T. Rowe Price Retirement 2040 Fund

N-CSR 1 arrpd.htm T. ROWE PRICE RETIREMENT 2040 FUND T. Rowe Price Retirement 2040 Fund - May 31, 2006

Item 1: Report to Shareholders

Retirement 2040 Fund

May 31, 2006

The views and opinions in this report were current as of May 31, 2006. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the fund’s future investment intent. The report is certified under the Sarbanes-Oxley Act of 2002, which requires mutual funds and other public companies to affirm that, to the best of their knowledge, the information in their financial reports is fairly and accurately stated in all material respects.

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Fellow Shareholders

U.S. stocks rose modestly in the last six months but produced stronger gains during the one-year period ended May 31, 2006. Returns were trimmed by a stock market decline in May sparked by fears that rising inflation would force the Federal Reserve to lift short-term interest rates higher than investors expected. Investment-grade bond returns were lower for the year as interest rates rose across all maturities and as the Fed gradually raised the fed funds target rate from 3.00% to 5.00% . Despite weakening in May, non-U.S. stocks strongly outpaced their U.S. counterparts in both periods, with emerging markets producing excellent results. The Retirement Funds generated solid returns during the past six and 12 months, benefiting from their broad diversification and our tactical decision to overweight stocks relative to bonds.

MARKET ENVIRONMENT

The economy accelerated at the beginning of 2006, expanding at a robust annualized rate of 5.3% in the first quarter (according to current estimates) versus a sluggish 1.7% in the final quarter of 2005 in the wake of last year’s Gulf Coast hurricanes. Manufacturing activity was sturdy, business and consumer spending patterns appeared to be healthy, and the unemployment rate dipped to 4.6% in May amid strong job growth. The red-hot housing market cooled off without a significant economic impact, and inflation remained generally contained, with few signs that elevated energy costs have passed through to other prices.

Nevertheless, central bank officials believe that stronger-than-expected economic growth and a renewed increase in energy costs have the potential to push inflation higher. The Federal Reserve—now led by Ben Bernanke following Alan Greenspan’s retirement at the end of January—raised the federal funds target rate in the last six months from 4.00% to 5.00%, a level the short-term benchmark has not seen in five years. The central bank has now lifted the target rate 16 times since mid-2004.

As shown in the graph on page 1, money market yields rose in tandem with the fed funds rate, increasing by approximately two percentage points over the last 12 months. Intermediate-term rates and long-term rates rose to a lesser extent. As a result, the yield difference across the maturity spectrum narrowed—also known as a flattening of the Treasury yield curve.

Despite rising interest rates and commodity prices, U.S. stocks rose over the last year, supported by solid economic and corporate profit growth and merger activity. Small- and mid-cap shares topped their larger peers. As measured by various Russell indexes, value stocks generally outperformed their growth counterparts across all market capitalizations in both the 6- and 12-month periods, though small-cap growth and value stocks fared about the same over the year. Non-U.S. stocks outpaced U.S. equities in both periods, led by emerging market equities, though Japanese and European stocks also did well. As in the U.S., value stocks tended to outperform growth internationally.

Investment-grade bond returns were narrowly mixed in both the 6- and 12-month periods ended May 31, as falling bond prices in a rising interest rate environment offset income. In both periods, municipal and mortgage- and asset-backed securities produced modest gains, but Treasuries and investment-grade corporate bonds declined, particularly long-term issues. High-yield bonds significantly outperformed investment-grade securities. The Lehman Brothers U.S. Aggregate Index, which measures the performance of domestic investment-grade taxable bonds, was flat over the final six months of our fiscal year and declined modestly for the year.

STRATEGY AND PERFORMANCE

As life expectancies have increased and traditional company pensions have diminished, more of the burden of retirement saving now falls on individuals, who face the specter of retirees outliving their assets. Our Retirement Funds help investors address this new retirement landscape. The funds are designed to provide shareholders a single, diversified portfolio that is managed to a specific retirement date and continues to provide appropriate asset allocation throughout retirement. Each Retirement Fund offers exposure to different asset classes and market capitalizations. The funds include international as well as domestic investments, and both growth and value investment styles. The funds are “funds of funds,” achieving their diversification by investing in other T. Rowe Price mutual funds.

