Is Your Target-Date Fund Suffering?

NEW YORK ( TheStreet) -- During the volatile markets of recent months, many target-date funds delivered disappointing results. When the S&P 500 dropped 13.9% in the third quarter, Goldman Sachs Retirement Strategy 2040 ( GRNAX) lost 17.7%, while DWS LifeCompass 2040 ( TGTAX) declined 17.0%, according to Morningstar. The showing was especially painful because target-date funds are supposed to protect assets in downturns by holding diversified mixes of stocks and bonds. But not all target-date funds trailed the S&P 500. During the quarter, Invesco Balanced-Risk Retirement 2040 ( TNDAX) returned 2.3%, while PIMCO RealRetirement 2040 ( POFAX) lost 9.7%.

The divergent returns should serve as a reminder that target-date funds vary considerably. Although the funds all aim to serve retirement savers, some portfolio managers take significant risk, while others maintain a cautious stance. Riskier funds suffered the biggest losses in the downturns.

Despite the recent setbacks, target-date funds have remained popular choices for 401(k) plans and other retirement vehicles. According to Ibbotson Associates, there are 383 target funds with $345 billion in assets.

Follow TheStreet on Twitter and become a fan on Facebook.

The funds are designed to be convenient solutions for savers who will retire in certain years such as 2020 or 2040. Funds designed for people who will retire in 2040 or 2050 start with big allocations of stocks. As the retirement date approaches, the portfolios gradually become more cautious, increasing their allocations to bonds. The thinking is that retirees must be careful because they do not have time to recover from temporary market downturns.

While portfolio managers agree about the need to gradually reduce risk, funds follow a range of strategies. Some managers argue that investors should have big allocations to stocks in order to support long retirements. At the aggressive end of the spectrum is Goldman Sachs Retirement 2040, which has 85% of assets in stocks. The big stock allocation hurt the fund during the downturn of the third quarter. But in a bull market, the Goldman Sachs fund could lead the pack. A more cautious choice is Fidelity Freedom 2040 ( FFFFX), which has 71% of assets in stocks.

Concerned about the threat of inflation, some funds hold a variety of different investments. Invesco Balanced-Risk Retirement 2020 ( AFTAX) has a big stake in commodities, which can rise along with inflation. Fidelity Freedom 2020 ( FFFDX) holds inflation-protected bonds.

Part of what separates the funds is their approach to handling the period after the retirement date. Some funds reach their final allocation on the retirement date. After that the allocation stays fixed -- no matter how many years an investor holds the account. Other funds continue lowering their stock allocation after the retirement date.

Among the more aggressive choices for retirees is American Century LIVESTRONG 2055 ( AREMX). The fund starts with about 85% of assets in stocks. When the portfolio approaches the retirement day, the stock allocation reaches 45% and then stays put. Wells Fargo Advantage DJ Target 2050 ( WFQFX) takes a more cautious approach. The fund starts with about 90% of assets in stocks. But by the retirement date, there will only be 23% of assets in stocks. The allocation keeps shifting so that five years after retirement only 15% of assets are in stocks.

Faced with volatile markets in recent years, some funds have been tinkering with their allocations, shifting to more conservative approaches. But one manager that has remained constant throughout is T. Rowe Price. The company's 2055 fund has about 90% of assets in stocks. At retirement the allocation is scheduled to shift to 55%. The figure keeps falling, reaching 40% 10 years after retirement. T. Rowe Price argues that its clients should prepare for retirements that can last 30 years. To provide income for such an extended period, retirees should own stocks that promise to deliver long-term capital gains.

Either a conservative or aggressive approach can work. But savers must shop carefully to avoid picking a fund that may produce a nasty surprise the next time that the markets drop.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.