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Target-Date Mutual Funds May Miss Their Mark

Washington blessed them as a way to put your 401(k) on automatic pilot and glide safely toward retirement.

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401k

But popular target-date mutual funds have badly missed the mark — and now regulators are asking why.

The Securities and Exchange Commission and the Labor Department are examining why the funds, which were supposed to become safer as their investors grew older, seemed to get riskier instead.

Big mutual fund companies like Fidelity and Vanguard promised that target-date funds would shift automatically from high-growth investments, like go-go tech stocks, toward safer ones, like bonds, as investors neared the year of retirement — a “target date,” like 2010, 2020 or 2030.

Labor Department officials evidently found the concept persuasive. In 2007, they issued an unusual rule that protects employers who automatically send workers’ 401(k) money to target funds if, later, the employees lose money. That so-called safe harbor unleashed a flood of money into the funds.

But as the stock market plummeted last year, some 2010 funds — which many investors thought would be invested safely by then to protect their nest eggs — lost 40 percent of their value. That showing was even worse than that of the Standard & Poor’s 500, which fell 38.5 percent.

Mary L. Schapiro, the chairman of the S.E.C., is now questioning whether fund companies misled investors about the risks associated with target-date funds, a concern the mutual fund industry says is unjustified.

Data collected by the S.E.C. shows that target-date funds vary widely in terms of their investment risks, even when they use similar target years or names. Even though federal officials put a stamp of approval on target-date funds, there are no clear standards about how they should work.

Funds marketed to people hoping to retire in 2010, for instance, have anywhere from 21 percent to 79 percent of their holdings in stocks, Ms. Schapiro said in a speech in New York last week, citing data collected by Morningstar .

No hard and fast rules exist for how to balance a portfolio as retirement approaches. A lot of variables come into play, including age, sources of income and appetite for risk. Some financial planners recommend that people who are at or near retirement age, and comfortable with some risk, invest about 40 percent of their portfolios in stocks.

But Ms. Schapiro said the S.E.C. was concerned that funds with the same target dates vary so widely in their investments and returns. The average 2010 fund had more than 45 percent of its holdings in stocks last year. The Fidelity Freedom 2010 Fund was 50 percent in stocks and lost a quarter of its value, according to Morningstar. The AllianceBernstein 2010 fund was 57 percent in stocks and fell by a third.

Funds leaning toward safer bonds, by contrast, fared far better. A Wells Fargo 2010 fund that was heavily invested in bonds lost just 11 percent, while a Deutsche Bank fund that also favored fixed-income investments was down just 4 percent.

“Funds with the same target date in their names can be structured, and thus perform, very differently,” Ms. Schapiro said.

Target-date funds have exploded since 2006, when Congress enabled companies to make them the automatic choice for employees who do not specify where they wanted to invest their 401(k) savings. The move, a boon for the mutual fund industry, occurred over the objections of insurance companies, whose money market-style “stable value” funds had been the default choice for 401(k) investments. About $182 billion has been poured into target-date funds, and fund companies have set up scores of them.

Now, in a reversal, a number of bills before Congress seek to provide greater disclosure of fees, more accurate marketing and improved financial advice to workers investing in target-date funds and other 401(k) funds.

“What we have is the Wild, Wild West of investing,” said David A. Krasnow, president of Pension Advisors, an asset management firm, at a hearing on June 18 held by the S.E.C. and the Labor Department. “Many people in target-date funds got run over by a truck and didn’t know why.”

Critics of target-date funds maintain that these investments are often opaque and difficult to understand. Mutual fund companies often create them by bundling existing mutual funds, some with good track records and some with worse records. This “fund of funds” concept enables mutual fund companies to collect more assets and fees, but can make it hard for investors to understand what these funds contain or how they are being charged.

Paul Schott Stevens, chief executive of the Investment Company Institute, the mutual fund trade association, defended target-date funds. The institute supports some elements of the many proposed changes, but opposes others.

“The future is bright for target-date funds, which are a useful tool,” said Mr. Stevens. “The idea was to remove the prospect that younger people would invest only in fixed income and older people only in equities. And, it does seem to have moderated that investing at the extremes. Before this, people were radically misinvested.”

Such assurances aside, the S.E.C. is looking into whether putting a date in a fund’s name should be prohibited, whether there is enough information about the risk of these funds and whether they are properly structured to provide for a safe retirement. There is also legislation calling for greater fee disclosure, more objective investment advice and the inclusion of low-cost index funds in workers’ 401(k) plans.

If regulators do not act, members of Congress say they will. One of them is Senator Herb Kohl, Democrat of Wisconsin, chairman of the Special Committee on Aging, who has been a critic of some aspects of target-date funds.

“At the end of the day, consumers need to know what they’re getting into.” Mr. Kohl said. “We’d like to see regulation, whether it’s a standardization of target-date composition, or increased clarification of information made available about the plans.”

If the combination of explosive growth and poor performance was not enough to raise alarms, another concern is that buyers of target-date funds are often the least sophisticated investors.

A study by Envestnet Asset Management and Behavioral Research Associations found a range of misconceptions, including that employees thought target-date funds would provide a guaranteed return, that their money would grow faster in target-date funds than in other investments, and that these funds allowed workers to put away less money and still be able to retire.

This conflict between perception and reality came into play at the joint S.E.C. and Labor Department hearing in Washington last week. Ms. Schapiro, the S.E.C. chairwoman, asked about the extent to which these funds “are marketed as the solution and pushed as a be-all and end-all.”

Joseph C. Nagengast, a principal at Target Date Analytics, responded that “if you read the marketing brochure, you could relax because everything will be O.K. But if you read the prospectus, it tells you to be careful.” Representative Rob Andrews, Democrat of New Jersey, worries that mutual fund companies that are advising employers on 401(k) plans are not disclosing enough about target-date funds or offering other options, like low-cost index funds.

“I’m not saying that pensions are being pillaged by greedy mutual fund companies,” said Mr. Andrews in an interview. “But I am saying that people should know how much they are paying and that investment advice should be in the best interest of the investor, not the adviser.”

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