The target-date funds systematically shift their allocations over time, investing in an appropriate proportion of stock and bond funds as the target retirement date draws near. The closer each fund gets to the stated retirement date, the more conservative its asset mix becomes, placing a greater emphasis on income and reducing investors’ overall risk. These shifts are intended to facilitate the accumulation of assets prior to retirement, as well as help investors manage their assets after retiring.

What makes our funds different is that we think investors need a greater allocation to stocks than has generally been recommended—both before and during retirement—to achieve their long-term retirement goals. Where many similar strategies reach a stable, typically very conservative allocation to stocks shortly after they reach their target date, our funds have approximately 55% in stocks at their target dates, and that allocation gradually diminishes over the next three decades. About 30 years after its designated retirement year, each fund will reach and maintain an allocation of about 20% in stocks. The Retirement 2005 Fund, for example, reached its target date during the first half of our fiscal year and continued its gradual equity reduction. At the other end of the spectrum, the Retirement 2035, 2040, and 2045 Funds are at their highest equity allocation of approximately 90%. For all target-date funds, the remaining assets are invested in fixed-income securities, including short-term securities. For those who prefer a more traditional asset allocation strategy, the Retirement Income Fund maintains an asset allocation of about 60% bonds and 40% stocks.

The funds’ managers may make some limited “tactical” variations to each fund’s target allocation. The T. Rowe Price Asset Allocation Committee considers adjustments to the weightings of stocks, bonds, and money market securities within the appropriate ranges for each fund, based on market conditions and economic fundamentals.

We believe the funds offer a convenient approach to retirement investing because investors do not have to determine a suitable asset allocation strategy, select the funds to implement the strategy, worry about managing the asset allocation strategy over time, or make tactical adjustments in response to changing market conditions. Since the underlying funds invest domestically and internationally in a wide range of equity and bond market sectors, investors gain the benefits of diversification as well as the expertise of individual fund managers who invest in these areas on a daily basis. (Of course, diversification cannot protect against loss in a declining market or assure a profit.) Fund expenses are limited to the expenses of the underlying funds, so there is no additional management fee charged for the asset allocation services provided to the fund.

STRATEGY REVIEW

The Retirement Funds began the fiscal year with a 3.5% tactical overweight to stocks, but the Asset Allocation Committee reduced that overweight to 3% in early November. In May 2006, the committee further reduced the overweight to 2.75% . We believe equities should perform better than bonds over the next couple of years, and corporate profit growth is still at solid levels. Our marginally lower tactical allocation is based on our belief that profit growth is likely to continue decelerating due to higher interest rates and higher energy prices. Our international equity allocation was neutral relative to the broad non-U.S. benchmark. International market valuations appear reasonable, as productivity increases are helping to maintain earnings growth despite modest revenue growth.

We continued to underweight fixed-income funds. We have been cautious on investment-grade bonds because of the challenging interest rate environment, and we reduced our exposure to high-yield debt because of rich valuations within that sector. In general, high-yield fundamentals remain favorable with good corporate profits and historically low corporate default rates. Within the short-term fixed-income sector, we had roughly 85% of assets in the Summit Cash Reserves Fund and 15% in the Short-Term Bond Fund, as the Fed’s measured pace of rate hikes made money markets more attractive than short-term bonds. With the Fed closer to the end than the beginning of its rate hike cycle, we began to increase our short-term bond allocation in May 2006. The higher money fund allocation positioned us to quickly take advantage of the Fed’s short-term rate hikes. A greater allocation to short-term bonds now allows us to extend this yield advantage for a longer time.

