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Will Your Target-Date Fund Hit the Target?

Morningstar weighs in on the target-date debate.

Target-date funds have come under hard scrutiny in recent months. These funds are designed to help investors prepare for retirement, and typically they invest more heavily in stocks in the decades before retirement and shift their asset mix to lean more heavily on bonds in the years immediately preceding and following retirement. Their performance in 2008 was disappointing, as the market's turmoil sparked larger-than-expected losses at many target-date funds designed for investors in or near retirement. With losses for those funds ranging from 4% to a sickening 41%, investors, legislators, and regulators have been debating the merits of target-date funds and discussing potential changes to them.

Target-date funds' recent showing has highlighted the side effects of equity-heavy portfolios for retirees and has uncovered weak spots in some fund companies' lineups. We expect those topics to figure prominently in upcoming hearings on target-date funds to be held before the Securities and Exchange Commission and Department of Labor in the coming weeks.

Let's Broaden the Debate
Morningstar welcomes discussion around what asset allocation may be suitable for retirees or near-retirees, and we, too, are homing in on the funds that truly let investors down. Yet we believe that the target-date fund debate should be broadened beyond a discussion of asset allocation. For instance, target-date funds are meant to be long-term investments, and some investors will hold the funds for decades. As a result, investors ought to consider whether a fund company has a strong history of putting shareholders first. Costs also are key, because lower expenses allow more of a fund's returns to compound year in and year out, and higher expense ratios mean that managers will need to perpetually shoulder more risk to deliver competitive returns. Assessment of funds' performance is useful, but greater transparency around fund companies' target-date series would give investors a better sense of what to expect in varying market conditions. With a deeper understanding, investors could use target-date funds more effectively, and advisors and 401(k) plan sponsors could make better decisions regarding which target-date series are most suitable for their clients.