Don't shy away from target-date funds

— -- If you live in Wethersfield, Conn., you know something about long odds. On April 7, 1971, a meteorite crashed through the roof of a house in Wethersfield, giving the occupants a rude awakening and a lifetime of bragging rights.

Well, not exactly a lifetime. Another meteor fell on Wethersfield — about a mile from the previous strike — on Nov. 8, 1982, crashing through a roof and lodging in the living-room ceiling.

The odds of two meteor strikes in the same town are long indeed. Investors in target retirement funds were hit with a long-odds event last year. Could it happen again? Sure. But even though target retirement funds have their flaws, they're still a good idea.

Target-date funds let you choose the date you want to retire. As that date approaches, the fund slowly becomes more conservative. By the time it hits its target date, it is, essentially, an income fund.

The thinking behind target-date funds makes sense. You want to have lots of stocks in your portfolio when you're young, because you'll have lots of time to make up losses. As you approach retirement, you should lighten up on stocks and increase your diversification. After all, you wouldn't want to get hit with the financial equivalent of a meteor strike just before retirement.

But that's pretty much what happened to target-date funds during the most recent bear market. Funds geared for those retiring next year sank an average 35.6% from Oct. 9, 2007 through March 9. Those marketed to people retiring in 2020 swooned an average 44.8%. What happened?

A highly improbable financial meltdown, that's what. Normally, stocks and bonds move in opposite directions. Unless your fund owned something other than ultrasafe Treasury securities, however, its bond holdings probably exploded. Bond traders dumped high-grade corporate bonds as if it were the end of the world.

"No simulations were equipped to deal with that," says Jeff Knight, head of global asset allocation for Putnam Investments.

Many target funds also diversified into international stocks, which plunged along with U.S. stocks. Real estate and commodities got hit, too. With just one exception — Treasuries — any diversification strategy fell to Earth with a thud.

Nevertheless, people who invested in 2010 target maturity funds were probably not expecting the astronomical losses some funds doled out. Oppenheimer Transition 2010 lost 54.3% during the bear market, for example, and AllianceBernstein's 2010 target fund plunged 47.1%.

"Put yourself in the place of a person who is retiring in seven months who thought he was invested in a safe target-date 2010 fund with low volatility and then lost 41% last year," Marilyn Dimitroff, chair of the Certified Financial Planner Board of Standards, testified before Congress on Thursday. "Devastating!"

The congressional hearings were aimed at fact-finding, rather than ritual public flogging. The fund industry wanted more disclosure of the funds' holdings — which would be fine if anyone read the filings that funds already provide.

The financial planner board proposes that target funds be given certain ranges of asset allocation, ensuring that a 2010 fund, for example, couldn't be 100% in stocks. The government uses a similar system in its own target funds for employees and military service people. "They have done very well," Dimitroff says.

Whether you agree with additional rules for target funds, you shouldn't ban them from your portfolio. Most times, virtually all types of investments don't sink at once.

Consider these rules when investing in a target maturity fund:

•Diversify. You shouldn't put all your assets into any one fund. You might consider bracketing your retirement age as well: Investing in a 2020 fund and a 2030 fund makes sense, because someone who retires in 2020 will probably be around in 2030, too.

•Read. If you're going to hitch your fortunes to a fund, take a few moments and read the fund's literature.

•Defend. If you're nearing retirement, build up a cash buffer, just in case the market tanks the year you retire. That way, you won't have to withdraw money from a swooning fund.

Just because target funds cratered last year doesn't mean that the concept is flawed. But if you put all your assets into one fund, your retirement fund might become a smoking crater.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com. Twitter: www.twitter.com/johnwaggoner.