There's more to choosing a one-stop fund than celebrity endorsement.
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By Christopher Davis | 05-09-06 | 06:00 AM | Email Article

American Century recently enlisted seven-time Tour de France winner Lance Armstrong to help sell its funds. The effort includes a splashy ad campaign urging investors to exert as much discipline in attaining their financial goals as Armstrong has in winning races and fighting cancer.

Christopher Davis is Director of Fund Analysis at Morningstar Canada.

Armstrong will perhaps add some allure to an increasingly popular, if somewhat unsexy, type of retirement-oriented investment called target-retirement funds. On May 15, 2006, American Century will rechristen its current target-retirement lineup (currently named "My Retirement" portfolios) with the LIVESTRONG moniker. (That's the same motto found on those once-ubiquitous yellow bracelets.) The firm will make an annual donation out of its own coffers to the Lance Armstrong Foundation, which raises money for cancer research. (Like Armstrong, American Century founder Jim Stowers II is a cancer survivor).

There's plenty of appeal behind target-retirement funds, also known variously as target-date or target-maturity funds, primarily because they're so easy to use. You simply pick the fund that corresponds with your retirement date, and the fund company handles the rest. Target-retirement funds are designed to provide one-stop exposure to stocks and bonds and are usually composed of other funds within a given fund family. The funds' asset allocations become increasingly conservative as an investor's retirement nears. For example, let's say you're planning on retiring in 2025. You'd buy a fund with a 2025 target date. As you approach retirement, the fund lightens up on stocks and adds more bonds.

The fact that American Century's target-retirement lineup has Armstrong's endorsement isn't reason enough to invest in the funds, however. American Century has plenty of worthy--and not so worthy--competitors to consider. In fact, target-date options vary widely between fund companies, and picking the right one could be the difference between a comfortable retirement and one that eventually leaves you running on empty. If you're thinking about investing in a target-retirement fund, here are some questions you should be asking yourself.

1. Will the fund suit my risk tolerance and help me meet my financial goals?
Funds with the same target dates can have very different asset allocations, especially in their split between stocks and bonds. American Century LIVESTRONG 2015  has 54% of its portfolio in stocks, for instance, while  Fidelity Freedom 2015  keeps nearly 60% in stocks and  T. Rowe Price Retirement 2015  sports a 70% stake. Some funds also change their asset mixes more gradually than others. At T. Rowe's target-retirement funds, stocks eventually slide to a modest 20% of assets, but only 30 years after the target date. By contrast, Vanguard's stock exposure reaches its low point--20% of assets--five to 10 years after the target date. The stock weighting at American Century's falls to 45% at the target date and holds constant for as long as shareholders own the funds.

We'd also point out that some target-retirement funds, such as Fidelity's and Vanguard's, heavily emphasize large caps while others, like American Century's and T. Rowe's, have more exposure to mid- and small caps. Foreign stocks account for nearly 30% of Putnam Retirement Ready 2040's  portfolio, while the foreign stake of TIAA-CREF Institutional Lifecycle 2040  soaks up just 13% of assets. The TIAA-CREF fund's international stake falls well short of the 20% weighting suggested by many financial advisors. Putnam's exceeds it, though that isn't necessarily cause for concern. After all, about 60% of the world's market capitalization resides outside the United States, and the weighting recommended by financial planners doesn't have much grounding in research.

Cautious types might be leery of more aggressive, stock-heavy options like T. Rowe's. After all, stocks tend to be more volatile than bonds. But don't lose sight of other risks beyond volatility. Inflation can take a heavy toll on a portfolio, especially over long periods of time. There's also the risk of outliving one's assets, particularly as life expectancies improve. T. Rowe argues investors need heavier stock exposure to guard against these risks. Still, while American Century's steady 45% post-target-date stock weighting might be acceptable for young retireees, it could bring too much volatility for someone late in their retirement to stomach.

