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Mutual Funds

Target-Date Funds Get a Makeover

Critics say they're too risky and want them to cut back on stocks.

When they first came out 13 years ago, target-date funds won nearly universal acclaim. The premise was -- and remains -- simple: You pick a fund with a date closest to your anticipated time of retirement, and the fund gradually becomes more conservative as the date approaches. But the funds' designers never anticipated the 2007-09 bear market.Because stocks fell so much and because most other investments lost money during the downturn, target funds benefited little from diversification and, consequently, suffered deep losses. For instance, from the stock market's peak on October 9, 2007, through its nadir on March 9, 2009, the average 2040 target fund lost 54% -- on par with the 55% plunge in Standard & Poor's 500-stock index. More stunning were the big losses among near-term target funds. The average 2010 fund, for example, declined 34% during the bear market.

The funds have become popular, in part because of a 2006 law that deems them an appropriate default investment in 401(k) plans and the like. Target-date-fund assets now total about $152 billion, compared with $66 billion at the end of 2005. Hewitt Associates says that 77% of employers offer the funds in their retirement plans.

Some lawmakers have begun pushing federal regulators to establish asset-allocation guidelines for the funds. At a recent hearing examining the funds, Sen. Herb Kohl (D.PWis.) said that because more Americans are "relying on 401(k)s and other defined-contribution plans as their primary source for retirement savings, we need to make sure their savings are well protected with strong oversight and regulation."

Some fund sponsors aren't waiting on Washington. Charles Schwab is trimming the amount allocated to stocks in its Schwab Target 2010 fund, which sank 28% during the bear market, from 55% to 45%. The move, Schwab says, is designed to reduce risk for investors with the least amount of time to recoup their losses.

Similarly, Robert Reynolds, president of Putnam Investments, wants the industry to limit the stock allocation of near-term target-date funds. He says that a 2010 fund shouldn't hold much more than 40% of its assets in stocks. At last report, Putnam's 2010 fund, which fell 24% during the bear market, had just 32% in stocks.

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For now, none of the three biggest sponsors of no-load funds -- Fidelity, Vanguard and T. Rowe Price -- is contemplating such a move. "We are sympathetic to the losses these funds have incurred," says Jonathan Shelon, manager of Fidelity's target-date funds. "But over the long term, the strategy will work." That strategy is based on the idea that even after you retire, you will live many more years and need the growth that stocks have historically provided to tide you over.

We still like the target-date-fund concept. But, particularly after the recent unpleasantness, be sure to look under the hood because allocations can differ significantly. Among 2010 funds, for instance, T. Rowe Price's is quite aggressive: As of March 31, it had 58% in stocks and 6% in junk bonds, which are similar to stocks in terms of risk. By contrast, Vanguard Retirement 2010 had 53% in stocks and nothing in high-yield bonds at last report. Among 2050 funds, Fidelity's had 89% in stocks and 10% in junk bonds recently, while Vanguard's held 90% in stocks and nothing in junk.

Tempering risk

We have no problem endorsing funds that are essentially fully invested in stocks for a goal 40 years away. But we can understand if you feel a bit squeamish about having half of your money in stocks when retirement is almost upon you. So, although target funds are meant to be your only investment for a particular goal, you could dampen risk by moving, say, 10% of your money into a high-quality-bond fund or, if offered in your employer-sponsored retirement plan, a stable-value fund.

But don't dump your target fund entirely. Even after you retire, it's likely that you'll live another 20 years, and perhaps longer. Over that lengthy a period, chances are good that stocks will do better than any other investment class.