Target-Date Funds Are No Bargains, Study Says

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BOSTON (TheStreet) -- Investors may be losing as much as $1.3 billion a year because of target-date funds' underperforming investments and fees, according to a study by Georgia State University.

Conflicts of interest can arise when fund managers turn to their own companies' mutual funds for employee retirement plans. Target-date funds tend to select high-fee and underperforming funds, resulting in the worst-case scenario seen in research by Vallapuzha Sandhya, a doctoral student of finance at Georgia's J. Mack Robinson College of Business, data from 2003 to 2008 show.

With target-date funds, investors choose a retirement year and let the fund automatically adjust a portfolio's exposure to stocks and bonds over time. Younger investors will likely have more aggressive portfolios, with upward of 90% devoted to stocks. In theory, the portfolios become more conservative as participants age. Target-date funds are typically made up of other stocks and bond mutual funds.

There's an alternative that deserves greater consideration, Sandhya says: "Balanced funds" that can do the job as well, if not better, by mixing stocks and bonds. Unlike target-date funds, balanced funds maintain their allocations, rather than adjusting for risk profile or market conditions. Popular examples include Vanguard Group's Vanguard Wellington, T. Rowe Price's T. Rowe Price Personal Strategy Balanced and Wells Fargo'sWells Fargo Advantage WealthBuilder Growth Balanced.

But traditional target-date funds remain attractive. Assets in target-date funds have skyrocketed from just under $2 billion in 1997 to $270 billion last month, according to the Securities and Exchange Commission.

Increased popularity, however, wasn't matched by improved oversight.

With the financial meltdown of 2008, many investors found that even as they were nearing retirement, their target-date fund was heavy on equities and had impractical levels of investment risk. That exposure had a disastrous impact on assets assumed to be safe: Losses of 30% to 50% in winding down target-date funds weren't uncommon as the recession took hold. In response, the SEC proposed tougher disclosure rules.

Target-date funds need to disclose not only the asset allocation percentages in their marketing materials, but also the underlying funds in which they invest, Sandhya says.

"These funds are aimed at people too busy to focus on their investments," she says. While investors who actively manage their investments have their choice of mutual funds, those who do not are often put into target-date funds, which are approved by the Department of Labor as default options -- billed as "just set it and forget it and everything is taken care of," Sandhya says, and many believe it.

"As a concept, target-date funds are a good instrument for retirement plans. The problem lies in the way they are structured and whether they are doing the right thing for their investors," Sandhya says.

She explains that otherwise underperforming funds, which are seeing reduced inflows, can be propped up by feeding them into target-date funds. Funds with higher-than-average fees are also chosen to boost profits at the expense of investors, Sandhya says.

She is quick to point out that many target-date funds take great care to protect investors. Her research doesn't identify those using a "fund of funds" approach and investing internally, which "opens up all kinds of potential for conflicts of interest."

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