No-Brainer Investing Carries Risks

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The problem: You just don’t have time, the inclination or financial experience to manage your retirement investments on your own.

The solution: Invest in a “target-date” or “life-cycle” mutual fund, letting the pros deal with tricky issues like choosing the best of stocks and bonds. Except that this solution doesn’t always work in the ways investors expect. Many were shocked when funds they thought were pretty safe racked up huge losses in 2008.

These funds have become enormously popular, especially in 401(k)s and similar workplace retirement plans that cater to people who don’t want to sit down every year to move money from one holding to another.

The typical target-date fund puts most of the young investor’s money into stocks, hoping for big returns, and gradually shifts it to bonds as the retirement or college-starting date approaches and safety becomes more important.

In 2006 the U.S. Department of Labor gave 401(k) plan administrators permission to use target-date funds as a “default” option for new plan members who did not choose another investment. About 96% of plans that automatically enroll new employees use target-date funds as the default, according to a study by the Special Committee on Aging of the U.S. Senate.

But the study found that asset allocations vary widely even among funds with the same target date, so that some funds are far riskier than others. Among funds with a 2010 target date, for example, the stock portion varied from 24% to 68%. Guidelines used in the Dow Jones Target Date Indexes (Stock Quote: DJ) say a fund should have just 28% of its assets in stocks when the target date arrives, while the average 2010 fund has 45% in stocks, the report said.

The result is wide variation in performance. The study found that the Deutsche Bank DWS Target 2010 Fund (Stock Quote: KRFAX) lost just 4% in 2008, while the Oppenheimer Transition 2010 Fund (Stock Quote: OTTAX) lost 41%.

Fund company materials provided to plan participants often fail to make it clear that the funds are not intended to be completely safe on the target date, the report said. Many funds continue to hold large stock positions on the target date to improve prospects for returns large enough to allow investors to make withdrawals for many years.

Fees can also be a problem, the study found, citing an analysis by market-data firm Morningstar Inc. (Stock Quote: MORN) which found that expense ratios for target-date funds ranged from 0.19% to 1.82%, with the larger amount potentially undermining returns.

The Committee on Aging and several federal agencies are looking at ways to improve target-date funds, possibly by requiring that investors be given better written disclosures.

In the meantime, investors should lift the hood to see whether funds offered by their workplace retirement plans really fit their needs.

Expense ratios should be at the lower end of the range, not much more than 0.2% a year.

And you should use an Asset-Allocation Calculator like the one at Morningstar to figure the mix of stocks, bonds and cash that best suits your needs. If your fund’s mix is off the mark, it probably would make sense to avoid the target-date option and get the proper asset allocation by selecting an assortment of ordinary funds instead.

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