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How We Learned to Love Target-Date Funds in a Decade

NEW YORK (TheStreet) -- When stocks plunged in 2008, many investors felt their faith in target-date funds sorely tested, suffering deep losses in investments they'd considered safe. But doubts appear to have dissolved, as TDFs show growing appeal, especially in 401(k)s.

TDFs use a heavy allocation to stocks when an investor is young, gradually moving to a more conservative mix of stocks and bonds near and after retirement. The automatic shift eliminates one of the biggest investing hassles. The investor selects a fund with a target date matching the expected retirement year, and the fund company does the rest.

Vanguard says 55% of participants in its 401(k)s now have target-date funds, up from 2% in 2004 and 28% in 2008. About 34% of all contributions are now directed toward TDFs, compared with almost nothing in 2004 and 13% in 2008.

How come?

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One reason: after the smoke cleared in 2008, investors presumably noticed their TDFs, despite big losses, actually did better than the markets as a whole. Previously, many investors had not understood clearly that TDFs may keep a lot of the individual's holdings in stocks even after the retirement date begins, to ensure enough growth to offset inflation. Along with the stock allocation comes a risk of loss when the market dives.

Another important factor is the growing adoption of a TDF option by employers. Last year, 86% of Vanguard-managed plans offered at least one TDF, up from 13% in 2004 and 68% in 2008. In recent years, more and more plans have designated TDFs as the automatic or "default" investment choice for new participants who do not specify another option. Earlier, plans typically used a low-return money market fund as the default.

"Adoption of automatic enrollment by Vanguard plan sponsors has grown more than six-fold since 2005," Vanguard says. "Among plans with more than 1,000 participants, six in 10 have adopted the feature by 2013 and six in 10 participants are in plans with automatic enrollment."

Wider use of TDFs has reduced the ranks of participants who take the riskiest investment course of either owning no stock funds or owning only stock funds, Vanguard says.

While the chief appeal of TDFs is their ease of use, investors do have two issues to consider.

As with all mutual funds, it is important to examine fees. TDFs typically charge a fee on top of those charged by the individual stock and bond funds in the plan. Keep total fees as low as possible.

Second, investors should examine the TDF's "glide path," which is the pace at which it shifts assets from stock funds to bond funds as the participant gets older.

With the steepest glide path, "to" funds get the equity allocation at or near to zero on the retirement date. That eliminates the risk of loss from a stock market downturn but generally cuts the expected investment return to the low single digits. The fund's buying power could shrink if inflation rises.

Many experts prefer "through" funds that maintain a healthy stock fund allocation to provide bigger expected returns. Vanguard's TDFs typically have a 50% allocation to U.S. and foreign stocks for a 65-year-old investor, gradually reducing the figure to about 25% at age 72, then keeping it there.

Fortunately, investors don't have to commit for life. If a "through" TDF feels too risky at or after retirement, you can switch to other options in the 401(k) plan or, if you have left the employer, roll the 401(k) assets into an IRA, which will allow you to invest in virtually anything.

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