PERFORMANCE REVIEW

We believe the Retirement Funds’ performance is best benchmarked against each fund’s combined index portfolio, as shown in the Performance Comparison tables. For comparison purposes, we also show the recently developed Dow Jones target-date benchmarks. However, these indexes are not an exact fit, because their allocation shifts do not match ours and because their construction tends to overweight certain sectors beyond their true weight relative to the overall market. They also have less exposure to stocks than our funds as retirement nears and during the retirement years.

In contrast, our combined index benchmarks are constructed to reflect our actual strategy. The domestic equity allocation (composed of the Growth Stock, Value, Equity Index 500, Mid-Cap Growth, Mid-Cap Value, New Horizons, Small-Cap Stock, and Small-Cap Value Funds) is benchmarked to the Dow Jones Wilshire 5000 Composite Index, which tracks the entire U.S. equity market. The corresponding index for our non-U.S. stock allocation (International Stock and International Growth & Income Funds) is the MSCI EAFE Index. Fixed-income (New Income and High Yield Funds) is measured against the Lehman Brothers U.S. Aggregate Index, and short-term fixed-income (Short-Term Bond and Summit Cash Reserves Funds) by the Citigroup 90-Day U.S. Treasury Bill Index. Tactical allocations between equities and fixed income are not incorporated into the combined index benchmarks.

In general, the Retirement Funds benefited from their overweight in stocks relative to fixed income as both domestic and non-U.S. equities outperformed investment-grade bonds for both the 6- and 12-month periods ended May 31, 2006. During both periods, the high-yield sector outperformed the investment-grade sector, which also helped performance.

Within the domestic equity portion of the portfolios, all our underlying funds posted gains for both the six months and year and generally outperformed the Dow Jones Wilshire 5000. (For performance variations, please see the individual fund commentaries.) The Small-Cap Stock, Mid-Cap Growth, and Mid-Cap Value Funds provided the strongest absolute returns for the 12-month period, while Mid-Cap Value, Value, and Small-Cap Stock recorded the best absolute returns for the six-month period. Relative to their benchmarks, Growth Stock and Mid-Cap Growth had the strongest returns for the year; for the six-month period, the Growth Stock Fund registered the best relative results. On the downside, Mid-Cap Value lagged its benchmark for both periods, and Small-Cap Stock trailed its benchmark for the most recent six months.

Among international stocks, our holdings generated strong absolute returns for both periods. On a relative basis, returns were mixed as the value-oriented International Growth & Income Fund outperformed the MSCI EAFE Index for both periods, while the International Stock Fund lagged the benchmark. Overall, international stocks detracted from relative performance of our funds.

Returns were mixed for our fixed-income holdings. The New Income Fund’s returns were modestly negative. The fund performed in line with the Lehman Brothers U.S. Aggregate Index for the fiscal year and lagged the benchmark for the six-month period. The High Yield Fund posted gains and outperformed the Lehman index during both periods, which helped portfolio performance. Despite our decision to overweight Summit Cash Reserves, our overall short-term fixed-income allocation hampered results as the Short-Term Bond Fund lagged the Citigroup 90-Day U.S. Treasury Bill Index.

RETIREMENT INCOME FUND

The Retirement Income Fund’s investment objective is to generate the highest total return consistent with an emphasis on both capital growth and income. The neutral allocation for the fund is 60% bonds and 40% stocks. The fund implements its strategy by investing in a set of underlying T. Rowe Price mutual funds.

The Retirement Income Fund returned 2.88% over the six months ended May 31, 2006, outperforming its combined index portfolio but lagging its Dow Jones benchmark, as shown in the table. The fund returned 7.03% for the fiscal year, outperforming both its combined index benchmark and the Dow Jones index. Returns for the fund’s Advisor and R Class shares were slightly lower, reflecting their additional expenses.

The fund’s results relative to its combined index benchmark were primarily due to the good performance of our fixed-income allocations during both the 6- and 12-month periods, especially our high-yield holding. Our overall short-term fixed-income allocation hampered relative results as money market securities benefited from rising rates while short-term bonds were weak. Although overweighting domestic stocks versus bonds was a plus, our U.S. equity allocation narrowly underperformed its benchmark during both periods. The international equity allocation aided absolute returns but trailed its benchmark during both periods because of weakness in our non-U.S. growth holding. Please see the Performance Review on page 5 for a closer look at the fund’s performance.

