Target-Date Funds Creating New Risks for Older Investors

Target-date funds are devising new strategies designed to help investors achieve a secure retirement. But along the way, they're introducing new risks for older investors.

What's under the hood? In recent years, many target-date funds have been trimming plain-vanilla bond holdings in favor of foreign developed and emerging-markets bonds, high-yield debt, and "unconstrained" bond strategies—which can invest anywhere in the bond market.

In the John Hancock Retirement Living Through 2015 fund (JLBAX), whose investors are just entering retirement, about 30% of the fixed-income allocation is in bonds rated BB or lower, according to Morningstar. Although high-yield bonds have been whipsawed lately, the allocation has "paid off handsomely" over the longer term because the fund added to the position in 2009, catching a major post-financial-crisis rebound, says Marcelle Daher, the fund's co-portfolio manager.

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Examining your target-date fund's underlying fund holdings can give you another view of the potential risks. The Dimensional 2020 Target Date Retirement Income fund (DRIRX), whose investors are on the brink of retirement, devotes nearly 30% of assets to DFA LTIP fund—a long-term TIPS fund that is highly sensitive to interest-rate changes and lost 26% in 2013. "I wonder if investors are prepared to see those types of losses in a bond portfolio while they're in retirement," Holt says. Dimensional says it doesn't expect its target-date funds to be more volatile than others in the industry.

How steep is the slope? A target-date fund's glide path "slope" is the rate of change in the stock allocation over time. Some target-date fund families have made their slopes a bit steeper lately, Holt says, by boosting stock allocations in the years leading up to retirement while holding them steady at the retirement date.

But a steeper slope can be riskier for investors. A fund manager who is trying to stay in line with a steep glide path may be forced to rapidly sell stocks in the years leading up to the target date, even if the market is slumping. And the fund may have difficulty recovering from those losses, since it will have relatively little exposure to any subsequent stock-market rebound.

To see an illustration of your fund's glide path, along with details on the underlying holdings, enter the fund name or ticker in the quote box at Morningstar.com and click "portfolio."