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By timestaff
June 5, 2009

Sometimes a great notion just doesn’t live up to its promise.

That’s certainly true for target-date retirement funds, which are all-in-one portfolios that automatically shift to grow more conservative by your retirement date. A staple of 401(k) plans—and the default option for most new investors—many target funds underperformed badly in the market meltdown. The typical 2020 portfolio dropped 30% last year. Worse, many shareholders in 2010 funds, who were poised to retire, got hit with similar losses.

Question is, who’s going to fix target-date retirement funds, and how?

Cue the federal government. On June 18 a hearing on target-date funds will be jointly held by the Labor Department and the Securities and Exchange Commission, which may eventually lead to new rules for these investments.

According to SEC chairman Mary Schapiro, who laid out the agenda for the hearing before a House financial services subcommittee earlier this week, regulators will examine the different asset mixes held by target date funds, which led to widely varying results. Among 2010 funds, Schapiro noted, returns last year ranged from -3.6% to -41%. The SEC and Labor Dept. will consider “whether additional measures are needed to better align target-date funds’ asset allocations with investor expectations,” Schapiro said.

Regulators will also look closely at whether a target-date fund’s name might be “misleading or confusing to investors,” Schapiro said. Not that there’s much question about investor confusion. One recent survey (pdf) found that 62% of investors polled thought “investing in a target-date fund means you will be able to retire on the target date.”

That would seem an obvious conclusion. But instead fund companies assume you will keep your money in your target fund for another two or three decades after retirement, instead of cashing out immediately. So the funds often hold a large stake in stocks, anywhere from 40% to 70% of the portfolio, until the retirement date, only then downshifting to bonds and cash.

Why assume such a long investing timeline? For one thing, higher stock allocations enable fund groups to tout better performance records, since historically (if not lately) stocks have delivered higher returns than bonds. The strategy is also a way to make up for the poor savings habits of 401(k) participants, since many fail to contribute enough to build adequate nest eggs.

Of course, taking greater risks to chase higher returns can easily backfire—just look at last year. As one would-be hearing witness, Joseph Nagengast of Target Analytics, wrote in his comments to the SEC (pdf), “If a fund labeled 2010 is really targeted to ‘land’ at 2040, it should be re-labeled as a 2040 fund.” (You can read comments from other experts seeking to testify at the SEC’s website.)

If any reforms do result from these hearings, they would likely focus on improved disclosure of target-date risks. But regulating asset allocation is more difficult. Even financial experts disagree about the proper portfolio mix of stocks, bonds and other investments. Will a government agency be a better judge?

Still, it’s clear by now that these investing choices should not be left up to the fund companies that market target funds, or employers, who aren’t financial experts. The best solution, as some 401(k) critics have pointed out, would involve guidance from independent fiduciaries, whose only concern is the interests of the fund shareholders—perhaps a federal retirement board should take on the task, as Vanguard founder John Bogle has suggested (pdf).

Meantime, a few fund groups are seeking to get ahead of any federal regulations by making their own changes. Schwab announced last month that it was reducing the amount of stock held by its target-date funds. Its 2010 portfolio, for example, shifted from a 50% stake in stocks to 43%. Other firms that have made similar fixes include Aim and OppenheimerFunds, according to Financial Research Corp.

It’s a start.

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