As of May 31, the fund’s assets were invested in T. Rowe Price funds according to the target and actual allocations shown on page 19. Actual allocations reflected the Asset Allocation Committee’s decision to overweight stocks relative to bonds but to reduce that overweight slightly in May. At the end of the period, the target allocations were 57.25% for cash and bond funds, up from 57.0% at the end of November, and 42.75% for stock funds, down from 43.0% six months ago.

RETIREMENT 2005 FUND

The Retirement 2005 Fund’s investment objective is to provide the highest total return consistent with an emphasis on both capital growth and income. The fund invests in a diversified portfolio, with both an increasing allocation to bonds and an increasing emphasis on short-term bonds over time, and implements its strategy by investing in a set of underlying T. Rowe Price mutual funds. The fund will reach its most conservative strategic allocation to stocks (approximately 20%) about 30 years after the year 2005.

The Retirement 2005 Fund reached its target date during the first half of our fiscal year. At that time, its neutral allocation to stocks stood at 55%, higher than most of our peer funds. Our analysis shows that this heavier exposure to stocks should improve retirees’ chances of keeping ahead of inflation during today’s longer retirements. The fund’s stock allocation will gradually decline over the next 30 years until it reaches approximately 20% in 2035.

The fund returned 3.21% over the six months ended May 31, 2006, and 8.51% for the 12 months, as shown in the table on page 7. The fund outperformed its combined index portfolio for both periods. Results were mixed against the Dow Jones Target 2005 Index.

Our domestic stock allocation helped results over both the six and 12 months, as the fund benefited from our tactical overweighting versus bonds. Overall, the equity allocation also outperformed its benchmark. The international stock allocation was a strong contributor to absolute returns, but trailed its benchmark during both periods because of weakness in our non-U.S. growth fund. The fund’s fixed-income allocation aided results during both the 6- and 12-month periods, primarily due to strength in our high-yield fund. Our short-term fixed-income allocation hampered relative results as money market securities benefited from rising rates while short-term bonds were weak. Please see the Performance Review on page 5 for a closer look at the fund’s performance.

As of May 31, the fund’s assets were invested in T. Rowe Price funds according to the target and actual allocations shown on page 19. Actual allocations reflect the Asset Allocation Committee’s decision to overweight stocks relative to bonds but to reduce that overweight slightly in May. At the end of the period, the target allocations were 43.25% for cash and bond funds, up from 42.0% at the end of November, and 56.75% for stock funds, down from 58.0% six months ago.

RETIREMENT 2010 FUND

The Retirement 2010 Fund’s investment objective is to provide the highest total return consistent with an emphasis on both capital growth and income. The fund invests in a diversified portfolio, with both an increasing allocation to bonds and an increasing emphasis on short-term bonds over time, and implements its strategy by investing in a set of underlying T. Rowe Price mutual funds. The fund will reach its most conservative strategic allocation to stocks (approximately 20%) about 30 years after the year 2010.

The Retirement 2010 Fund gained 3.92% during the past six months and 9.95% for the 12 months, as shown in the table. The fund outperformed its combined index portfolio over both periods. It outpaced the Dow Jones Target 2010 Index for the year but trailed the benchmark for the most recent six months. Returns for the fund’s Advisor and R Class shares were slightly lower, reflecting their additional expenses.

Our domestic stock allocation helped results over both the six and 12 months, as the fund benefited from our tactical overweighting versus bonds. Overall, the equity allocation also outperformed its benchmark. The international stock allocation was a strong contributor to absolute returns but trailed its benchmark during both periods because of weakness in our non-U.S. growth fund. The fund’s fixed-income allocation aided results during both the 6- and 12-month periods, primarily due to strength in our high-yield fund. Our short-term fixed-income allocation hampered relative results as money market securities benefited from rising rates while short-term bonds were weak. Please see the Performance Review on page 5 for a closer look at the fund’s performance.

