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Nine out of 10 investors in target date funds would like their investments to provide stronger protection against market losses in the years nearing and in retirement, according to a new study by ING Investment Management. That's understandable. People don't want to lose a lot of money just as they need to tap it for income.

Yet many target date funds have a relatively high exposure to stocks as investors approach retirement age, leaving them vulnerable to significant risk of investment losses. The industry's rationale: When investors retire, they are entering a 30-year time horizon, or even longer, and the equity exposure enhances the growth potential of their portfolios.

Maybe that works in theory, but in reality, it can get ugly. Back during the 2008 financial crisis, investors in 2010 target date funds took it on the chin, with several funds losing 30 percent or more of their value just two years before the projected retirement date. The average 2010 fund lost 23 percent that year, according to Morningstar. See the table of selected funds below for the gory details.

To complicate matters, plan sponsors who choose target date funds for their employees often don't understand the underlying assumptions in these funds. It seems this information is hard to get. At recent Department of Labor hearings, fund providers were unwilling to disclose them, according to an article in the current issue of Plansponsor Magazine.

A bit of history

Target date funds are an easy retirement planning solution, designed for hands-off investors who didn't want the hassle of researching funds. They're supposed to have an appropriate asset allocation for long-term investors, and as the target date draws near, they gradually become more conservative. But some are way too gradual about becoming conservative.

Target date funds are the rage within 401(k) plans because they were sanctioned as qualified default investment alternatives, or QDIAs, after the 2006 Pension Protection Act became law. Translation: Employers who automatically enroll their workers in a 401(k) plan could funnel employees' contributions into these funds without worrying too much about legal ramifications. Assets have mushroomed from $15 billion in 2002 to $381 billion last year, according to Strategic Insight.

The industry employs one of two divergent strategies with their so-called glide paths. Some fund firms engineer their funds to take people "to" their retirement by actually assuming a conservative stance, allocating less to stocks and more to bonds and cash. Others take investors "through" the target date, meaning they allocate a large amount to stocks at the target date so that the portfolio has a chance to grow. The investment firms adopting this "through" approach are hoping to keep the assets until the retiree's death.

In fact, that article in Plansponsor Magazine asserts that the majority of target date funds "are designed with the assumption that the participant is invested in the product until death."

Another study, published in the March 2010 Journal of Financial Planning, suggests that fund firms have an economic incentive to keep risky assets in these funds. That's because over time, the funds may have higher returns, which translates to higher revenues for the firms since they get a percentage of the assets.

But Josh Charlson of Morningstar doesn't buy that theory. "The argument for keeping significant allocations to equities is that investors may have many years to live post-retirement and will need capital growth to sustain their income needs. Sure, there is potentially some self-interest in holding higher-cost asset classes, but firms make money on bond funds, too. A more important consideration is probably simply holding on to investor assets in any form once they separate from a company," he says.

Whether a company employs a "to" or "through" glide path may not have any bearing on investor behavior, he adds.

Target date funds have "sticky" assets because the investors (or their employers) blithely throw money in them without having to think about it too much. And investors in these funds feel more confident with this type of investment decision, according to that ING study. A majority (53 percent) feel they will meet their retirement goals with target date funds. But 20 percent also believe that these funds will produce guaranteed income. That's just not part of the deal.

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