2. How good are the underlying fund holdings?
Because most target-retirement offerings are funds of funds, the success of your target-retirement fund will hinge on the quality of its underlying investments. Thus, you'll need to do a little bit of research on each of a target-retirement vehicle's holdings, which you can find on the "Portfolio" page of a Morningstar.com fund report. Reading Morningtar's Fund Analyst Reports (free to Premium Members of Morningstar.com) is one easy way to get a grasp on whether these funds are worth their salt. If you're doing your own research, look carefully for the same attributes you'd seek in any fund--experienced management, a good long-term record, and reasonable costs.

Expenses are a big driver of fund performance over the long haul, so you want to pay special attention to costs. Even in cases where target-retirement funds don't charge any fees for putting the whole mix together, the expense ratios of the underlying holdings still pass through to shareholders. The total expense ratio, which includes the underlying holdings' expenses, is located on the "Snapshot" page of a Morningstar.com fund report. As you might expect, Vanguard is the reigning low-cost leader of the target-retirement fund universe, an outgrowth of the fact that its Target Retirement funds are composed of super-cheap index offerings. ( Vanguard Target Retirement 2035's  annual levy is an ultralow 0.21%, for instance.) On the other hand, AllianceBernstein's lineup is rife with higher-cost options. The A shares of its 2035 target-date offering weigh in at 1.25%. American Century's LIVESTRONG funds come in somewhere in between--the firms' 2035 offering costs 0.92%. We'd look for funds with total expense ratios below 1%, and as always, cheaper is better.

3. Is tax efficiency a consideration?
By and large, target-retirement funds are geared toward investors in 401(k)s and other tax-protected retirement savings vehicles like IRAs. As a result, most aren't run with tax efficiency in mind. Those that invest in aggressive, high-turnover strategies could expose investors in taxable accounts to a lot of capital gains, creating a tax headache. American Century's LIVESTRONG portfolios include several funds that fit that description, such as  American Century Growth  and  American Century Vista .

Taxable investors therefore should be looking for target-retirement funds that are comprised of low-turnover offerings. With a lineup of low-turnover--and historically tax efficient--index funds in their portfolios, Vanguard's Target Retirement offerings could make a lot of sense if you're investing in a taxable account.

4. How will the fund fit with my current holdings?
With all-in-one stock and bond exposure, target-retirement funds are designed to be an investor's only holding. Yet for many folks, this often won't be the case. It's possible that combined with your existing holdings, your new target-retirement fund could give you more exposure to certain areas of the market than you'd want. For example, if you bought one of the American Century's LIVESTRONG funds and had already owned American Century Growth, you might have more of your portfolio in large-growth stocks than you'd be comfortable with. That's because American Century Growth is the LIVESTRONG funds' large-growth holding.

To see how well a target-retirement fund might fit in your existing portfolio, you can use Morningstar.com's free Instant X-Ray tool. To use it, simply enter in the tickers and amounts of each of your holdings along with the target-retirement fund you're considering. Then click "Show Instant X-Ray." You'll get a portrait of how your portfolio would look as a whole with the new addition. Look first at the pie chart depicting the portfolio's breakdown between stocks, bonds, and cash. If you had a lot of stock investments to begin with, then the tailored asset allocation of your target-retirement fund could end up seriously out of whack.

Within Instant X-Ray, you can see stock and bond style boxes (two nine-box grids in the upper right-hand corner of the X-Ray page) illustrating the investment styles of your holdings. Don't worry if your holdings aren't spread out evenly across the nine squares, but you do want to make sure that all of your assets aren't concentrated in one or two squares of the Morningstar style box. The Instant X-Ray also shows you how the portfolio would be distributed across the various sectors of the market as well as how they compare to the S&P 500 Index. Again, don't be alarmed by modest divergences from the S&P 500, but if there are sectors where your stake would be twice the index's, then you'd want to pause.

Of course, you don't need to dump everything else you own to make room for a target-retirement fund. But at least make sure that your other investments don't undercut your efforts.

Overall, we think it makes a lot of sense to invest in a target-retirement fund. Once you pick one, they're easy, low-maintenance investments. But before you do so, make sure you do your homework. Despite their tame appearance, not all target-retirement funds are created equal.

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Christopher Davis does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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