As of May 31, the fund’s assets were invested in T. Rowe Price funds according to the target and actual allocations shown on page 20. Actual allocations reflected the Asset Allocation Committee’s decision to overweight stocks relative to bonds but to reduce that overweight slightly in May. At the end of the period, the target allocations were 34.75% for cash and bond funds, up from 33.5% at the end of May, and 65.25% for stock funds, down from 66.5% six months ago.

RETIREMENT 2015 FUND

The Retirement 2015 Fund’s investment objective is to provide the highest total return consistent with an emphasis on both capital growth and income. The fund invests in a diversified portfolio, with both an increasing allocation to bonds and an increasing emphasis on short-term bonds over time, and implements its strategy by investing in a set of underlying T. Rowe Price mutual funds. The fund will reach its most conservative strategic allocation to stocks (approximately 20%) about 30 years after the year 2015.

The Retirement 2015 Fund returned 4.20% and 10.85% over the six and 12 months ended May 31, respectively, as shown in the table. The fund outperformed its combined index portfolio for both periods, while returns versus the Dow Jones index were mixed. Our domestic stock allocation helped results over both the six and 12 months, as the fund benefited from our tactical overweighting versus bonds. Overall, the equity allocation also outperformed its benchmark. The international stock allocation was a strong contributor to absolute returns but trailed its benchmark during both periods because of weakness in our non-U.S. growth fund. The fund’s fixed-income allocation aided results during both the 6- and 12-month periods, primarily due to strength in our high-yield fund. Our short-term fixed-income allocation hampered relative results as money market securities benefited from rising rates while short-term bonds were weak. Please see the Performance Review on page 5 for a closer look at the fund’s performance.

As of May 31, the fund’s assets were invested in T. Rowe Price funds according to the target and actual allocations shown on page 20. Actual allocations reflected the Asset Allocation Committee’s decision to overweight stocks relative to bonds but to reduce that overweight slightly in May. At the end of the period, the target allocations were 28.75% for cash and bond funds, up from 27.5% at the end of November, and 71.25% for stock funds, down from 72.5% six months ago.

RETIREMENT 2020 FUND

The Retirement 2020 Fund’s investment objective is to provide the highest total return consistent with an emphasis on both capital growth and income. The fund invests in a diversified portfolio, with both an increasing allocation to bonds and an increasing emphasis on short-term bonds over time, and implements its strategy by investing in a set of underlying T. Rowe Price mutual funds. The fund will reach its most conservative strategic allocation to stocks (approximately 20%) about 30 years after the year 2020.

The Retirement 2020 Fund returned 4.56% and 11.87% during the 6- and 12-month periods ended May 31, 2006, respectively. Returns for the fund’s Advisor and R Class shares were slightly lower, reflecting their additional expenses. The fund outperformed its combined index portfolio over both periods, but results were mixed versus the Dow Jones Target index.

Our domestic stock allocation helped results over both the six and 12 months, as the fund benefited from our tactical overweighting versus bonds. Overall, the equity allocation also outperformed its benchmark. The international stock allocation was a strong contributor to absolute returns but trailed its benchmark during both periods because of weakness in our non-U.S. growth fund. The fund’s fixed-income allocation aided results during both the 6- and 12-month periods, primarily due to strength in our high-yield fund. Our short-term fixed-income allocation hampered relative results as money market securities benefited from rising rates while short-term bonds were weak. Please see the Performance Review on page 5 for a closer look at the fund’s performance.

As of May 31, the fund’s assets were invested in T. Rowe Price funds according to the target and actual allocations shown on page 21. Actual allocations reflected the Asset Allocation Committee’s decision to overweight stocks relative to bonds but to reduce that overweight slightly in May. At the end of the period, the target allocations were 22.25% for cash and bond funds, up from 22.0% at the end of November, and 77.75% for stock funds, down from 78.0% six months ago.

