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A popular 401(k) choice is still badly broken

February 18, 2014: 5:00 AM ET

Target-date funds did well in 2013 for all the wrong reasons.

FORTUNE -- There were cheers last week on news that the average balance of Americans' 401(k) accounts had grown to $89,300. That's not enough to retire on. But it's nearly double the average $45,519 that was in those accounts five years ago.

The problem is more and more of that money is in funds that do a poor job of insuring those retirement funds will continue to grow, namely so-called target-date funds. About half a trillion dollars are invested in these funds, up from just over $70 billion in the mid-2000s. And much of that money pours in via 401(k) accounts.

The funds are supposed to give you a pre-calibrated portfolio, usually spread between stocks and bonds, based on when you are likely to retire. The funds recalibrate that portfolio as you get closer to retirement. The closer you are to retirement, the less risky the portfolio is supposed to be. But it doesn't always work that way. And there seems to be no uniformity in how portfolios are put together. A 2015 target-date retirement fund from T. Rowe Price and Fidelity might have very different holdings of stocks and bonds, though the average investor wouldn't know that.

MORE: Goldman pushes hedge funds for your 401(k)

A few years ago, the Securities and Exchange Commission began to look into whether target-date funds mislead investors into a false sense of security. The regulator has proposed a rule to address this issue. It's up for comment and appears to be stuck there.

So, it seemed like welcome news recently when theĀ Wall Street Journal reported that target date funds had proved at least some naysayers wrong. Last year, the article said, was a "year of redemption" for the funds. Target-date funds, even those that were close to their target retirement year, did pretty well in 2013. That was a surprise to some, who worried that the funds might suffer huge losses if bonds had a bad year, which they did in 2013 -- their worst since 1994.

Good news? Not really. The funds performed well in 2013 because they didn't hold enough bonds, relative to what they should. Last year was a down year for bonds. But that is relatively rare. And the average bond fell only 2%. The stock market falls by 10 times as much in its worst years. So the funds' good performance in 2013 was not because they are safer than they seem. It's because they are riskier, putting more money in stocks than they should. That bet paid off in 2013, when the market was up 30%, but it won't always.

MORE: Is your 401(k) ripping you off?

Mutual fund companies have loaded up target-date funds with stocks because, over time, stocks tend to do better than bonds. And with more stocks, the funds on average should show higher returns over long periods. The fund companies can then tout those returns and how they are better than a competitor with the same date target fund. What you aren't told is that greater performance comes with the risk that a good portion of money you put in the fund could go poof if you happen to retire in a year, like 2008, when the market drops.

In January, for instance, when the stock market dropped, T. Rowe Price's Retirement 2015 fund (TRRGX) fell 1.7% in one month, which, if it had continued to go that way, would have been down just over 18% for the year. That would be pretty bad for anyone retiring next year. But the market recovered in February, and so did T. Rowe's retirement fund, up 1.9% in the first two weeks of February. Problem solved! Not really.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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