Better make that “intended.” Target-date funds geared to a 2010 retirement had lost 27% on average for the year through Dec. 11, according to fund-tracker Lipper Inc. That’s painful enough for someone nearing retirement, but investors in the most aggressive of these portfolios have seen one-third or more of their savings evaporate — stripping the shine off their golden years and possibly forcing them to work longer. Shareholders of more conservative 2010 funds have fared relatively better, down 25% or less.
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Target-date retirement funds have been billed as “set-it and forget-it” investments. These one-stop shops blend a fund company’s stock and bond offerings into a single all-purpose portfolio. Allocation to stocks and bonds is automatically rebalanced over time, and the fund is supposed to ratchet down risk gradually as retirement nears.

Target-date funds have proved enormously popular with retirement savers, and the U.S. Department of Labor has even green-lighted them as “qualified default investment alternatives” for 401(k) plans.

Yet a crucial shift in the design of some of these funds has profoundly impacted investors’ fortunes in the bear market.

A couple of years ago, leading providers boosted the equity portion of these portfolios and decided to hold this stock-heavy line well into people’s retirement years.

The strategy is rooted in the belief that retirees should have substantial amounts of money in stocks to get through old age and not outlive their money. The average 2010 target-date fund had about 48% of assets in stocks at the end of September, according to consulting group Financial Research Corp.
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Fidelity isn’t the only leading fund company to have reworked its target-date funds. Vanguard Group increased stock allocations, also in 2006, while T. Rowe Price Group Inc. has always channeled more to stocks in its retirement-oriented funds than its peers.

“We think in terms of long time periods,” said Jerome Clark, manager of T. Rowe Price’s retirement funds. “The vast majority in our modeling of the outcomes are going to be better served by a higher equity, growth-oriented approach.”

But this answer to so-called longevity risk has been costly in the bear market. The alterations that were made during a more bullish time have added to target-date funds’ troubles as the market melted down.

T. Rowe Price Retirement 2010 Fund, for example, commits about 57% of assets to stocks; it’s down 29% so far this year.

Fidelity Freedom 2010 Fund, meanwhile, keeps 47% of its portfolio in stocks and has lost 28%, while Vanguard Target Retirement 2010 Fund, with 54% in stocks, is off 23%.

The longevity argument also doesn’t fully account for investors who can’t handle gut-wrenching volatility, particularly with retirement in sight.

“There are funds on the edge in terms of their asset allocation that have lost a pretty large amount for someone close to retirement,” said Greg Carlson, a fund analyst at investment researcher Morningstar Inc. “We’ve been wary of funds like that.”

Oppenheimer Transition 2010 Fund is a prime example. The portfolio recently had 65% of assets in U.S. and international stocks, with 30% in bonds and about 5% in cash. The fund’s Class A shares are down 44% for the year, according to Morningstar.

Alliance Bernstein 2010 Retirement Strategy Fund is another stock-heavy offering, with 65% in equities, 32% in bonds and 3% in cash. Investors in its Class A shares have been hit with a 36% loss year-to-date.

Other target-date funds where shareholders have suffered above-average declines include John Hancock2 Lifecycle 2010 Fund, down 33% year-to-date, Principal LifeTime 2010 Fund, off 37%, and Putnam Retirement Ready 2010, down 30%.
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Of course, there’s no way for investors to undo the damage of the past year. But the bear market proves that people close to retirement especially have to be proactive about stock-heavy target-date funds and take a hard look at whether or not they should continue to invest in them or find a more palatable alternative.

The ratio, developed in 1969 by Nobel Prize-winning economist James Tobin, shows the Standard & Poor’s 500 Index is still too expensive relative to the cost of replacing assets, said Napier. While the 39 percent drop in the index this year pushed equity prices below replacement cost, history suggests the ratio must sink further as deflation sets in, he said. The S&P; may plunge another 55 percent to 400 by 2014, Napier said.

“The Q has come down to its average, however it’s not always stopped at the average,” said Napier, Institutional Investor’s top-ranked Asia strategist from 1997-1999. “It has tended to go significantly below that in long bear markets.”

Shares have fallen this year as the worst financial crisis since the Great Depression caused almost $1 trillion of bank losses and dragged the world’s largest economies into recessions. The MSCI World Index has tumbled 44 percent in 2008, set for the biggest annual decline in its four-decade history.
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Napier, who teaches at Edinburgh Business School and advised clients to buy oil in 2002 before it tripled, based his S&P; 500 forecast on the Q ratio for U.S. equities as well as the 10-year cyclically adjusted price-to-earnings ratio, another measure of long-term value.

Before the trough in 2014, investors are likely to see a so- called bear market rally for the next two years as central bank actions delay the onset of deflation, Napier said.

“In the long run, stocks will become even cheaper,” said Brian Shepardson, who helps manage $1.9 billion at Xenia, Ohio- based James Investment Research. The firm’s James Balanced Golden Rainbow Fund beat 98 percent of similar funds this year. “There’s a likelihood of some type of rally and further pullback surpassing the lows we’ve already set.”

The Q ratio on U.S. equities has dropped to 0.7 from a peak of 2.9 in 1999, and reaching 0.3 has always signaled the end of a bear market, said Napier, 44, the author of “Anatomy of the Bear,” a study of how business cycles change course. The Q ratio for U.S. equities has fluctuated between 0.3 and 3 in the past 130 years.

When the gauge is more than one, it indicates the market is overvaluing company assets, while a Q ratio of less than one signifies shares are undervalued because it is cheaper to buy companies than to build them from the ground up.

At the end of the four largest U.S. bear markets in 1921, 1932, 1949 and 1982, the Q ratio fell to 0.3 or lower, and history is likely to repeat, said Napier. From the 1982 trough, the S&P; 500 grew more than 14-fold to the middle of 2000, when Napier says the last bull market ended.
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Napier’s prediction for a plunge in the S&P; 500 hinges on deflation that is unlikely to materialize, according to Bob Brusca, president of Fact & Opinion Economics and a former chief of international markets at the New York Federal Reserve. Consumer prices dropped 1 percent in October. So-called core prices, which exclude food and energy, dropped just 0.1 percent, and prices will probably increase 0.7 percent in 2009, according to the median estimate of economists surveyed by Bloomberg.

“Oil and commodity prices have fallen, but we’re not seeing a widespread deflation like he’s talking about,” Brusca said in an interview in New York. “To have what he discusses, we’d have to have terrible deflation.”
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“For those who are worried about losing much of their investment almost overnight, very clearly you’d want to wait for those signals to give a much stronger case,” he said. “The bear market will have “a painful resolution, it’s just a question of how painful, over what period of time and for what parties.”

Federal Reserve Chairman Ben S. Bernanke’s indication that he will use “quantitative easing” to prevent deflation points to a stock market rally that may last for the next two years, Napier said. With quantitative easing, a tool pioneered by the Bank of Japan, central banks can stimulate inflation by printing money and flooding the market with cash in order to encourage consumers to spend.