RETIREMENT 2025 FUND

The Retirement 2025 Fund’s investment objective is to provide the highest total return consistent with an emphasis on both capital growth and income. The fund invests in a diversified portfolio, with both an increasing allocation to bonds and an increasing emphasis on short-term bonds over time, and implements its strategy by investing in a set of underlying T. Rowe Price mutual funds. The fund will reach its most conservative strategic allocation to stocks (approximately 20%) about 30 years after the year 2025.

The Retirement 2025 Fund returned 4.90% over the six months ended May 31, 2006, and 12.81% for the year, as shown in the table. The fund outperformed its combined index portfolio for both periods, but results were mixed versus the Dow Jones index. Our domestic stock allocation helped results over both the six and 12 months, as the fund benefited from our tactical overweighting versus bonds. Overall, the equity allocation also outperformed its benchmark. The international stock allocation was a strong contributor to absolute returns but trailed its benchmark during both periods because of weakness in our non-U.S. growth fund. The fund’s fixed-income allocation aided results during both the 6- and 12-month periods, primarily due to strength in our high-yield fund. Please see the Performance Review on page 5 for a closer look at the fund’s performance.

As of May 31, the fund’s assets were invested in T. Rowe Price funds according to the target and actual allocations shown on page 21. Actual allocations reflected the Asset Allocation Committee’s decision to overweight stocks relative to bonds but to reduce that overweight slightly in May. At the end of the period, the target allocations were 16.75% for bond funds, up from 15.0% at the end of November, and 83.25% for stock funds, down from 85.0% six months ago.

RETIREMENT 2030 FUND

The Retirement 2030 Fund’s investment objective is to provide the highest total return consistent with an emphasis on both capital growth and income. The fund invests in a diversified portfolio, with both an increasing allocation to bonds and an increasing emphasis on short-term bonds over time, and implements its strategy by investing in a set of underlying T. Rowe Price mutual funds. The fund will reach its most conservative strategic allocation to stocks (approximately 20%) about 30 years after the year 2030.

The Retirement 2030 Fund returned 5.43% over the six months ended May 31, 2006, and 14.05% for the 12-month period, as shown in the table. The fund outperformed its combined index portfolio but trailed its Dow Jones index for both time periods. Our domestic stock allocation helped results over both the six and 12 months, as the fund benefited from our tactical overweighting versus bonds. Overall, the equity allocation also outperformed its benchmark. The international stock allocation was a strong contributor to absolute returns but trailed its benchmark during both periods because of weakness in our non-U.S. growth fund. The fund’s fixed-income allocation aided results during both the 6- and 12-month periods, primarily due to strength in our high-yield fund. Please see the Performance Review on page 5 for a closer look at the fund’s performance.

As of May 31, the fund’s assets were invested in T. Rowe Price funds according to the target and actual allocations shown on page 22. Actual allocations reflected the Asset Allocation Committee’s decision to overweight stocks relative to bonds but to reduce that overweight slightly in May. At the end of the period, the target allocations were 8.25% for bond funds, up from 7.5% at the end of November, and 91.75% for stock funds, down from 92.5% six months ago.

RETIREMENT 2035 FUND
RETIREMENT 2040 FUND
RETIREMENT 2045 FUND

The investment objective of the Retirement 2035, 2040, and 2045 Funds is to provide the highest total return consistent with an emphasis on both capital growth and income. The funds invest in diversified portfolios, with both an increasing allocation to bonds and an increasing emphasis on short-term bonds over time, and implement their strategies by investing in a set of underlying T. Rowe Price mutual funds. The funds will reach their most conservative strategic allocation to stocks (approximately 20%) about 30 years after their target dates.

The Retirement 2035, 2040, and 2045 Funds will follow similar investment paths for some years before their allocations begin to differ. Until that time, their performance will be measured against the same combined index portfolio. Each has a different Dow Jones Target benchmark. The funds are managed as separate portfolios; because of asset flows and other technical considerations, their total returns will vary, and their allocations to underlying funds may also be slightly different.

