If you opened a 401(k) account after 2006, chances are that some or all of your savings are in a target-date fund. At the end of 2014, 48% of 401(k) participants had invested in target-date funds. Let’s review how and why target date-funds are becoming an ever-popular option for 401(k) account holders, the advantages and disadvantages of owning target-date funds, and how to evaluate whether or not target-date funds are actually a good idea for you.
Target-date funds are very often a default investment option in 401(k) plans
Also known as lifecycle funds or TDFs, target-date funds were first offered in early 1990’s as investments vehicles that cover a wide range of assets, including equities, bonds, and index funds. The key feature of a target-date fund is that it has a growth-oriented portfolio allocation that shifts to an income portfolio allocation as the fund draws near its target date. So, a 2040 target-date fund will have more aggressive holdings in 2020 than in 2035. The Pension Protection Act of 2006 (PPA) officially assigned target-date funds the status of qualified default investment alternative. (QDIA). The objective was to promote retirement savings of employees by automatically enrolling those employees in funds with default investment alternatives that meet adequate standards of fiduciary duty. (To learn more about this, read: What is a Fiduciary and Why Does it Matter?) Since its QDIA designation, the total holdings in target-date funds ballooned from an estimated $110 billion in 2006 to about $600 billion in 2013. According to the latest data from the Employee Benefit Research Institute (EBRI), more than 70% of 401(k) offer target-date funds and 48% of 401(k) participants hold this type of funds.
The main advantage: convenience
The average investor doesn’t know much about investing other than the year that he plans to retire. So, the pitch of taking on higher risk for bigger returns at the beginning and, eventually, switching to more conservative holdings towards the end makes sense for the novice investor. However, despite the convenience, there are many financial disadvantages to owning a target-date fund!
Disadvantage 1: Target-date funds charge high fees
A review of more than 1,700 target-date funds found that the average expense ratio was 1.02% or $102 per $10,000. For example, the Blackrock LifePath 2050 Fund Class A currently has an expense ratio of 1.46% or $146 per $10,000. Shopping around, you can find target-date funds with much lower expense ratios, such as the Vanguard Target Retirement 2050 Fund with a 0.16% expense ratio or $16 per $10,000. Still, this “lower” expense ratio is more than three times of that from the non-TDF Vanguard 500 Index Fund Admiral Shares (0.05% or $5 per $10,000). By choosing a target-date fund, you’ll often pay significantly more than for an alternative investment option that may already be available to you inside your 401(k).
Disadvantage 2: Target-date funds have highly variable historical returns
In the same review of over 1,700 target-date funds, the highest and lowest five-year average annual returns were 9.6% and 2.9% for target-2010 funds and 13.8% and 7.5% for target-2050 funds. This means that some of these funds barely covered the high investment fees that they command. The wide range of average returns happens because there is a type of target-date fund called “through fund”s. These type of funds seek to minimize the risk of outliving your nest egg by continuing to build growth past the target date.
Disadvantage 3: Target-date funds are generally actively-managed funds
While there are some very talented active fund managers out there, those managers are the exception rather than the rule! Only 20% to 35% actively managed funds beat the benchmark for their category. Additionally, trying to time the market costs investors between 1.5% and 4.3% every year.
Disadvantage 4: A one-size-fits-all investment approach may not be suitable for your financial plans
In theory, a glide path in asset allocation matching your target retirement date sounds great. The reality is that the set allocation to stocks of a target-date fund may leave you at times overexposed or underexposed to your true risk tolerance. For example, an individual with substantial assets in a pension plan may tolerate a higher investment risk in the target-date fund closer to retirement and could be missing out on gains because of the formulaic approach of the target-date fund. On the other hand, another individual that is just beginning to build a nest egg may tolerate a higher exposure to equities, such as an index fund trading a foreign stock market or a basket of foreign stock markets, than the one offered by a target-date fund. Life happens! In certain years or stages of your life you may be able to take on a more or less risk by adjusting your allocations to maximize your gains and minimize your losses, and this is not possible with a target-date fund, which makes large assumptions based on just the target year of retirement. Adjusting the allocation of funds yourself within your 401(k), as opposed to “setting and forgetting” your money in a target-date fund, is not as difficult as it sounds. There are a lot of great benefits (high degree of control and greater gains over time): How and Why to Change Your 401(k) Setup Percentages Human Interest offers automated, personal investment advising, the adjustments to your allocations and the selection of funds are done for you!
Is a target-date fund right for you?
Given the strong disadvantages of target-date funds, you should only invest in target-date funds when you have no other options to save for retirement. Getting started with an employer-sponsored 401(k), even when the default or only option investment option is target-date fund, is preferable to not having one due to the many tax advantages that a 401(k) plan offers and the benefit of receiving a match from your employer. However, a better plan is to look for other investment options within your 401(k) that have lower expense ratios. Not only will you minimize your investment fees, but also you’ll increase your chances of higher investment returns. Research has shown that there is an inverse relationship between investment fees and returns. A great place to start your research is to take a look at the prospectus of your target-date fund and look at the fund’s asset allocation. For example, here are the holdings of the Vanguard Target Retirement 2050 Fund as of May 31, 2016:
|Vanguard Total Stock Market Index Fund Investor Shares
|Vanguard Total International Stock Index Fund Investor Shares
|Vanguard Total Bond Market II Index Fund Investor Shares
|Vanguard Total International Bond Index Fund Investor Shares
Or in simple terms, about 90% in stocks and 10% in bonds. You could copy that asset allocation by investing in a low-cost equity index fund and a bond index fund from your 401(k). In the event, that your current 401(k) doesn’t provide you access to other options, then consider switching to a 401(k) plan administrator offering you access to low cost index funds. One of those 401(k) providers is Human Interest, which gives you access to Vanguard Admiral funds without any minimum account balance on your part (usually, you would need $100,000 for them), which carries a lower expense ratio than the Vanguard Target Date Fund. When you have access to a total of 30,000 funds through a provider like Human Interest, you could replicate this target fund in its entirety at a lower cost. Furthermore, the investment algorithms and automatic portfolio rebalancing adjusts to the more appropriate risk settings as you age, so that you get the convenience of a target-date fund but the low fees of index funds. In summary, under most circumstances, sticking with a default target-date fund will limit the growth potential of your 401(k) and mismatch your true risk tolerance with that of your portfolio.
Article ByDamian Davila
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.