The Perfect Place to Invest for Retirement?

Updated

As interesting as I find investing, I know lots of people don't share my enthusiasm for the subject. And when it comes to saving for retirement, many investors would love just to be able to pick a simple all-in-one investment vehicle that would automatically adjust to fit their change in risk tolerance -- and then just put their retirement plan on autopilot.

That's the idea behind the target date retirement fund. These mutual funds and ETFs are designed to take investors who plan to retire in or near a certain year in the future and invest their money so that it will accumulate and grow during their working careers before getting more conservative and producing more income after they reach retirement.

A huge industry
Since the introduction of target funds in the early 1990s by Wells Fargo (NYS: WFC) and the BGI division of Barclays (NYS: BCS) , the target fund industry has shown explosive growth. With more than 40 different mutual fund families offering target funds, the category has grown from around $10 billion in 2000 to nearly $370 billion under management as of early November -- despite two bear markets in the interim. But have target funds met their shareholders' needs? Amid controversy in recent years, it's clear that the answer to that question isn't as obvious as it should be.

Even with a large roster of companies competing for target fund business, the big players in target funds are Fidelity, Vanguard, and T. Rowe Price (NAS: TROW) , which combine for more than 60% of the assets of target funds industry-wide. Vanguard alone has nearly $90 billion under management, with target funds that will soon extend all the way out to 2060, according to recent filings with the SEC.

Are the funds on target?
But a critical study of target funds from research company Lipper takes a look at some of the controversy that has arisen about the funds in recent years. Back in 2008, many target funds suffered huge losses -- even funds with target dates in the near future, which many believe should've been invested more conservatively. According to an earlier Lipper study that examined target fund prospectuses, the consensus view among fund managers was that the appropriate stock allocation for target funds at their respective target dates was 50% -- despite substantial variation among different providers.

Since the market meltdown three years ago, target funds have generally adjusted their glide paths to reduce their stock exposure more dramatically as shareholders approach retirement. Although 50% is still the most common allocation, the average has dropped from 43% in 2008 to 40% today. Moreover, the highest exposure among the funds surveyed dropped 10 percentage points, from 65% three years ago to 55% in 2011.

The other major finding is that more target funds now continue to make adjustments to asset allocations even after reaching their target date. Rather than simply putting investors into a vanilla income-producing fund or keeping the same allocation as at retirement, nearly two in three funds now make tailored adjustments designed for retirees -- motivated at least in part by wanting to retain those customers longer.

Indexing made even simpler
The key to understanding target funds is that they're usually structured as funds of funds, owning shares of the fund company's other offerings. Whether you look at traditional mutual funds or new target ETFs, if you drill down to figure out which stocks the funds own, you'll find the usual large-cap suspects, such as General Electric (NYS: GE) , Apple (NAS: AAPL) , and Procter & Gamble (NYS: PG) . And as funds approach their target dates, you'll find more emphasis on income, with both bonds and higher-dividend stocks like Merck (NYS: MRK) playing a greater role.

The biggest lesson on target funds from the market meltdown, though, is that you need to understand the way your target fund makes investment changes before a big downturn. Otherwise, you can get a nasty surprise -- one that you could have anticipated simply by reading the fund's materials.

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At the time thisarticle was published Fool contributor Dan Caplinger always strives to find perfection in investments. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Wells Fargo, T. Rowe Price, and Apple, and has created a covered strangle position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of Procter & Gamble and Apple, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy may not be perfect, but it's darn close.

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