Jim Cramer Explains: The 3 Troubles With Target-Date Funds

Jim CramerBy Jim Cramer

It was supposed to be so easy.

Target-date funds were designed as the buy-and-forget investment, especially for retirement accounts.

Investors choose a fund with the target date of the year they will turn 65 or expect to retire.

A 43-year-old worker, for example, would buy shares in a fund with a target date near 2040. A 55-year-old would buy a 2022 fund. You get the idea.

As the target date comes closer, the fund automatically shifts from more aggressive to more conservative investments.

The promise of automatic asset allocation and diversification has prompted plan sponsors and participants to swarm to target funds (and their precursors, known as life-cycle funds).

Assets in target-date funds have jumped from $71 billion at the end of 2005 to nearly $378 billion at year-end 2011, according to Morningstar.

What's more, 72% of companies offer target funds as the default investment for workers who don't specify where they want their money to go, according to a recent survey from Towers Watson.

To be fair, target funds are probably better than defaulting to a money market fund or throwing darts to pick your 401(k) options -- something plenty of 401(k) participants do, unfortunately. But like any heavily hyped investment, these things are flawed. Extremely flawed. Let me count the ways:

Performance. Target funds weren't immune to the market chaos starting in 2008. The average 2010 target fund, for instance, lost 22% in 2008 while the average target-date funds for 2036 through 2040 lost 39%, according to Morningstar. The next two years brought healthy bounce-backs for the average target date fund in every time frame, but in 2011 the group underperformed again, with almost all funds showing losses.

Actively managed target funds are particularly susceptible to poor performance, says David O'Meara, a senior investment consultant with Towers Watson. (More than 50% of target fund assets are in actively managed funds.)

There's a simple reason why they don't do well.

"Most fund companies don't have the skill set to outperform the market in every asset class -- large-cap, small-cap, non-U.S. equities and fixed income," O'Meara explains. "It's hard enough to outperform one market benchmark, but then when you start packaging 10 or 20 managers, most organizations are going to fail to outperform."

Fees. Most target funds are basically a fund of funds, so fees add up quickly. As always, index funds will be the least costly -- Vanguard's index target funds charge 18 basis points in expenses -- but some companies charge significantly more than 1% in expenses for actively managed target funds.

These fees take a big chunk out of your nest egg. According to a recent Towers Watson white paper, the average worker making $125,000 over the course of a career who pays $20 in fees for every $10,000 invested in target-date funds would lose three years worth of retirement income to fees. The same worker who paid $100 in fees for every $10,000 invested, would lose 15 years worth of retirement income. That's a lot of cruises and greens fees going to fund companies.

The Right Target. Making sure the target funds offering in your 401(k) are right for you takes a lot more work than simply picking the date closest to your retirement year.

The way target funds are allocated among different asset classes up to and beyond your retirement varies widely. Some may keep a majority in stock, even past retirement date. Others may move to a majority in fixed income well before you retire. Still others may invest in REITs and commodities to further diversify the fund, which can be a good thing, especially if these sectors aren't represented elsewhere in your 401(k) investment menu.

The point is investors still have to do plenty of homework to make sure their default option is invested the way they want it to be. There is no such thing as buy and forget.

Because you have to manage target funds the same way you would any other investment, why not throw yourself in completely and come up with your own investment picks that offer diversification and -- one hopes -- much higher returns.

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