With Target Date Funds Simple Isn’t Always Easy – On The Investor
When it comes to 401k accounts, target date funds (TDF) have seen massive adoption in the past 10 years. Over 70% of 401k plans on the market offer some form of TDF and 60% of people in their 20s use them. 1. By 2019, Cerulli Associates estimates 90 percent of new 401k contributions will be invested in TDFs. 2.
This rapid adoption isn’t particularly surprising. In concept, a TDF is not a horrible investment for retirement when used correctly. At first glance, they offer many of the things you want in a solid retirement strategy. Namely, they offer simplicity and a diversified allocation that becomes more conservative the closer you get to your targeted retirement date.
But take a look at the elephant in the room when it comes to target date funds. They can be built with 100% proprietary funds, often from the same institution providing the 401k plan to the participant!
That seems a little like the fox guarding the chicken coop, doesn’t it?
Vanguard is the current market share leader, managing $224.9 billion in TDFs. They are followed by Fidelity and T. Rowe Price (as of 12/31/16, according to Morningstar Inc.’s annual Target-Date Fund Landscape report). These three firms manage more than 71% of all TDF assets, effectively controlling the industry.
The simplicity of a TDF can’t be denied. Unfortunately, you often end up paying for that simplicity in the form of the higher internal fees associated with these proprietary funds.
A Target Date Fund Case Study: Walmart’s 401k plan
For an example, let’s take a look at Walmart’s 401k plan. With 1.5 million 401k participants and $22 billion in plan assets, it is one of the country’s largest retirement plans. Given this size, Walmart can negotiate extremely low fund costs for its associates. The TDF options within their plan have internal expenses of 0.34%. That is roughly 50% of the industry average 0.71%. This makes Walmart’s plan one of the best-case scenarios for TDFs when it comes to expense.
Yet even in this “best-case scenario” of comparatively low expense ratios, a Walmart employee can do better. A lower expense ratio of 0.17% can be achieved by individually selecting the appropriate index funds available in their plan (based on the allocation algorithm used at blooom.com). This may not sound like much of a difference. But on a $100,000 account, that is a savings of $170 per year — to start — in fees. Compounded over a 30 year investing career, can amount to almost $100,000 of fee savings!
The Other Downsides to Target Date Funds
Another potential downside of investing in a TDF is that they tend to use a more conservative allocation. This may not really be appropriate for a new or even mid-career professional. When you are a decade or more from retirement, you can actually lose out on potential returns. The reason: you may be too heavily invested in bonds. Think about it this way, you won’t find a ten-year period in history where stocks haven’t done considerably better than bonds over that period (see: Putting Stock In Stock video). So a TDF that is 14% allocated towards bonds for someone who is 20 years from retirement may not be a good fit. It may be a more conservative investment than what that person would ideally choose for their goals.
The high internal expense ratios and potentially misallocated investment strategy aren’t the only downsides. A final drawback of TDFs can occasionally come from the behavior of the investors themselves. At blooom, we see “behind the curtain” into the accounts of thousands of 401k investors from all across the country. Unfortunately, we notice these funds are often not being used correctly.
Take for example:
- An investor who has selected multiple TDFs, or
- Even every TDF available in their plan, or
- An investor who has selected a TDF and then a completely random selection of individual funds.
According to a study by Financial Engines and Aon Hewitt, more than 60% of people who selected a TDF in their retirement account have also selected other funds. 3. In these cases, the TDFs are not being used in the manner for which they were created. Therefore, they are not providing the most value to the investor.
The Better Alternative to Target Date Funds
But even assuming you have selected the correct TDF (one that corresponds closely with your ideal retirement age), and you haven’t “tainted” the benefits of the TDF by mixing in a few other random funds on the side, there are still downsides to using a TDF as your retirement strategy:
|Target Date Fund||Recommended Alternative|
|Allocation||100% from one fund family (brand)||Select funds from across all available options using those with the lowest cost|
|Investment Strategy||Often place too high a percentage in bonds for someone 20+ years from retirement||Keep a greater percentage (even as high as 100%!) in stocks until you’re within 20 years of retirement|
|Fees||Proprietary funds are used, often at a higher cost||You can often build a portfolio with lower overall expense ratio, depending on available options in fund lineup|
If the simplicity of a TDF is what appeals to you as an investor, instead consider having your account managed by a fiduciary robo-advisor service such as blooom.com. We act in your best interest by choosing the funds with the lowest fees and at the right allocation for your goals.
Recently, one of our blooom clients messaged us and said, “You can pick your friends and you can pick your spouse but can’t pick your 401k provider!”
Set Up The Alternative In Less Than Five Minutes
We want companies to realize that a 401k plan stocked with target date funds is only a good first step. So when it comes to our colleagues’, friends’, and family’s retirement security — good isn’t good enough. Fortunately, you can make that choice now. And set your account up in less than five minutes.
1. New Hires Continue to Favor Target Date Funds for 401(k)s Investment Company Institute. April 28, 2016. https://www.ici.org/401k/news/16_news_ebri_ici_target
2. Millennials: There’s A $454,000 Leak In Your 401(k) Forbes. May 12, 2016. https://www.forbes.com/sites/arielleoshea/2016/05/12/the-454000-leak-in-your-retirement-plan/#1e4282e769ce
3. Not so simple: Why target-date funds are widely misused by retirement investors Financial Engines and Aon Hewitt. March 2016. https://financialengines.com/docs/financial-engines-tdf-report-022916.pdf
The information is provided for discussion purposes only and should not be considered as investment advice. The information does not represent a recommendation to buy or sell securities. Past performance is no guarantee of future results. Just because an investment performed well in the past does not mean it will do well going forward. And vice versa.
Prior to blooom he co-founded another investment advisory firm that grew to manage over $500 million for clients. At blooom, Chris leads the company in building innovative financial services to reach a brand new audience of under-served Americans. Blooom has been named one of the world’s most innovative companies by Fast Company, and Chris was selected as “Ten to Watch in 2016" by WealthManagement.
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