The Funds That Ate Your Retirement Really Didn't

Target-date funds, particularly those designed for investors retiring around 2010, received a lot of attention in the wake of equities' October 2007-March 2009 bear market--but for many of the wrong reasons. Investors assumed these broadly diversified investment vehicles would hold up well in a downturn. But target-date 2010 funds, for example, lost 37% in the bear market. That's a lot less than most equity indexes, but it was a steep drop for investors very close to or just entering retirement.

There were two major issues that caused 2010 funds to suffer so badly. First, many of the nonequity securities they own dropped nearly as far as stocks (even further in some cases), including high-yield bonds, convertible debt, and even some bonds rated as investment-grade. In addition, the funds tend to own healthy stakes in companies based outside the United States, which generally performed even worse than U.S.-based firms (which, as represented by the Wilshire 5000 Index, declined 55% in the bear market). For example, the MSCI EAFE Index dropped 59% and the MSCI Emerging Markets Index lost 60%. True, many target-date funds ratchet down their foreign weightings before they reach their target date, but such exposure still dragged down the funds.

Second, many target-date funds were launched during equities' rally from late 2002 to late 2007. (Indeed, 19 of the 30 target-date 2010 funds were rolled out during this period.) This surge may have made equities more attractive to managers of target-date funds when they built models (often predicated on historical asset class returns) as they were designing or tweaking the funds' glide paths. (A glide path illustrates how a target-date fund's asset allocation is scheduled to change over time.) That confidence in equities in turn possibly made the managers focus more on longevity risk--the risk that investors in the funds would run out of money in retirement. As a result, the typical 2010 fund had an equity weighting of 54% at the end of September 2007, just days before equities' peak. (That weighting has since declined to 47%.)

Mounting a Comeback
Despite suffering a sharp loss, investors who held onto their target-date 2010 funds through the bear market and the ensuing rally have generally emerged with gains--albeit modest ones. From stocks' Oct. 9, 2007, peak through Feb. 17, 2011, target-date 2010 funds gained 5% on average. And 14 of the 23 funds that were in operation through the entire period posted a gain. Meanwhile, the S&P 500 declined 7% over that period and the MSCI EAFE Index lost 17%. Fund-specific outcomes certainly varied, though.  MFS Lifetime 2010 , for example, limited its loss during the downturn with its conservative asset allocation (its stake in equities was 32% going into the bear market) and posted an 18% gain for the entire period. On the other hand,  Oppenheimer Transition 2010  put investors through the wringer. A big stock weighting and the implosion of top holding  Oppenheimer Core Bond (OPIGX) led to a stomach-churning 54% loss in the downturn, and revamping the bond fund into a more-conservative option meant it didn't perform well in the rebound. Thus, Transition 2010 is still well under water with a 21% loss since the market's peak.

What Now?
Target-date 2010 funds have turned out to be more volatile than investors expected, and some fund shops deserve criticism for the substantial risk their 2010 funds took on--particularly Oppenheimer. More broadly, firms need to balance their concerns about longevity risk and market risk so their target-date funds can hold up well in a downturn and not shake out fundholders near the bottom due to excessive volatility. There is currently some debate as to whether target-date funds should be managed with the assumption that investors will withdraw their money from them when they retire, and thus the funds should be positioned more conservatively as they near their target dates. Currently, the majority of target-date funds sport a glide path that continues well after retirement--some of the funds' equity weightings are slated to continue declining for another 10-15 years after their target dates.

However, those concerned more with longevity risk and who believe target-date funds can serve investors well into retirement can point to the fact that patient holders of 2010 funds fared respectably through this turbulent period. Furthermore, a look at target-date 2010 funds' volatility relative to that of market indexes demonstrates that their ups and downs weren't out of line, given the funds' makeup. The average standard deviation of their returns over the trailing three and five years fell almost precisely between those of the S&P 500 Index and the Barcap Aggregate Bond Index--and those benchmarks don't include the more-turbulent small-cap and emerging-markets stocks or high-yield bonds that target-date funds typically hold.

We strongly encourage investors of all stripes, no matter their risk tolerance or expectations, to look into a target-date fund's asset allocation and glide path to make sure they can handle the potential downside risk and the prospects for long-term appreciation before taking the plunge. Generally speaking, investors with a longer time horizon might be able to tolerate funds with bigger stakes in equities (emerging-markets stocks in particular) and larger weightings in high-yield bonds. Meanwhile, others might be happier with a more conservatively positioned target-date fund in which the ups and downs shouldn't be as pronounced.