Target-Date Funds Enable Investors to Own a Diverse Portfolio

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Target-Date Funds Enable Investors to Own a Diverse Portfolio
Target-Date Funds Enable Investors to Own a Diverse Portfolio

Picking the right investments for your retirement savings is no easy task. There are more than 10,000 mutual funds and countless stocks and bonds on the market. But to simplify your search, consider a target-date fund.

These mutual funds are designed to serve people who will retire in a particular year such as 2020 or 2040. Holding broad collections of stocks and bonds, the funds offer one-stop shopping. By buying a single fund, you can own a diverse portfolio that should deliver competitive results and avoid the worst losses in downturns.

Because the funds are convenient solutions, they have become favorite investments for 401(k) and other retirement plans. Many employers have selected target funds as default options. Unless employees opt for other choices, plan contributions are automatically invested in target funds. Even during the financial crisis, investors continued pouring into the funds. Now the target funds rank as one of the fastest-growing fund categories, with $345 billion in assets.

Achieving diversification

A typical target fund achieves diversification by investing in a collection of other funds. T. Rowe Price Retirement 2040 invests in a group of 18 funds. Holdings include T. Rowe Price Growth Stock Fund, T. Rowe Price International Stock Fund, and T. Rowe Price New Income Fund, a bond portfolio. About 40 companies offer target funds. Top choices include Invesco Balanced-Risk 2020, Fidelity Freedom 2020, and T. Rowe Price Retirement 2020.

Funds that are designed for people who will retire in 2040 or 2050 start with big allocations to stocks. As the retirement date approaches, the portfolios gradually sell stocks and shift to bonds. Fidelity Freedom 2050 starts with 90% of assets in stocks. By the time the saver retires 40 years later, the fund will only have 49% in stocks. The shift is made automatically according to a predetermined plan. Savers need not make any decisions.

The funds aim to become more conservative as the saver ages. While stocks tend to deliver bigger returns over the long term, they are riskier than bonds.  The target funds seek to focus on bonds during the stage when aging retirees will need reliable income and can't afford to suffer big losses.

Aggressive Funds

Though all the funds become more conservative over time, they follow different strategies. Some funds are aggressive and hold relatively large stock positions, while other funds are more cautious and have large bond stakes. At the aggressive end of the spectrum is Goldman Sachs 2040, which has 85% of assets in stocks.  A more cautious choice is Fidelity Freedom 2040, which has 71% of assets in stocks.

Which fund should you take? That depends on your tolerance for volatility.  Either aggressive or cautious funds can work. But before you buy any fund, make sure you pick one that suits your temperament.

In bull markets, the aggressive funds should record the best gains. In the difficult markets of recent years, the tamer choices have done the best. The impact of the divergent approaches became clear during the third quarter of 2011. In a period when most stocks dropped sharply, the aggressive Goldman Sachs fund lost 17.7%, while the cautious Fidelity fund only dropped 13.1%.  During the past three years, the cautious Fidelity Freedom fund has returned 11.2% annually, while the Goldman Sachs choice lagged with a return of 9.4%.

When you shop for a fund, pay particular attention to the portfolio allocation after the retirement date. Some funds reach their final allocation on the retirement date. After that the allocation stays fixed—no matter how many years an investor holds the account. Other funds continue lowering their stock allocations after the retirement date.

Among funds that are aggressive after the retirement date is American Century LIVESTRONG 2050. The fund starts with 85% of assets in stocks and gradually lowers the figure to 45% on the retirement date. After that the allocation stays put. Wells Fargo Advantage DJ Target 2050 takes a different approach.

The fund starts with 85% of assets in stocks. By the retirement date, there are only 23% of assets in stocks. Then the allocation keeps shifting, so that five years after retirement only 15% of assets are in stocks.  For wary investors who worry about losing their nest eggs after retirement, a cautious choice like the Wells Fargo fund may be a sensible solution.

Conservative approaches

Faced with volatile markets, some funds have been tinkering with their allocations, shifting to more conservative approaches. But T. Rowe Price has not changed its allocation during the rough times. The company's 2055 fund has about 90% of assets in stocks. At retirement, the allocation reaches 55%.

Then the figure keeps falling, reaching 40% ten years after retirement. T. Rowe Price argues that clients should prepare for retirements that can last 30 years. To provide income for such an extended period, retirees should own stocks that can deliver long-term capital gains.

While all the target funds own stocks and bonds, some portfolios hold especially broad mixes that include specialized assets. Goldman Sachs 2020 holds emerging market bonds. Those yield more than U.S. securities and can help to diversify portfolios. The managers of Fidelity Freedom 2020 argue that retirees should prepare for inflation, which can erode the purchasing power of people living on fixed income.

For protection the Fidelity fund owns commodities. Those can rise along with inflation. Fidelity also holds inflation-protected bonds. The principal of the bonds rises along with inflation. By holding such resilient bonds, funds such as Fidelity's can achieve the goal of protecting retirement portfolios.

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