The funds outperformed their combined index portfolio benchmark for both the 6- and 12-month periods but lagged their Dow Jones indexes, as shown in the table. Returns for the 2040 fund’s Advisor and R Class shares were slightly lower, reflecting their additional expenses. Our domestic stock allocation helped results over both the six and 12 months, as the fund benefited from our tactical overweighting versus bonds. Overall, the equity allocation also outperformed its benchmark. The international stock allocation was a strong contributor to absolute returns, but trailed its benchmark during both periods because of weakness in our non-U.S. growth fund. The funds’ fixed-income allocation aided results during both the 6- and 12-month periods, primarily due to strength in our high-yield fund. Please see the Performance Review on page 5 for a closer look at the funds’ performance.

As of May 31, the funds’ assets were invested in T. Rowe Price funds according to the target and actual allocations shown on pages 22-23. Actual allocations reflected the Asset Allocation Committee’s decision to overweight stocks relative to bonds but to reduce that overweight slightly in May. At the end of the period, the target allocations were 7.25% for bond funds, up from 7.0% at the end of November, and 92.75% for stock funds, down from 93.0% six months ago.

OUTLOOK

The Retirement Funds’ results over the past year have been gratifying and reflect the solid performance of global markets. As we write this report, however, stock markets around the world are experiencing losses. By the time you read this letter, they may well have stabilized or begun to climb once again. More likely, the various markets and asset classes will be moving in different directions. This kind of volatility is normal in investing and points to what we believe is the strength of our investment approach, which incorporates a disciplined strategy, broad diversification, and a long-term focus. Whatever the near term holds, we believe that shareholders will be well served over the long term by the Retirement Funds’ combination of individual fund selection and asset allocation management in a single portfolio that matches the investor’s personal time horizon. Thank you for your confidence in T. Rowe Price.

Respectfully submitted,

Edmund M. Notzon III
President and chairman of the funds’ Investment Advisory Committee

Jerome A. Clark
Vice president and portfolio manager

June 20, 2006

RISKS OF INVESTING

The Retirement Funds’ investment in many underlying funds means that they will be exposed to the risks of different areas of the market. As with all stock and bond mutual funds, each fund’s share price can fall because of weakness in the stock or bond markets, a particular industry, or specific holdings. Stock markets can decline for many reasons, including adverse political or economic developments, changes in investor psychology, or heavy institutional selling. The prospects for an industry or company may deteriorate because of a variety of factors, including disappointing earnings or changes in the competitive environment. In addition, the investment manager’s assessment of companies held in a fund may prove incorrect, resulting in losses or poor performance even in rising markets. Investors should note that the higher the fund’s allocation to stocks, the greater the risk.

Bonds are subject to interest rate risk, the decline in bond prices that usually accompanies a rise in interest rates, and credit risk, the chance that any fund holding could have its credit rating downgraded or that a bond issuer will default (fail to make timely payments of interest or principal), potentially reducing the fund’s income level and share price. High-yield corporate bonds could have greater price declines than funds that invest primarily in high-quality bonds. Companies issuing high-yield bonds are not as strong financially as those with higher credit ratings, so the bonds are usually considered speculative investments.

Funds that invest overseas may carry more risk than funds that invest strictly in U.S. assets. Risks can result from varying stages of economic and political development; differing regulatory environments, trading days, and accounting standards; and higher transaction costs of non-U.S. markets. Non-U.S. investments are also subject to currency risk, or a decline in the value of a foreign currency versus the U.S. dollar, which reduces the dollar value of securities denominated in that currency.

GLOSSARY

Citigroup 90-Day U.S. Treasury Bill Index: An index designed to track short-term government securities.

Combined Index Portfolios: Blended index portfolios used as benchmarks for each fund. The Combined Index Portfolios are composed of the following underlying indexes:

Retirement Income Fund—An unmanaged portfolio composed of 34.0% Dow Jones Wilshire 5000 Composite Index, 30.0% Lehman Brothers U.S. Aggregate Index, 30.0% Citigroup 90-Day U.S. Treasury Bill Index, 6.0% MSCI EAFE Index.

