In recent years, the TDF has become a dominant force in 401(k) retirement plans and appears to be an easy investment pick. Yet there are downsides to consider. In fact, target-date funds were just named a “ticking time bomb of ERISA legislation.”
What are target-date funds?
Target-date funds (TDFs) are mutual funds that offer decreasing levels of risk as retirement nears. Accordingly, they tend to come with lower returns over time. TDFs, sometimes called lifecycle funds, are securities that gradually move assets from stocks to bonds as a target date approaches. The target date is the expected date of retirement. For example, a TDF with a target date of 2030 would be aimed at someone planning to retire in the year 2030.
What to know about TDFs:
- Target-date funds today are, for many plans, the primary investment vehicle in a 401(k), making them a convenient investment choice.
- The intent of a TDF is to make it easier to save by relieving 401(k) participants of having to choose specific investments. Instead, allowing them to elect a ‘set it and forget it’-style suite of investments.
- TDFs weren’t common financial products until Congress formally recognized them in conjunction with the Pension and Protection Act of 2006, which stipulated that these funds can be used as the default investment in 401(k) plans.
- According to research by JPMorgan, nearly 90% of retirement plan contributions will go into target-date funds in 2019.
- A survey conducted by Fidelity Investments concluded that half of all 401(k) accounts have 100% of their assets in lifecycle funds. The same analysis estimated that these investments make up more than 30% of total 401(k) assets.
While prevalent and simple to use, TDFs have their drawbacks
While they were designed to be easy-to-use products, recent scrutiny suggests that TDFs may face litigation for not adhering to a fiduciary responsibility, that is not acting in consumers’ best interests. Here are some reasons why.
Above-average fees:Some TDFs charge above-average fees. A recent survey by Blackrock subsidiary FutureAdvisor found that the average expense ratio of TDF’s is above 1.00%. This translates into more than $100 spent per year on management for every $10,000 invested. In comparison, a robo-advisor often comes with lower fees. Human Interest’s average annual expense ratio of 0.57%.
Hidden fees:Many target-date mutual funds actually invest in other funds that also charge management fees. For example, according to its most recent prospectus, the T. Rowe Price Retirement 2030 fund (TRRCX) has a 0.67% expense ratio. A quick look at its most recent holdings reveals the fund owns the T. Rowe Price International Value Equity fund (TRIGX), which itself charges 0.81%. That means that owners of this fund are paying both fees, totaling to nearly 1.5%.
Treating every investor the same:Another disadvantage of lifecycle funds is that they mostly take only a target retirement date into consideration when making investment decisions for a portfolio. A 2050 fund, for example, will gradually sell stocks and buy bonds as 2050 approaches. But adequate retirement planning may benefit from taking into account much more information than a mere date. In addition to date, a retirement plan could take into account things like risk tolerance, health needs, if you plan to keep working in retirement, etc., for instance. Think about it this way: Just because you share an expected retirement date with someone, doesn’t mean that your investment needs, comfort with risk, or other factors are the same. Target-date funds tend to put every investor into the same bucket rather than providing personalized investment advice that best meets an individual’s needs.
Issues with diversification:The portfolios of target-date funds can also be a concern. Because of their wide diversification, a TDF may miss the upside of an overall bullish market if only a few economic sectors are responsible. They may also allocate assets in stocks that have higher levels of risk, so it’s important to know not just that your investments are in stocks, but what types of stocks are being used.
Glide path glitches:Each TDF has its own path outlining the formula they use to determine how and when an investor’s mix of assets will shift over time. That is, the pace at which they move funds from investments with higher equity exposure, such as stocks to those that are more conservative, such as bonds. When looking into a TDF, it is important to learn more about the fund’s strategy and cadence for this transition. In addition, since not all stocks carry equal risk, it is important to go a level deeper to understand whether there’s any consideration related to the type of stocks, and the corresponding risk.
Reduced protection against inflation as retirement nears:One of the paradoxes of target-date funds is that, while they’re designed for retirement saving, they may not perform very well at the point of retirement. Precisely because they transition to lower-performing assets as retirement approaches, the return on TDFs may not do a good job of keeping up with inflation, compared to stocks, when returns are high. For example, the FutureAdvisor study found some lifecycle funds with target dates near the present had lower returns than funds in the same fund family with retirement dates further out. This isn’t surprising, given the investment strategies of such funds. But the lowest returning lifecycle fund had a return of just 2.9%, which barely surpasses inflation. This decline is expected since it’s built into the design of the fund, but it can be surprising for retirees, who certainly need their investments to keep pace with inflation.
The biggest question: What happens beyond retirement day?And this issue brings us to the last point, which is what happens when the target date is reached. While this time is when most investors will begin withdrawing funds, inevitably some assets will remain. Investment strategies post-retirement vary from fund family to fund family. Some funds continue shifting assets to bonds and cash for up to 30 more years, while others just maintain the strategy in place when the target date is reached. Neither approach will work for all investors. It’s important to understand how your money will work for you not just leading up to the day of your retirement, but throughout your retirement.
Managed accounts offer additional services
While a target-date fund looks through a narrow lens (at only the expected retirement date), a holistic approach to planning for retirement may consider other factors such as risk tolerance, life expectancy, other retirement accounts, goals, and anticipated cost of living during retirement. A managed retirement account tends to do a better job of factoring in these types of important variables, rather than setting up one investment based solely on a planned retirement date. While offering advantages over TDFs, 71% of 401(k) plans offer TDFs but only 40% offer a managed account.
At Human Interest, we have found that low-cost index funds perform better over the long term than lifecycle funds do. That’s why we offer a large assortment of index funds. One example is Vanguard’s S&P 500 Index fund, which is available through the Human Interest portal and has an expense ratio of just 0.04%. This is one of the lowest management fees in the industry.
In total, we provide our clients with more than 30,000 mutual funds. This allows for a much greater degree of diversification for employees than an automatic plan that just puts all employees, regardless of their individual circumstances, into lifecycle funds. Because we know that everyone’s situation is unique, and requires individualized service, we offer free, personalized investment advice to employees who need it. And, workers with a Human Interest 401(k) can trade their own selection of funds if they wish, as we have no financial connection to any fund or fund family.
Human Interest also has an automated investing program that combines tailored investment service with regular rebalancing, i.e., periodic buying or selling of assets in a portfolio to maintain a specified level of asset allocation or risk. Other advantages of a Human Interest 401(k) include greater access to global assets, our focus on reducing fees, and an emphasis on long-term appreciation rather than short-term gains.
For more information on Human Interest’s low-cost 401(k) services, click here to learn more about how it works.