workers will own a mix of investments heavily weighted toward equities, international stocks and other risky assets and as they age--come closer to their retirement "target date"--the more conservative becomes the portfolio. Cash and fixed income securities make up a larger portion of the portfolio.

The percentage of all 401(k) plan participants using target date funds increased from 25 percent in 2007 to 33 percent in 2009, according to the Employee Benefits Research Institute (EBRI).

One reason for the growth is the fund relieves workers from the task of making asset allocation decisions. Another factor is that a target date fund is an acceptable "default" option in a retirement plan. In other words, if you elect to participate in a company's 401(k) or are automatically enrolled in the plan but aren't sure where to put the money the company is allowed by law to place your money in a target date fund.

The embrace of target date funds is worrisome. First of all, the underlying idea is deeply flawed. The assumption is that equities are less risky to own with time. The historical evidence is compelling that the notion is false. Uncertainty compounds with time.

Put it this way: You're an intrepid investor in 1900. Both the U.S. and Argentine equity markets looked extremely attractive. The buy-and-hold investor would have pocketed a small fortune in U.S. equities. A buy-and-hold investor would have been essentially wiped out in Argentina over the course of the century. That would hurt at retirement.

The other problem is design flaws. These funds often hold a considerable amount of equities even with a looming target date. For example, the average target-date fund with a retirement target of 2010 had half its portfolio in equities going into 2008. Fund values subsequently fell 23 percent on average during the bear market. Like all Wall Street products, not all target date funds are the same. Some are low-fee, some are high-fee. Some are relatively simple comprised of a handful of equity and fixed income index funds, plus cash. Others include everything from real estate to jink bonds.

If you do put money in a target date fund, check to see if it has low fees and a simple investment strategy.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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