Over the next couple of weeks, six finalists will be auditioning for the opening of “staff writer” at Consumerism Commentary. Each will be providing two guest articles to share with readers. After the six writers have shared their guest articles, readers will have an opportunity to provide feedback before we select the staff writer.

This article is presented by J.J., a financial adviser and published financial author.

Target date funds are under scrutiny in Washington as lawmakers figure out if they work the way they’re supposed to.

Also known as lifecycle funds, these funds become less risky as time goes on. They’re popular in 401(k) plans and other retirement plans because they make diversification easy. You select one target date fund from your plan’s menu, and that fund spreads your money among numerous underlying funds.

Most people are told to select the fund that has a number closest to their retirement year. Plan to retire soon? You might choose the “2010 Target Date Fund.” If you’re 26 years old, you might select the “2050 Target Date Fund.”

These funds are also common in 529 college savings programs where they may be called “age based” funds. The concepts are the same, so we’ll talk in terms of retirement for now.

For some, especially those who will not put time and energy into studying their investments, target date funds are a fine choice. They offer diversification and continuous re-balancing. They may have exposure to things (alternative strategies, commodities, or sector funds) you can’t find on your plan’s menu or that you don’t have enough money to buy into.

However, they’re far from perfect. Let’s cover a few of the major problems and what you can do about them.

What’s the right mix?

There are dramatic differences in how they’re constructed. For example, consider two funds with a target year of 2010. This would be a fund designed for an older investor — planning to start spending the money within a year — who presumably does not want to take much risk.

Fund Company A’s 2010 fund might have 26% in stocks, but Fund Company B’s 2010 fund might have 72% in stocks. Indeed, that’s exactly what happens. Morningstar published a study showing equity exposure in 2010 funds, and results are all over the board. Do most 65-year-olds want 72% of their money in the stock markets?

Critics suggest fixing this problem by standardizing equity exposure for each target year, or at least requiring more understandable charts showing the fund’s risk level. Some investors may be comfortable with high risk portfolios, but they should at least know what they’re getting into.

Who’s running the money?

Target date funds are made up of 10 to 30 underlying funds. Are those funds any good?

Critics argue that some fund companies put poor funds into their target date funds to feed money into those poor funds. If that’s the case, the Large Cap Value portion of your target date fund may be run by an under-performing manager or team. Of course, this is less of a risk if the fund company only uses index (or passive) funds.

The best target date funds are probably multi-fund-family funds. For example, T. Rowe Price’s target date funds are composed entirely of T. Rowe Price mutual funds. John Hancock uses different money managers to subadvise pieces of their target date funds. This lets them use best-of-breed managers for some portions of the portfolio and index funds for other portions.

Note that I have nothing against (nor do I endorse) either of the above companies; this is just food for thought.

What about fees?

It’s always hard to tell how much you’re paying with a mutual fund. Target date funds are especially tricky because they’re made up of many underlying funds. Most companies disclose “overlay” fees, the fee for creating the mix of investments and managing it over time, in a prospectus, but few investors look under the hood.

Multi-fund-family funds may have arrangements that create potential conflicts of interest. Why is one manager used instead of another? Hopefully it’s because of superior management, but you know it’s not always that simple.

Finally, some say that target date funds have excessive equity exposure because equity funds generate more revenue. That may help explain why a 2010 fund has 72% in stocks.

What can you do?

Target date funds are designed to make life easy, so requiring you to do homework kind of defeats the purpose. However, they’re out there and they may be your only option (or the best option available to you). It pays to know how they work and how you can improve your chances:

• Ask for help. Your 401(k) provider, financial advisor, or DIY investment company should be able to help you figure out what you’re investing in.
• Look under the hood. Understand how much is in stocks, bonds, foreign assets, and other assets. Are you comfortable with that mix?
• Make changes. If you don’t like what you see, use something else. If you’re limited to your employer’s retirement plan menu, consider using other investments. Talk to the HR department about your concerns.
• Bend the rules. Target date funds are designed for you to put 100% of your money into a fund with a target date near your retirement date. You can always use a different year to increase or reduce risk, or you can put 80% into the target date fund and 20% into another fund.
• Lean on regulators. Let them know what’s important to you or hope for the best.

Tell us about your experience with target date funds. Why do you use them or avoid them?

This is a guest article by J.J., one of six finalists interested in being Consumerism Commentary’s staff writer.

Photo credit: eyeliam

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