Retirement 2005 Fund—An unmanaged portfolio composed of 46.5% Dow Jones Wilshire 5000 Composite Index, 35.5% Lehman Brothers U.S. Aggregate Index, 10.5% Citigroup 90-Day U.S. Treasury Bill Index, 7.5% MSCI EAFE Index.

Retirement 2010 Fund—An unmanaged portfolio composed of 53.5% Dow Jones Wilshire 5000 Composite Index, 29.0% Lehman Brothers U.S. Aggregate Index, 8.5% Citigroup 90-Day U.S. Treasury Bill Index, 9.0% MSCI EAFE Index.

Retirement 2015 Fund—An unmanaged portfolio composed of 58.5% Dow Jones Wilshire 5000 Composite Index, 27.0% Lehman Brothers U.S. Aggregate Index, 4.5% Citigroup 90-Day U.S. Treasury Bill Index, 10.0% MSCI EAFE Index.

Retirement 2020 Fund—An unmanaged portfolio composed of 63.5% Dow Jones Wilshire 5000 Composite Index, 23.5% Lehman Brothers U.S. Aggregate Index, 1.5% Citigroup 90-Day U.S. Treasury Bill Index, 11.5% MSCI EAFE Index.

Retirement 2025 Fund—An unmanaged portfolio composed of 67.5% Dow Jones Wilshire 5000 Composite Index, 19.5% Lehman Brothers U.S. Aggregate Index, 13.0% MSCI EAFE Index.

Retirement 2030 Fund—An unmanaged portfolio composed of 74.0% Dow Jones Wilshire 5000 Composite Index, 11.0% Lehman Brothers U.S. Aggregate Index, 15.0% MSCI EAFE Index.

Retirement 2035, 2040, and 2045 Funds—An unmanaged portfolio composed of 75.0% Dow Jones Wilshire 5000 Composite Index, 10.0% Lehman Brothers U.S. Aggregate Index, 15.0% MSCI EAFE Index.

Credit Suisse High Yield Index: An index designed to track the high-yield bond market.

Dow Jones Moderately Conservative Portfolio Index: An index composed of an underlying blend of U.S. and non-U.S. stock, bond, and cash indexes. It is designed to capture 40% of the risk and return of the Dow Jones Aggressive Portfolio Index, an all-stock index.

Dow Jones Target Date Portfolio Indexes: Indexes composed of different allocations of stocks, bonds, and cash. Each month, beginning 35 years prior to an index’s stated target date, the amount allocated to stocks gradually decreases and the amount allocated to bonds/cash increases in a predefined manner. The target date in each index’s name reflects the year the benchmark’s allocation no longer changes. At that time, the index will become the Dow Jones Target Today Index with a portfolio composed of 20% stocks.

Dow Jones Wilshire 5000 Total Market Index: An index that tracks the performance of all U.S. common equity securities.

Lehman Brothers U.S. Aggregate Index: An unmanaged index that tracks domestic investment-grade bonds, including corporate, government, and mortgage-backed securities.

Lehman Brothers 1-3 Year Government/Credit Index: An index that tracks short-term debt instruments.

MSCI EAFE Index: An index that tracks the stocks of about 1,000 companies in Europe, Australasia, and the Far East (EAFE).

Russell 2000 Index: An index that tracks the stocks of 2,000 small U.S. companies.

S&P 500 Stock Index: An index that tracks the stocks of 500 primarily large-cap U.S. companies.

Yield curve: A graph depicting the relationship between yields and maturity dates for a set of similar securities. These curves are in constant flux. One of the key activities in managing any fixed-income portfolio is to study trends reflected by comparative yield curves.

GROWTH OF $10,000

This chart shows the value of a hypothetical $10,000 investment in the fund over the past 10 fiscal year periods or since inception (for funds lacking 10-year records). The result is compared with benchmarks, which may include a broad-based market index and a peer group average or index. Market indexes do not include expenses, which are deducted from fund returns as well as mutual fund averages and indexes.