Should Retirees Rely on Target-Date Funds?

NEW YORK ( TheStreet ) -- Seeking to save for retirement, investors have poured money relentlessly into target-date funds. Assets in the funds now top $500 billion, up from $160 billion in 2008, according to the Investment Company Institute.

With so much cash flowing into retirement funds, researchers are asking, if you invest faithfully in a target fund, will you have enough income to enjoy a secure retirement? The question is difficult to answer, but recent research by Morningstar suggests that most funds are on track to achieve their goals. Morningstar argues that the odds of success are greatest for funds from T. Rowe Price and other companies that follow relatively aggressive strategies.

The target funds aim to provide off-the-rack retirement portfolios. The funds hold diversified packages of stocks and bonds designed for people who will retire around certain dates such as 2020 and 2040. When the target date is more than 20 years away, the funds tend to hold most of their assets in stocks. Then as the retirement date approaches, the portfolios gradually shift away from stocks and into conservative bonds. The average 2040 fund has 75% of assets in stocks with the rest in fixed income. Funds with a date of 2015 have 40% in equities.

Each fund follows a somewhat different approach. On the more aggressive end of the spectrum is TIAA-CREF Lifecycle 2040 ( TCLOX), which has 88% of assets in stocks. A more cautious choice is Invesco Balanced-Risk Retirement 2040 ( TNDAX) with 16% in equities.

To determine which strategies are more likely to succeed, Morningstar considered how a typical worker might fare. The researchers started with a hypothetical 23-year-old employee who earns $45,000 and saves 7% annually. The worker receives 2% annual pay increases until he retires at 65. In retirement, he will receive $37,350 (in today's dollars) from Social Security, and he needs to take $13,950 from the retirement-date fund to cover other costs. The researchers assumed that equities will return 8% annually, while fixed income will return 3.5%.

To estimate how much income the worker might obtain from different target-date funds, Morningstar ran thousands of scenarios, including cases where stocks soar or plummet. In the most optimistic scenarios, the worker would die in his 90s with portfolios of more than $10 million. In the pessimistic outcomes, the saver would exhaust his entire portfolio by the time he reached his early 70s. On the whole, the odds seemed pretty good that the saver would not go broke. The saver exhausted his savings in 3% of the scenarios by the time he turned 75. In 42% of the scenarios, the assets vanished by age 95.

The T. Rowe Price portfolios had relatively high success rates. The hypothetical saver would run out of assets by age 95 in 38% of the scenarios. In comparison, savers in Fidelity's funds ran out of assets by age 95 in 43% of the scenarios. Morningstar argues that either company's approach is sound, but the researchers say that T. Rowe Price enjoys a slight advantage because the company has higher equity allocations. T. Rowe Price Retirement 2040 ( TRRDX) has 89% of assets in equities, compared with a figure of 72% for Fidelity Freedom 2040 ( FFFFX).

Morningstar notes that the more aggressive approach comes with some disadvantages. The T. Rowe Price funds are relatively volatile, and they could lag if stocks move into a persistent bear market.

Some critics worry that the target funds may prove less successful than the Morningstar study suggests. John Bogle, founder of Vanguard, argues that target-date funds hold too much fixed income. To make his argument, Bogle describes a typical investor who receives Social Security. On the day of retirement, the value of the Social Security income is comparable to a bond portfolio with $300,000 in assets. Now suppose the retiree has $300,000 in a target-date fund, Bogle says. If the fund is entirely invested in equities, then the saver will have half his assets in bonds and half in stocks -- a sound allocation. But the average target fund for retirees has only 40% in equities. That means the hypothetical retiree has 80% of assets in bonds.

Bogle warns that big holdings of bonds could prove disappointing. With yields puny these days, the future returns of bonds are likely to be small. That could spell trouble for retirees who expect target-date funds to provide reliable income.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

If you liked this article you might like