Some Target-Date Funds Visit the ‘Junk’ Shop

The Bloomberg story said that while John Hancock’s Lifecycle 2010 mutual fund is marketed as an investment that “becomes more conservative” for people approaching retirement age, 35% of the fund’s debt holdings in September were high-yield corporate bonds, according to Morningstar Inc.

For example, according to Bloomberg, the Hancock fund’s holdings include bonds that financed construction of a New Mexico casino hotel, Inn of the Mountain Gods, that was in default as of December 15. The U.S. default rate on high-risk, high-yield bonds was 11.28% in November, according to Standard & Poor’s.

A single bond in default is “not going to make or break the fund” because it’s a very small portion of the thousands of bonds in the fund, Bob Boyda, senior vice president in the investment management services division of John Hancock told Bloomberg. “Even if a bond is in default it may have tremendous value.”

The problem, according to Laura Pavlenko Lutton, editorial director in Morningstar’s mutual-fund research group: target-date funds may present greater risks than consumers have been aware, Bloomberg reported. The target-date funds blossomed  into a $311-billion business by 2008, a year after the U.S. Department of Labor said employers may use them as an auto-enrollment investment option for 401(k) plans.

Junk Bond Amounts 

Other 2010 retirement funds with bonds rated below investment grade include: Principal Funds LifeTime 2010 Fund, at 21% of its total debt holdings; the Fidelity Freedom 2010 at 17.1%; T Rowe Price’s Retirement 2010 Fund at 13.1%; American Funds’ American 2010 Target Date Retirement Fund at 11.4 %; and TIAA-CREF’s Lifecycle 2010 Fund at 6.6%, as of the latest portfolio disclosure, according to Morningstar.

Jonathan Shelon, manager of Fidelity Investments’ Freedom Funds, told Bloomberg that risk is only one of the concerns that someone who’s about to retire needs to consider. They also need to generate enough income to last during their retirement years, he said.

Meanwhile, Principal Financial Group and TIAA-CREF said their allocation in high-yield bonds also offers diversification, according to spokeswomen for the companies.

Bloomberg said three of the nine largest target-date fund companies don’t have any junk bonds in their 2010 or 2015 target-date funds: Vanguard Group, Wells Fargo & Co., and ING Groep NV. Their overall bond holdings range from 35% in ING’s fund to 65% in Wells Fargo’s fund.

Vanguard Group’s avoidance of high-yield bonds is “very conscious,” said John Ameriks, head of the company’s investment counseling and research group. Junk bonds wouldn’t add “significant diversification,” and would raise expenses, he said.

Junk Bond Objections 

“I am extremely disturbed by the amount of junk bonds found in many 2010 target-date funds,” said Senator Herb Kohl, a Wisconsin Democrat and committee chairman. “Stronger regulation is needed to ensure that participants on the brink of retirement are not exposed to such excessive risk.”

Kohl said in a statement he will introduce legislation to require target-date fund managers to act as fiduciaries if their plans are offered as automatic enrollment options in 401(k) plans (see Senator Says Target-Date Legislation Coming).

The Kohl announcement is available here .