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Moving some target-date funds from autopilot to manual

Leslie Kramer, Special to CNBC.com
Wednesday, 23 Oct 2013 | 5:46 PM ET
Alex Slobodkin | E+ | Getty Images

Target-date funds are the fastest-growing choice in the 401(k) market. These "set it and forget it" investments are raking in the assets for good reason: They make the initial decision easy, and then run on "autopilot" through the investor's timeline to retirement.

But something notable has been happening inside the autopilot funds: Two behemoths, Fidelity Investments and T. Rowe Price, have been making pretty big adjustments, resetting the funds to "manual" in a sense. And you can learn a lot about target-date funds by taking a closer look at the changes.

1. Competition is heating up

As of September, Fidelity, T. Rowe and Vanguard Group controlled more than $400 billion of the total $546 billion in target-date fund assets, according to Lipper. Yet their dominance shows signs of vulnerability. When such funds came to prominence in 2005, the Big Three companies controlled 84 percent of assets. That's down to 74 percent.

The erosion of Fidelity's leadership position has been especially pronounced. The company controlled 61 percent of target-date fund assets in 2005 and is now down to 32 percent.

Meanwhile, even as the Big Three's overall share of the market has fallen, Vanguard and T. Rowe remain at all-time highs, with 26 percent and 17 percent, respectively.

The result of more competition means that, for an industry that tends to innovate at a glacial pace, your autopilot investment may be changing course more than you'd expect.

(Read more: Pros and cons of target-date funds)

"I wouldn't say I am 'concerned', but we need to take a close look behind the changes and make sure there is something substantive there, not just marketing." -Josh Charlson, Senior mutual fund analyst at Morningstar

2. Fund company investment philosophy makes a big difference

Fidelity has made what fund watchers consider the biggest move of all to its Freedom target-date funds, increasing equity allocation to 90 percent from 75 percent for funds at least 20 years from retirement. Lower increases in equities exposure will occur at other stages along what is known as the "glide path."

Fidelity noted an increased risk appetite among investors before making the change. "The research we do lets us monitor contribution rates ... and how that behavior might be changing over time," said Andrew Dierdorf, co-portfolio manager of Fidelity Freedom Funds. "Those are important assumptions to look at when building a glide path for a target date strategy."

In addition, Fidelity weights its expectation that bond prices to drop as interest rates rise.

"Bond real returns have historically been at 3 to 3.5 percent, but given what interest rates are today, we believe that figure will be several hundred basis points lower than what they have been," Dierdorf said.

(Read more: The new retirement age is ... never)

3. Change for the wrong or right reason?

Fund researchers expressed some skepticism about Fidelity's move.

Morningstar senior mutual fund analyst Josh Charlson noted that Fidelity's performance has lagged the past few years part because of its conservative investment approach. Its funds will now be more in line with those of Vanguard and T. Rowe Price, which already were close to 90 percent in equities for participants more than 20 years from retirement.

"I do think they looked back and saw that they lost some market share," Charlson said, adding that the change warranted looking deeper into Fidelity's methodology.

Jeff Tjornehoj, Lipper's director of fund research, said he is concerned that fund companies will all end up in a zero-sum game of "me-too" products.

"Fidelity thought years ago the competition wouldn't be so aggressive, and as markets have turned around, it will leave products in the dust if under-allocated to what's hot," he said.

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Charlson said that target-date funds about 10 years out from retirement show the most variation among fund companies and are the best place to determine their approach to risk.

"Some can be as high as 60 percent invested in equities closer to retirement, while others drop to 25 to 35 percent at that point, so it's a very different risk profile," he said.

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4. The biggest drawback could be the drawdown

Rather than changing the asset allocation of its flagship lifetime Retirement Funds, T. Rowe Price has rolled out a new series: Target Retirement Funds. In a world of way too many products, differentiating between the two series might be best described as the equivalent of choosing between Diet Coke and Coke Zero.

The change is significant, though. In the new series, 42.5 percent of assets are invested in equities at the named retirement date, compared with 55 percent for Retirement Funds. Wyatt Lee, portfolio manager in the asset allocation group, said, "Different investors have different strategies, which means they have a need for different target date designs."

In contrast to Fidelity's getting more aggressive, T. Rowe is getting more conservative, and it reveals the reason for its move in the marketing language on its website.

"Our new target-date fund series seeks to reduce volatility as you near retirement and may better support withdrawals over a shorter time period," it says.

(Read more: Training your brain to be a better investor)

"They don't want to just send you a check on the retirement date and let you take it from there. They want to manage it for rest of your natural life," said Tjornejoh at Lipper. "T. Rowe is looking to create a product that is not me-too, and if they can produce a better stream of income, it will do well."

5. "To and through" ... and in between

T. Rowe's decision also relates to the increased experimentation with the target-date concept of "to and through." Generally speaking, "to" plans are more conservative, dialing back their exposure to equities, and increasing their cash and bond position dramatically in the last few years before the investor retires.

T. Rowe is not the first company to offer a second series with a less aggressive glide path, Charlson said, but it becomes harder to distinguish between series the finer they're sliced.

"I wouldn't say I am 'concerned,' but we need to take a close look behind the changes and make sure there is something substantive there—not just marketing," he said.

Charlson said it's good that autopilot is just a figure of speech, adding that having a professional manager oversee a glide path should entail tweaks. But he said the recent activity level was high compared with previous years.

"It's a huge part of the defined contribution market now, and it's definitely been up there in terms of activity," he said.

"When they make changes it absolutely can ripple through the rest of the industry," Tjornehoj said. "And if they stumble, that's what everyone else is waiting for. It doesn't take much."

An investor must make sure that such stumbles don't also dent your portfolio along with a company's market share. It's one case in which you don't want the "me-too" effect to affect you.

—By Leslie Kramer, Special to CNBC.com

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