INVESTING FOR YOUR

401(k) is about to go on auto pilot, but you want to keep your hands on the wheel.

Thanks to the Pension Protection Act signed into law last year, companies can automatically enroll employees in 401(k) plans. That's great for people who are lax when it comes to saving for retirement. What's more, much of the nest-egg money will flow into what's known as lifestyle or target-date funds diversified funds that are designed to reallocate your assets from aggressive to more conservative as you age.

It will be the latest boost to a category of funds that have already exploded in popularity.

Between 2003 and 2005, assets in these funds also known as target-retirement funds held within 401(k)s grew a whopping 141%, according to investment-research firm Cerulli Associates. Meanwhile, total 401(k) assets increased only 20%. There were only 22 target-date portfolios in 2000, according to investment-research firm Lipper, compared with 122 by year-end 2006; 49 new portfolios have been launched since the beginning of 2007 alone.

"That's definitely one of the strongest-growing investment vehicles in the industry," notes D.J. Lucey, an analyst with Cerulli. "With the PPA clarifying the suitability of lifecycle funds [for 401(k)s], I can see them growing even more substantially than they already have."

But do lifecycle funds make sense for you? True, they can be a huge improvement for folks who, left to manage their portfolios alone, end up chasing hot returns, parking their savings in money-market funds, or not saving at all, says Roy Weitz, who runs the industry watchdog FundAlarm.com. "But there's a big area between the people who do nothing, and the people who'd do something stupid," he says. "Those are the investors who might be better off on their own."

Here's why you may want to think twice before throwing your retirement stash into a target-date fund.

One Size Doesn't Fit All

Lifecycle funds make an appealing story: You put all your retirement savings in one fund, conveniently named after your planned retirement year. It's typically a fund of funds diversified across several equity and fixed-income categories, with a heavier equity stake early on that gradually shifts into more conservative investments. Typically, assets continue adjusting for five to 30 years after reaching the target date, eventually morphing into the fund family's Retirement Income fund.

In other words, this could be the only fund you'll ever buy. "It's perfect for investors going into a 401(k) plan who are not educated about investments and don't want to be," says Ellen Rinaldi, principal of the Investment Counseling and Research group at Vanguard. Yet, Rinaldi concedes, target-retirement funds aren't for everybody. "These funds are designed for a broad class of people," she says. "But not everyone fits in."

Harold Evensky, a fee-only certified financial planner in Coral Gables, Fla., has one fundamental problem with these funds: By grouping together investors based on their age alone, these funds overlook many of the factors that help determine one's appropriate asset allocation. "On average, [target-date funds] are a good answer," he says. "But people aren't average."

An employee who is near retirement and has a sizable portfolio outside of his 401(k), for example, might be able to afford a more aggressive or conservative 401(k) strategy depending on his risk tolerance than an employee whose retirement eggs are all in the 401(k) basket. Likewise, an investor whose spouse plans to work for 10 additional years could retain a higher equity stake longer than spouses who will retire together.

One way to get around this is to switch your target date, fund companies say. Go for a later-dated one if you need a more aggressive approach; choose an earlier date if you are more risk-averse. But by doing so, you're also submitting your portfolio to a reallocation strategy designed for people retiring either before or after you. If you choose a 2030 fund but plan to retire in 2020, for example, you might find yourself with a larger share of equities than you should have in your first 10 years of retirement.

Limited Choices

Target-retirement funds are sold as a "buy it and forget about it" solution. But if you're the type who likes to know what's on your investment plate, a look into your fund's holdings could leave you with an unpleasant taste.

"I've seen middling funds used in target-date funds," says Greg Carlson, an analyst with investment research firm Morningstar. One is the Fidelity Europe fund, he says. Following a management change last year, the fund's 2006 returns trailed its category by 8.4 percentage points, according to Morningstar. Year to date, its one-year return ranks it worse than 98% of its competitors. While individual investors could decide to seek a better European stock fund elsewhere, with the Freedom funds you have no choice: The fund is in all target-date portfolios, notably among the top five in 2050 and 2045. (Granted, past performance is no indication of future results and, as Fidelity Freedom Funds co-portfolio manager Jonathan Shelon points out, the idea of retirement investing is taking a long-term view. "Our job is not to chase performance," he says.)

Some target-date funds also seem to simply overstock on funds. Rather than building a portfolio around, say, five to seven solid and inexpensive funds like Vanguard, some fund companies throw in 20 or more individual funds in each of its target portfolios. That, in turn, leads to overlap. "You'll see three large-cap funds within a portfolio," says Morningstar's Carlson. "[The fund companies] say they're reducing risk. I say it dilutes returns. And once you start including too many funds, you're bound to get mediocre funds in there."

Bottom line, target-date funds are more work than you think, FundAlarm's Weitz says. "You have to at least scan the list of underlying funds and try to figure out, do they seem to be good funds and are they in the right proportion," he says. If you don't feel comfortable with the fund's choices, he recommends investing your 401(k) money in a good balanced fund and looking for diversification in your IRA.

Allocation Is in the Eye of the Beholder

Take a careful look at the asset allocations of several different target-date funds and you'll see one fund's idea of appropriate equity exposure can be vastly different from another's. T. Rowe Price starts off investors retiring in 2040 with 92.25% in equities, while at Schwab, 2040 investors get 81.67%.

At Russell, meanwhile, investors in the 2040 Strategy Fund are entirely exposed to the stock market, as its fund managers factor in "human capital" the value of your future earnings as offsetting the risk of an all-equity portfolio. "The risk you're taking is a very small part of your entire savings," says Matt Smith, managing director at Russell Retirement Services. "If you're at two years into your career, you still have 38 years to save."

Smith may have a point. In a widely-read paper published in October 2005, Thomas Fontaine, a senior portfolio manager at AllianceBernstein, pointed out that most target-date plans were too conservative in an investor's early retirement-saving stage. (Several months later, most fund companies increased the equity stake of their target-date portfolios.) Fontaine showed that a 25-year-old investor starting with a 100%-equity portfolio that slides down to 65% at age 65 could save as much as $113,000 more in 20 years, compared with a 90%-equity portfolio that gradually shifts to 35%. The difference becomes even more pronounced later in life: A 45-year-old investor with $225,000 in the aggressive plan would save more than $1 million more than a 45-year-old in the conservative one. (Granted, a prolonged bear market could limit the returns of such an aggressive portfolio. Human capital aside, Fontaine also offsets this risk by allocating a steady 10% of each portfolio to global REITs, which aren't correlated to the stock market.)

Meanwhile, Fontaine points out, many target-date plans also shift into conservative investments too rapidly. At Fidelity, for example, a 40-year-old investor will have roughly 83% of his portfolio in stocks, Vanguard allocates 87% and T. Rowe Price, 92%. AllianceBernstein's own Retirement Strategy funds keep investors out of fixed income the portfolio is made up of 90% stocks and 10% REITs until they turn 40. "We think midlife is a prime time to compound earnings dramatically," Fontaine says. "You still have 15 to 20 of your best working years ahead of you, so if you do account a market downturn, you have the wherewithal to replace that capital."

Which fund family's strategy will prove best is impossible to predict. But one thing's for sure: At the end of the day, one will win and another will lose. Question is, which one are you getting today?

"It's a big issue," Weitz says. "If you get a fund that significantly underperforms in 30 years and you could have gotten a better one today and ridden that one all the way through retirement, you've made a terrible mistake."

Target-Date Fund Retirement Glide Paths by Fund Family

% Equity Retirement year (current age)