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Cramer on Retirement: The Trouble With Target Funds

(Editor's note: This is the third in a series of columns on retirement by Jim Cramer, founder of TheStreet, and Wally Konrad, former senior editor for Smart Money magazine. To read the first installment, click here. The second article is here.)

NEW YORK (TheStreet) -- It was supposed to be so easy.

Target-date funds were designed as the buy-and-forget investment, especially for retirement accounts.

Investors choose a fund with the target date of the year they will turn 65 or expect to retire.

A 43-year-old worker, for example, would buy shares in a fund with a target date near 2040. A 55-year-old would buy a 2022 fund. You get the idea.

As the target date comes closer, the fund automatically shifts from more aggressive to more conservative investments.

The promise of automatic asset allocation and diversification has prompted plan sponsors and participants to swarm to target funds (and their precursors, known as life-cycle funds).

Assets in target-date funds have jumped from $71 billion at the end of 2005 to nearly $378 billion at year-end 2011, according to Morningstar.

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What's more, 72% of companies offer target funds as the default investment for workers who don't specify where they want their money to go, according to a recent survey from Towers Watson.

To be fair, target funds are probably better than defaulting to a money market fund or throwing darts to pick your 401(k) options -- something plenty of 401(k) participants do, unfortunately. But like any heavily hyped investment, these things are flawed. Extremely flawed. Let me count the ways...

Performance. Target funds weren't immune to the market chaos starting in 2008. The average 2010 target fund, for instance, lost 22% in 2008 while the average target-date funds for 2036 through 2040 lost 39%, according to Morningstar. The next two years brought healthy bounce-backs for the average target date fund in every time frame, but in 2011 the group underperformed again, with almost all funds showing losses.

Actively managed target funds are particularly susceptible to poor performance, says David O'Meara, a senior investment consultant with Towers Watson. (More than 50% of target fund assets are in actively managed funds.)

There's a simple reason why they don't do well.

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