In the mid-1970s, I saw the movie 2001: A Space Odyssey. I didn't understand it then, and I still haven't figured it out now. What I do vividly recall, however, is thinking just how far off the year 2001 seemed at the time.

But alas, 2001 has come and gone. Space travel, which seemed so amazing then, is taken for granted today. The same can be said about target-date funds. The first target-date funds were introduced in 1994. Back then, a target date of 2010 — the first major target date — seemed extremely far away. But here we are, just six months from 2010.

As of late 2008, approximately $26 billion was invested in 2010 target-date funds. Much of the money invested in 2010 funds belongs to the leading-edge baby boomers, who are now ready to move into the next phase of their lives.

So, with 2010 right around the corner, it makes sense to ask how 2010 funds are faring in this ugly equity environment. Are target-date funds protecting investors' assets as they approach their retirement date? Have the funds hunkered down primarily in bonds and cash, and largely sidestepped the equity market avalanche that began in 2007 and has yet to let up?

Serious flaws

Not exactly. In fact, investors are in for a big shock. The four largest 2010 target-date funds — which collectively hold about 90% of all the assets invested in 2010 funds — have each experienced quite significant losses in 2008.

>> Fidelity Freedom 2010 was down 13% year to date through Sept. 30, 2008.

>> T. Rowe Price Retirement 2010 lost 14%.

>> Vanguard Target Retirement 2010 dropped 11.2%.

>> Principal Life-Time 2010 plummeted 16.7%. *

On average, these four 2010 funds lost 13.7% year to date through Sept. 30, 2008. Consider what a loss of that magnitude translates into for a 63-year-old baby boomer who has a $500,000 account balance in the "average" 2010 fund on Jan. 1, 2008. By Sept. 30, the account value in his or her fund had dropped by $68,500.

These funds are nearly one year from reaching their target date. What will happen if investors intended to withdraw their money at the target date and purchase annuities? Isn't it true that the glide path — the dynamic asset allocation model that governs the portfolio from inception to the target date and beyond — is supposed to guard against exactly this sort of meltdown?

Ideally, the answer is yes. The reality is quite different.

Consider that the S&P 500 — with its 100% equity allocation — lost 19.3% year to date through Sept. 30, 2008. Many of these 2010 funds, which supposedly have a diversified portfolio and a risk-attenuating glide path, just barely outperformed a 100% equity portfolio.

Results like that point to both a design problem as well as a failure to manage risk properly within the fund. A stated desire to factor in boomers' increased longevity led product manufacturers to err on the side of growth rather than on asset preservation.

Too much equity

So what happened? Well, let's take a look at the equity allocation patterns, defined as the sum of U.S. equity and non-U.S. equity. The average equity allocation of the four largest 2010 target-date funds was 52.2%.

Compare this with the equity allocation and performance of the Plansponsor On Target 2010 Index, a target-date index designed and maintained by Target Date Analytics. (Full disclosure: I am a principal of Target Date Analytics.)

On Target's performance in 2008 sets a standard for how a 2010 fund should behave as it closes in on its target date. The reason is clear: The On Target 2010 Index had an equity allocation of about 8%, compared with the 52.2% average equity allocation maintained by the four largest 2010 target-date funds.

Clearly, the On Target 2010 Index has a far more conservative glide path. Through Sept. 30, 2008, the index lost only 0.8%. This prudent approach produced a year to date loss of only $4,100 in an account that had a $500,000 balance at the beginning of 2008. Remember that an S&P 500 account lost $96,450, while the top four 2010 target-date funds dropped $68,500 on average.

Target-date funds are qualified default investment alternatives within the provisions of the 2006 Pension Protection Act. A default investment vehicle should take a more conservative approach to protect investors.

Of the more than 30 2010 target-date funds in existence right now, nearly all of them are too aggressive as they approach their target dates. A target-date fund that is within five years of its end date should not be running primarily on high-octane equity fuel.

Timing is everything

Caution comes at a price, of course. The first nine months could have looked quite a bit different from the mess that has played out before us. If that time period had produced a 15% return for equities, the On Target 2010 Index would have underperformed the average 2010 fund. Not fully capturing the upside is always the price of avoiding the downside. And while maybe I'm just being cautious, that certainly seems like a reasonable approach for a 63-year-old.

Luckily, being conservative does not necessarily mean that performance will be inferior over the long run. The whole point of a glide path is to take appropriate amounts of risk at the right time, providing investors with the right results.

The Plansponsor On Target 2010 Index performed as well as the average 2010 target-date fund over the past three-, five- and 10-year time periods, as of Dec. 31, 2007. But it was not because the Index had any big upside years. Instead, it was due to the fact that the Index succeeded at avoiding any big losses. If there is a secret to investing, that truly is it.

This comparison is confined to 1998 to 2007 to remove the impact of 2008, which would obviously provide an advantage to the equity-light On Target Index. But, as its performance so far in 2008 shows, the On Target Index became more defensive at the right time — as it approached its target date. Thus, the primary goal should be asset protection, so that investors can arrive safely at the target date and then make needed plans for the retirement-income distribution phase.

It is naive and clearly dangerous for mutual fund companies to assume a target-date fund is the ideal product during the post-retirement years. The stated target date is an ending, not the beginning of a new long-term retirement period in the same fund. Investors should not have to stay in the same fund in order to recover the losses they sustained during the two years prior to the target date. If the target date is truly an ending, the asset allocation glide path must be more conservative. In other words, it should look more like the On Target Index.

Being cautious with other people's money should be the mantra when designing a target-date fund or target-date index — particularly when that person is over 60 years old. The Plansponsor On Target 2010 Index did exactly that.

Despite seeming so far away a few years ago, we really are on the doorstep of 2010. A target-date fund that fails to attenuate risk near its target date has failed in its primary purpose. Given that premise, nearly all 2010 target-date funds are failing right now. Even worse, virtually all of the target-date funds coming down the pike — 2015 funds, 2020 funds, and so on — are cut from the same cloth and will likewise experience big losses near their target dates if the equity markets decline.

To fix the problem, fund companies must retool the target-fund glide path to take less equity risk as the target date approaches. Beyond that, broader diversification will help a lot as well. But that's a topic for another article.

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Craig L. Israelsen, Ph.D., is an associate professor at Brigham Young University. He is also a principal at Target Date Analytics (www.TDBench.com) and the designer of the 7Twelve Portfolio (www.7TwelvePortfolio.com).