The Target Date Funds in Your 401K Aren’t Worth the Costs
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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.
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11 Comments so far
leave a commentStrategy #2 is not an index fund (although you can choose to use index funds for the stock and bond investment respectively). Second, the notion of a constant percentage in each asset class may sound appealing as you are accumulating more when prices go down and selling when prices go up. However, constant rebalancing in this manner is just like writing both call and put options. It gives a better payoff if stocks
don’t move much, at the expense of worse payoff if stocks move a lot.
I really don’t like this article, for a number of reasons. In particular…
If you want to keep your risk constant, then you need to tweak your portfolio to be more conservative as it grows.
If someone invests their retirement funds in one lump sum at the age of 30, sure, it makes sense to keep a constant allocation.
But if someone has 200k at age 30, 500k at age 40, and 1mil at age 50, then if you want to keep the DOLLAR VALUE risk (the real risk) constant, then your PERCENTAGE risk must go down.
It seems to me that you’re entirely missing the point of the typical advice to invest less aggressively as you get older. It’s not at all about market timing, and I’ve never heard anyone claim that this strategy is designed to maximize your expected returns. It’s not.
As I understand it, the point is that as people get older, they often put a higher priority on having predictable assets and income than on getting the very highest returns. That’s very important when planning for retirement. Put another way, if a 30 year old loses everything in a stock crash she’s got many years to recover, but if the same thing happened to a 65 year old who’d just quit his job it could be a disaster.
You may not agree with that advice (I think it depends quite a bit on individual risk tolerance and assets), but to characterize it as “a backwards form of market timing” is ridiculous. Now, the “higher fees” argument is a very good one, but that applies to mutual funds in general. There are certainly target date funds with very low fees: as one example, none of Vanguard’s offerings have expense ratios above 0.2% (or any other fees). That’s hard to beat no matter what sort of fund you invest in.
//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.//
Thing is this strategy only shifts the risk from the start of the plan where you can probably make it up, to near retirement where you have little wiggle room, basically making it so you will never be able to sleep during the last two years of your working life over whether or not a sudden downturn in the market would make it so that you will have to work at Walmart for the rest of your life. Sure gradually reallocating your money from stocks to bonds may end up minimizing your gains, but you’ll at least get some sort of guarantee on what you are going to end up with at end, something you won’t have if you have half of all your money in the air until the very last day.
You are correct however about target date funds not being worth it, due to the fees.
You leave a good point about the allocation and higher fee for target date fund. One caveat is that some people do not know when would be a good time to adjust the allocation, and they might often put too much allocation to stocks when it’s close to retirement. The target date fund is tailored based on the age of someone, rather than market timing. Stocks performing poorly (assumed going down) in the early days is a good thing for investors, since everything is on the cheap. And this is really market timing, and most investors are not good at it. So I don’t know how valid it would be.
There are also some concerns about the strategies you outlined. It’s assuming some random distribution of the stocks, and they’re really hard to predict. The good thing about the reallocation of target date fund is that it doesn’t care what the stock is doing, and it reallocates based on the risk tolerance of the investor. I hope you have some numbers that you can show to us about the 2 strategies too, that’d be very helpful and would clear up some confusion.
And it’s also more of the psychology behind an investor rather than the logics. Some people just want to put their money in there and move on with their lives because they don’t want to learn much about it. And in fact if they had to choose the fund allocation to invest in, they would probably not invest in the 401k at all (or would do it rather late in the game).
Bottom line: DIY might be worth it, might be not. Thanks for this article, really got me thinking!
But you’re ignoring the fact that you don’t want your retirement savings to disappear overnight because of a market drop the year before you wish to retire. The movement to lower-risk investments is to stabilize your retirement funds as you prepare to retire. You need that additional stability to plan properly. Hit a recession with 50% of your retirement assets in stocks and you won’t be retiring next year like you had hoped.
as a former industry member, this is a simple yet great article. Whether or not you are in a target date fund a lot of advisors tend to use something similar to the target date model when allocating people’s portfolios (ex. modern portfolio theory, etc.)-like the article states, it has its benefits and drawbacks. with that said the question is, is your advisor a salesperson or truly an advisor of yours?
It’s a great thing to second-guess mutual fund products that purport to be an all-in-one solution in retirement planning. But I disagree with most of your premises. In fact, I think this is doing a huge disservice to Mint’s readers, who might just take your advice, not understanding how different it is than they’d get nearly anywhere else.
First, it’s easy to “do it yourself” and still adopt the allocation timelines that these funds take. In fact, millions of investors do it, and nearly all of the time, the mutual fund companies even let you know the exact underlying funds they’re investing in. If you rebalance once a year (as you’d have to do to return to your 50/50 allocation anyway), it would take exactly the same amount of work to rebalance into a new allocation.
Second, you seem to either not understand or not want to address the basic premise of mainstream portfolio allocation. Mainstream advisors recommend a more bond heavy allocation late in someone’s life because of the risks of a bad stock year late in life. It’s not the average performance people are worried about. It’s the performance they could experience in extremely bad market years like 2002 and 2008.
For your simulation to carry any weight, you’d have to show the “worst-case scenario” for each example, using actual historic market returns rather than a random distribution around an average return, which leaves out those extremely good and extremely bad years for stocks. It’s hard to understand or criticize your simulation because you left unsaid so many extremely relevant assumptions–even basic things like your assumed “average” return for stocks and bonds or if you just assumed a random distribution around the average or if you had fat tails to account for actual returns, etc.
Basically, if you’re going to try to upend everything every credible advisor, magazine, book, and newspaper has advised, you better go a bit deeper in your analysis.
Also, it’s a little unfair to reference the regulatory criticism without telling people what the criticism was. Basically, target-date funds from different companies had wildly different allocations from each other for people close to retirement. So some savers who thought they were in a conservative allocation weren’t and lost a lot of money. If YOUR suggested portfolio of 50/50 all the time had been used by these funds, there is no doubt you’d be facing the same scrutiny, given that it would have lost 25%+ of its value in the downturn for people who couldn’t afford to lose that much.
I know this blog is edited, and I really hope someone at least points to other some other opinions and mentions if something is unconventional advice next time.
This is horrible advice. You don’t provide any numbers to back up your claims over various historical periods. The only useful advice is to avoid high fund fees. Although you blanket all target date funds with high fund fees. Nice.
Does anyone working right now honestly think they are going to retire? I’m in my 30s and when I’m old enough to retire and I ask when I can stop working my Wal-Mart manager is going to pat me on the head and escort me back to the front of the store…
Yes, I plan on retiring. Just because you don’t save for retirement doesn’t mean other people don’t.