A target-date fund operates under an asset allocation formula that assumes you will retire in a certain year, and adjusts its asset allocation model as it gets closer to that year. The target year is identified in the name of the fund. So, for instance, if you planned to retire in or near 2010, you might have picked a fund with 2010 in its name. As the default investment option in many peoples' 401(k)s, target funds were supposed to offer investors more safety as retirement approached. Unfortunately, this has not turned out to be the case for those nearing retirement in 2009. (For background reading, see The Pros And Cons Of Target-Date Funds.)

For example, the Oppenheimer Transition 2010 funds (if you were planning to retire around 2010) took a hit to the tune of 41% in 2008, putting a serious damper on retirement hopes for some investors. That means that to get back to where you were before the crisis, your portfolio would need to go up about 67% in two years if you were planning on retiring in 2010 – and to get such a high return requires taking on more risk. The Oppenheimer Fund was not alone though, as other target date fund also suffered significant losses.

A Popular Option
Target-date funds (also known as life-cycle funds) have become increasingly popular in recent years. They have a huge appeal to investors and company-sponsored retirement plan administrators. They are marketed as packaging everything an investor needs in a single account. The money manager picks the funds, rebalances the portfolio to take a more conservative approach and minimize risk as retirement approaches, and provides ongoing oversight. With a professional money manager monitoring the portfolio for a specific goal on a specific date, investors and plan sponsors feel a certain sense of safety. The investors merely need to make their regularly scheduled deposits (taken automatically from their paychecks) and wait for retirement to arrive. The plan sponsors don't need to worry about whether their employees will have a secure, well-managed retirement nest egg. On paper, it sounded like a simple, uncomplicated solution to the age-old challenge of saving for retirement.

The Pension Protection Act of 2006 fostered much of the growth, as it permitted plan sponsors to make target-date funds the default option in company-sponsored plans. Unless investors opted out or selected different funds, their money could be channeled right into target-date funds. The approach had so much appeal that target-date funds attracted $178.1 billion at their peak, according to Morningstar data. Plan sponsors love them so much that 53% of employer-sponsored retirement plans include target date funds, according to consulting firm Greenwich Associates.

Mother of Modern Bears
All was well for target-date funds until the bear market of 2008. With a 38% decline in the Standard and Poor's 500 Index, target-date funds took a hit along with the rest of the market. Some fell more than others, as there is no standard rule for asset allocation. Target-date funds were thrust into the spotlight as investors began to wonder if their exposure to the stock market was too high. What is the right mix of stocks or bonds? When should you take a more conservative approach? How do you justify a 40%+ loss to someone who thinks retirement is one year away?

At this point, the government got involved. Committees such as the U.S. Senate's Special Committee on Aging sought increased regulations and oversight with regard to target date funds amid the financial crisis in 2008. (For more on the financial crisis, see Market Bottom: Are We There Yet?)

Vendors React
Financial services providers are not usually bigs fan of legislation, as it tends to impede sales and add to costs. In response to additional scrutiny on target date funds, a host of fund companies including Fidelity Investments, Principal Financial Group, Charles Schwab and Payden & Rygel all lowered their fees on target-date funds.

Fees, as every investor knows, detract from investment returns. Therefore, fund companies lowered fees to try to mitigate the damage done by the credit crisis to target funds/retirement funds. (For a related reading on fees, take a look at Break Free of Fees With Mutual Fund Breakpoints.)

The Verdict?
While the "set it and forget it" model has great appeal, common sense and the wisdom gained by living through a bear market argue for a more active and vigilant approach to investing.

This doesn't mean that you need to avoid target-date funds, but you should do your homework up front. When examining target-date portfolios, review the portfolio's stock market exposure and make a decision based on your level of comfort with that exposure. Keep in mind that just because you want to retire in 2030 doesn't mean you have to put your money in the 2030 fund. If you want a more conservative approach, consider the 2025 fund or the 2020 fund. If you want a more aggressive approach, take a look at the 2035 or 2040 fund.

Target-date funds, like most other investments are neither all good nor all bad. Intelligent choices need to be made based on your personal goals and risk tolerance. The best way to make those choices is to educate yourself.

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