The Target Date Funds in Your 401K Aren’t Worth the Costs

Investing Advice

If you participate in an employer-sponsored retirement plan at work such as a 401(k) or 403(b), chances are you’re investing in a so-called target-date fund.  A target-date fund essentially automates a portfolio reallocation strategy for you based on a date you set in the far future (your target retirement date), so that you don’t have to do it yourself. (You can learn more about target-date funds and retirement investing in this video.)
According to a recent study, more than 70% of active 401(k) plans use target-date funds as the default investment choice. This means that understanding the special risks of these funds is important for anyone who is currently using a 401(k) to save for retirement, or may do so in the future.
Target-date funds would be great if fund managers could foresee the future. But because they can’t, the actual returns from these products may be disappointing for many investors.

In fact, the problems inherent in these popular managed products have lead to recent investigations by the SEC. The result of this scrutiny is likely to be changes in the way that these funds are marketed to consumers and what additional risk disclosures are needed.

Many traditional financial managers believe that you should have a lot of exposure to risky and growth oriented assets (like stocks) early in your investing life and that over time you should reduce that exposure in favor of lower-risk assets like bonds.

This all seems reasonable and convenient, but it rests on a potentially erroneous premise. If stocks perform well in the early days of your investing life, then the strategy works very well.  But what if stocks perform poorly in the early days and very well as you approach your target retirement date? You will have maximized your losses and minimized your gains by using a target-date fund!

The problem is, we don’t know which will happen — and yet a target date fund’s managers are acting as if they do.

This is a backwards form of market-timing, which has been shown to be a very speculative thing to do. The only thing we really know for sure is that this strategy will accumulate higher fees to pay for the endless adjustments performed by the fund’s managers.

There is an alternative that still takes advantage of diversification and compounding returns, at a far lower cost. Rather than reallocating your exposure each year of your investing life, you could hold your exposure to each asset class constant, using index mutual funds or ETFs.

We can make an easy comparison of the two strategies over a 20-year period by averaging the yearly stock and bond exposure from the reallocation strategy into a static portfolio. This is a very simplified allocation, but the principle is the same regardless of the number of asset classes used.

Strategy #1: Reallocation – 20 year target
Year 1 – Stocks 70%, Bonds 30%
Year 2 – Stocks 68%, Bonds 32%
Year 3 – Stocks 66%, Bonds 34% … and so on.

Strategy #2: Static allocation – 20 year target
Year 1 – Stocks 50%, Bonds 50%
Year 2 – Stocks 50%, Bonds 50%
Year 3 – Stocks 50%, Bonds 50% … and so on.

If we assume that up and down years for stocks occur at random with a slightly positive bias, you will find that the probability for large and small returns at the end of the 20-year period is roughly equal between the two strategies. Neither one has an advantage over the other. If stocks perform very well in the early years, then strategy #1 performs better; however, if stocks perform more evenly or better towards the end of the period, then strategy #2 performs better.

However, there is one big factor that we didn’t include in the comparison above: on average, target-date fund fees are a full percentage point higher than those of a good index fund. If we were to include that in our calculations, you would have effectively given away an additional 17% of your total portfolio in the form of additional fees to managers, over the 20-year period. Perhaps investors should be told that managers cannot guarantee that they are providing enough value to justify those fees.

The bright side to all of this is that strategy #2 is easy. You can do it yourself.

Article Provided by Learning Markets.

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