Great Retirement Funds

One of best ideas to come out of the financial-services industry in recent years is target-retirement funds. These funds allow people who know little or nothing about investing their retirement money -- and lack the time and energy to learn -- to invest in funds that allocate their money automatically among stocks, bonds and cash.

These funds typically, but not always, invest in other funds offered by the same fund firm. They've become a huge and growing percentage of 401(k) and 403(b) plans, but they can also make sense for IRAs and other retirement plans.

In a target-retirement fund, professionals decide what percentage of your money belongs in stocks and what percentage should go into bonds and cash. The pros also allocate your money between large-company stocks and small-company stocks, between foreign and U.S. stocks and between growth and value stocks.

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Most important, as you get closer to retirement, the funds adjust, gradually raising their allocation to lower-risk bonds and cash. Target-retirement funds are a whole lot easier than picking from a menu of ten or 20 funds and making your own adjustments as you grow older.

Unfortunately, as with almost any good idea, the fund industry has overdone it. There are now hundreds of target-retirement funds -- and some charge annual expenses of more than 2%. What's more, the publicized expense ratios often don't include the costs of the underlying funds. And many funds do a surprisingly bad job of allocating your money among different types of stocks.

Don't get me wrong. If you don't know much about investing, a target-retirement fund is almost always your best choice. Indeed, Congress last year passed legislation that allows employers to automatically enroll employees in 401(k) plans unless a worker opts out -- and permits employers to put employees into target-retirement funds unless a worker chooses another investment.

But only a handful of these retirement funds are truly excellent. The problem: few fund companies do everything well. Indeed, many of the best fund firms are boutiques that concentrate on running a small number of funds that employ just one or two investment styles. To run a terrific target-retirement fund, a fund company needs to be at least average at running foreign funds, domestic funds, small-company funds and large-company funds. And they need to charge low prices.

The best offerings

At the end of the day, the best in this business are familiar names: Fidelity (which dubs its entry "Freedom" funds), T. Rowe Price and Vanguard. (The American group's target funds, just launched last month, are too new for a thorough evaluation but look superb.)

Fidelity, Price and Vanguard each offer inexpensive target-retirement funds. When it comes to costs, Vanguard, as usual, is the low-price leader. For example, it charges 0.21% a year for its 2030 target fund, which is designed for investors who plan to retire in 2030. Fidelity charges 0.74% for its 2030 version and T. Rowe charges 0.76%. Those expense ratios are the total expense ratios -- those three firms charge nothing on top of the fees of the underlying funds.

All three companies are pretty good at investing in all corners of the stock and bond markets. Fidelity's stock funds have struggled a bit recently (see Tough Times for Fidelity), but they're still good funds. Both Price and Vanguard have performed admirably of late.

The Price target funds have been my favorites for years and they remain so. Reason: They invest more in stock funds than the other funds do. "We took the position that we wouldn't do what would make employees comfortable," says Jerome Clark, who runs the funds. "Instead, we decided to do what's right and communicate it to employees."

To be fair, Fidelity and Vanguard both have increased their allocations to stock funds in recent years. Still, Price puts a higher percentage of its target funds in stocks, particularly as you near retirement.

Price's 2030 fund invests 77% of assets in stocks. By contrast, Vanguard's fund puts 73% in stocks and Fidelity's has just 69% in stocks. (These statistics, provided by Morningstar, count only the percentage of the underlying stock funds actually invested in stocks.)

The Price 2010 fund, designed for someone retiring in just a few years, has 64% of its assets in stocks, compared with 56% for the like Vanguard fund and 51% for the similar Fidelity fund. "Before we settled on the allocations, we did a significant amount of modeling, focusing on 30-year periods since 1926," Clark says.

The fact is, to keep your money growing late in your working life, you'll do best to keep two-thirds or more of your money in stocks. In early retirement, you may want to cut back to 60% in stocks, and later to as little as 40% in stocks.

All three firms do a good job of allocating money to foreign stocks. In their 2030 funds, Price and Fidelity each have 20% of assets in foreign stocks, and Vanguard has 17%.

But all three do poorly at allocating money to small-company stocks. Again in the 2030 fund, Vanguard has 7% and Fidelity and Price each have 6%.

The long-term numbers show that small-company stocks tend to beat large-company stocks, and a bigger weighting in those stocks would increase diversification. No, this isn't a time to put too much in small-company stocks, but the broad-based Dow Jones Wilshire 5000 index has more than 8% in small-company stocks.

Even when the outlook for small caps was rosier than it is today, Fidelity, Price and Vanguard gave them short shrift. Nevertheless, that bad decision doesn't spoil their target funds. As places for your retirement money, they are first-class choices.

Steven T. Goldberg is an investment adviser and freelance writer.