A quiet revolution is sweeping through the mutual fund world. Over the past few years, target-date funds — prepackaged retirement funds with a mix of stocks and bonds that adjust to become more conservative as you age — have begun reshaping the retirement landscape.
Target-date funds are gobbling up money as increasing numbers of 401(k) plan administrators default employees into them: At year-end they accounted for $481 billion in assets, well more than double the $183 billion they had in 2007, according to the Investment Company Institute. Moreover, last year nearly two-thirds of the money flowing into defined-contribution plans went to target-date funds, according to Callan Associates. “Most people in the industry are envisioning that target-date funds eventually will have the majority of assets,” says Lori Lucas, who oversees Callan’s defined-contribution practice. “People don’t know what else to do with their money.”
Yet while target-date funds may appear simple, the differences in their construction can be dramatic. Some are filled with index funds, others with actively managed ones. Their asset allocations and “glide paths” — the way the asset allocation shifts as investors age — can differ greatly. Some have begun adding alternatives, like commodities and real estate, to the mix. And fees are all over the map.
Consider the differences between two of the big fund companies’ 2030 target-date funds, which are geared toward people retiring in 17 years. Vanguard Target Retirement 2030 had 78% of its assets in stocks and 22% in bonds as of March 31, while Fidelity Freedom 2030 had 63% in stocks, 29% in bonds (including inflation-protected bonds and real estate debt), and 8% in commodities. Performance? The Vanguard 2030 fund had an annualized return of 11.2% for the past three years, according to Morningstar, vs. a comparable 9.9% for the Fidelity 2030 fund.
A target-date fund may not make sense for a hands-on investor. But if you’d rather not worry about asset allocation and rebalancing, it may be a smart choice. How to pick the right one? If you’re investing through a 401(k) plan, where the vast majority of target-date assets are held, you won’t have a lot of choice. Companies typically offer one fund family’s target-date lineup — the three largest by far are Fidelity, Vanguard, and T. Rowe Price — and your only decision is what target year to pick. That year generally corresponds to your expected retirement date. But Mark Wilson, chief investment officer at the Tarbox Group, a fee-only adviser in Newport Beach, Calif., says he often chooses funds for his clients with target dates slightly beyond their expected retirement to get somewhat more aggressive portfolios.
A common mistake: Putting money in multiple target-date funds in a Chinese-menu type of approach, which muddles the focus of the funds and may create unknown risks. Says Jeremy Stempien, director of investments at Morningstar Investment Management: “Target-date funds are designed to do everything. Investors should do all, or nothing.”
This story is from the June 10, 2013 issue of Fortune.