They're finally investing in the wider array of products that have helped put big pension funds ahead of the pack
Target-date mutual funds were supposed to lead a revolution in retirement savings. These funds, which automatically adjust their asset mix as an investor's retirement date approaches, were seen as a way for individual investors to achieve the discipline, diversity, and typically higher returns of pension funds. Now, 15 years after the first target-date fund launched, they are finally positioned to live up to their initial promise.
What took so long? One reason is that many funds didn't previously include the range of investments that have helped the traditional pension plan—that rapidly disappearing benefit—outperform the average 401(k) retirement savings plan. Commodities, emerging-markets stocks, and even private real estate are now being thrown into the mix. Target-date funds are also gaining traction because of 2006 legislation that makes it possible to use them as the default investment option in employer-sponsored retirement plans such as 401(k)s. Through May, target-date funds held $204.2 billion in assets, up from $116 billion in 2006, with funds managing for a 2020 retirement date grabbing the biggest share of assets, according to consulting firm Financial Research.
That doesn't mean there's uniformity among providers—far from it. The mix of assets varies because "firms have very different investment philosophies," says Lynette DeWitt, research director at Financial Research.
STOCKS FOR THE LONG HAUL
One key variable among the funds is the size of their equity stakes. Conventional wisdom once held that retirees should pare equities as they move into their 60s. But AllianceBernstein and T. Rowe Price argue that people need to invest more aggressively to make their nest eggs last longer. How much stock is enough? The typical pension fund is 65% invested in equities. A study by Watson Wyatt Worldwide shows that in target-date funds, equity allocations in the year of an investor's retirement range from 20% to 65%.
The makeup of equity investments varies, too. The thinking used to be that investors with a long time horizon should focus on small-company stocks, which historically outperform large caps. Jonathan Shelon, co-manager of Fidelity Freedom Funds, says mega-caps, with their broad businesses and large international components, offer investors diversity. That's why Fidelity Investments, the largest target-date fund provider, with $94.4 billion in assets, introduced Fidelity 100 Index Fund (FOHIX) last year. It's made up of major U.S. companies and has an average market cap of $110 billion. In contrast, the Standard & Poor's (MHP) 500-stock index has an average market cap of $51 billion. Fidelity 100 gets a 10% weighting in the company's year 2050 target-date fund.
Target-date fund providers are also hiking their stakes in international equities. From 2005 to 2007 the international-equity weighting in these funds rose by as much as 7%, to a typical 17%. Managers say they want to capture a more accurate representation of global capital markets. T. Rowe Price broadened its international-equities position in target-date funds from 15% to 20% last November, beefing up investments in emerging markets such as Brazil, Russia, and China.
Real estate holdings, another pension-fund staple, are popping up in more portfolios. AllianceBernstein has put as much as 10% of its target-date fund assets in real estate, compared with 3.6% for the typical target-date fund, according to fund tracker Morningstar (MORN). Target-date providers typically invest in publicly traded real estate investment trusts (REITs), but some are now also investing directly in malls and office buildings, a common practice among pension plans.
Hedging strategies, long used in the institutional world, are also adding zest to target-date portfolios. Treasury inflation-protected securities (TIPS) and commodities have cropped up in a few target-date funds, including those offered by Fidelity and Principal Financial Group (PFG). Providers are mulling ways to invest in hedge funds and private equity, too. But these more esoteric holdings are hard to trade, which creates a problem for mutual funds that have to be priced daily. And in another step away from the traditional, Bank of America (BAC) is considering adding themed investments, such as Asian currencies, nuclear power, and water, to the mix in its target-date funds, says Dan McNamara, Bank of America's managing director for planning and investment products.
It's too soon to determine whether the improved asset allocation in these funds will boost returns or lessen risk. Pension plans outpaced 401(k) plans from 1995 to 2006, according to Watson Wyatt, with pension funds delivering a median annualized return of 10.3%, vs. 9.21% for 401(k)s. (The returns are skewed toward the largest pension funds and don't break out target-date portfolios.) Investors looking for a simpler way to build a diversified nest egg should compare the results of their current holdings to the returns of the new generation of target-date funds to decide whether ease offers more reward than effort.
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