Retirement funds are evolving. Now what?

Target-date funds may be a somewhat blunt instrument when it comes to retirement planning, but they have quickly become the investment of choice for 401(k) plan sponsors and participants — whether by design or by default.

A major challenge for the industry, however, is to determine what to do when target-date funds reach their targets and investors have to figure out their needs for income in retirement.

Opinion is split on whether allocations should freeze at the retirement date, continue to get more conservative or if other solutions will better address investors' needs.

"Target-date funds are not customized to individuals, while the need for retirement income is," said Jeff Holt, a fund analyst with research firm Morningstar. Companies are considering using annuities or structuring some form of guaranteed withdrawal benefit in the funds to address the looming issue. "As more people retire, I expect there will be much more emphasis on finding good solutions."

The question of what to do when funds hit their target dates won't likely slow growth in the sector.

Mathew Jensen, director of target-date strategies at Fidelity, expects that investments in target-date funds will continue to increase because investors have done well with them.

"Target dates have delivered on their promise of getting people into age-appropriate portfolios," he said. "They're a big component of defined contribution plans, because they work so well."

Since 2006, when the Pension Protection Act gave the funds a green light as a qualified default option for companies automatically enrolling employees in a 401(k) plan, assets in target-date funds have swelled from about $100 billion to more than $700 billion, according to data from Morningstar. The funds invest in stocks, bonds and other assets, with the mix determined by the age of the target investor group.

"Target-date funds aren't perfect," Holt said. "They don't accommodate individual circumstances, but they do provide a more diversified portfolio that changes over time based on age."

The market is dominated by the three biggest administrators of 401(k) plans — Vanguard, Fidelity and T. Rowe Price. Their share of assets in target-date funds has fallen in the last five years, but they still manage more than 70 percent of total assets in the funds, according to Morningstar data.

Costs associated with target-date funds have become a major issue over the past decade. The costs have declined rapidly as fund managers use cheaper underlying investing strategies (i.e., passively managed funds) and as investors gravitate toward cheaper fund managers, such as Vanguard Group.

Vanguard has an average expense ratio of 0.17 percent on its target-date funds. Since the end of 2008, the average asset-weighted expense of target-date funds industry-wide has fallen from 1.04 percent to 0.78 percent at the end of 2014, according to Holt at Morningstar.

Fund companies are also making some subtle, and not so subtle, changes to how the funds are managed. Target-date funds invest in a portfolio of stocks, bonds and, increasingly, other asset classes and tailor the mix to correspond to an individual's expected date of retirement.

The allocations follow a "glide path" over time. The further out the targeted retirement date, the more risk the fund takes. As the target date approaches, the allocations tilt more toward bonds and less-risky assets, the idea being that people nearing retirement can no longer afford big hits to their portfolio.

Increasingly, fund companies are looking to broaden the mix of assets they hold in target-date funds. "Ten years ago, the funds invested in stocks and bonds and maybe some REITs (real estate investment trusts)," Holt said. "Now we're seeing a lot more funds carving out allocations to other asset classes, like commodities, emerging markets debt and even alternative investments."

This wider diversification is a good thing, said Anne Ackerley, managing director of BlackRock's U.S. and Canada Defined Contribution Group. BlackRock added real estate and treasury inflation-protected securities (TIPS) to its target-date funds in 2007, then emerging markets securities and commodities in 2011.

"It comes down to how much diversification it adds and how much it costs to achieve it," Ackerley said. "It's a trade-off between risk, return and cost."

Some firms — most notably the largest target-date manager, Fidelity Investments — are also adding some flexibility to the allocation glide path that the funds follow, depending on market conditions.

At the end of 2013, Fidelity adjusted the target allocations across its target-date fund lineup, increasing domestic and international equity exposures and reducing allocations to bonds and short-term funds. It also gave its portfolio managers latitude to adjust allocations by 10 percent in either direction, depending on their views of the market.

"Starting points matter," Fidelity's Jensen said. "We added active asset allocation to the Freedom funds to either improve performance or reduce risk."

Jensen said the flexibility is not tactical management but rather a judgment that shorter-term outlooks for an asset class — typically, "business cycle views" — are worth considering in the allocation models. "The glide path is a living thing, and we're regularly refreshing our assumptions based on our research."

At the end of the day, the biggest benefit of target-date funds as a default option on retirement plans is not the investments they make as much as their success as a savings vehicle.

"Even the best investments can't make up for a lack of savings," Ackerley said. "Put your money in a target-date fund and contribute regularly."

She added: "It's the best thing that most people can do to prepare for retirement."

— By Andrew Osterland, special to CNBC.com

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