New pension act's default funds likely to come in 4 flavors

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If you could pick just one fund for all of your retirement savings, what would it be?

Experts, editors and investors have kicked that question around for decades without a satisfactory answer, but the U.S. Department of Labor will try to at least give a partial answer in the next few months.

It's part of the fallout from the Pension Protection Act of 2006, a bill recently approved by Congress and now awaiting President Bush's signature. The issue stems from the bill encouraging employers to automatically enroll workers into their company's retirement plan.

The idea is simple: Make workers opt out of the plan - instead of having to choose to take money from their paycheck - and inertia and common sense will cut by more than half the number of workers who do not save.

Automatic enrollment requires an appropriate "default" investment, the holding spot for new retirement savings for workers who simply let the boss build their savings.

That's where the Department of Labor comes in. It must decide which type or types of fund are right for the job. It's not the same as selecting one fund from the entire universe - because each employer will use one or more issues as default picks - but it's close.

And as long as the government must answer the question of the ideal fund for someone who wants to invest with minimal effort, average investors - many looking for simple answers in managing retirement savings - should consider it, too.

The Department of Labor guidelines are expected to say that employers should deposit automatic contributions into accounts that pursue long-term capital appreciation.

Say goodbye to the traditional ultra-conservative options - money-market funds, stable-value funds and guaranteed investment contracts - that have been the default for the few employers who already have automatic enrollment.

Those picks limited the employer's liability, but didn't generate sufficient growth; the Labor Department guidelines will give employers an idea of what risks they can get into on behalf of workers.

All signs point toward just a few potential options: balanced funds, life-cycle funds, lifestyle funds and managed accounts.

Ideally, an investor would be a bit more active in building a retirement portfolio - and the Pension Protection Act encourages employers to bring in independent financial advisers to help individuals do just that - but these are the likely one-size-fits-all offerings.

Balanced funds may not pass muster. While they split assets between stocks and bonds, a balanced fund typically tilts toward whichever asset the market currently favors; the investor may not be aware of the slant. Moreover, there is no consideration of the investor's risk tolerance.

Lifestyle funds are all about comfort with risk. The focus here is asset allocation; funds come in conservative, moderate and aggressive flavors. The problem is that the choice of allocation typically doesn't change over time, but the investor's risk tolerance does.

"With a target-risk portfolio, the default could be in the middle - a moderate allocation - and that won't be right for all employees," says Kristin Gibson, director of national accounts for Russell Retirement Services.

"It's too conservative for a worker in their 20s, and may be too aggressive for someone nearing retirement. ... A true default choice for a worker's lifetime would start aggressive and become more conservative as the employee gets older."

That's why life-cycle funds - also known as target-maturity funds - are likely to be the big winner. Typically, these funds aim for a certain retirement date; workers get a portfolio appropriate for someone their age. An older worker could be in a default fund aimed at people who are retiring in four years, while the 20-something newbie gets something aimed at people whose working life will span the next four decades.

Life-cycle funds may seem the obvious choice, but they have issues, too. The vast majority of these funds are less than three years old, so the Labor Department has little performance data to see if they truly deliver.

A lot of different management styles are represented in life-cycle investing; you can find target-date funds with as few as five holdings - all index funds run by the same fund family - and as many as 1,000 (all individual securities).

That could make managed accounts attractive to some plan sponsors. Managed accounts can work like any of the other choices, depending on how they are designed.

Effectively, they are private mutual funds, pools of money that - when created for a retirement plan - can reflect the instructions of the employer. Besides that customization and personalization, their big advantage is that they tend to be low-cost alternatives to traditional funds.

"You're likely to see a lot of plans use target-date funds as a starting point, but you may see a move away from funds and toward managed accounts in time," says Steve Patterson, vice president for Charles Schwab's 401(k) business. "Of course, the easiest way to avoid worrying about the default choice - good or bad - is to actively select your investments and not let your employer do it for you."

Charles Jaffe is senior columnist for MarketWatch. He can be reached at Box 70, Cohasset, MA 02025-0070.

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