Retirement Advisor

The Drawbacks Of Target Date Mutual Funds

It is basically the “set it & forget it” retirement investment choice for the fiscally apathetic.

Target Date Mutual Funds

Your investment choices may be very limited within a typical employer 401K plan. You most likely will have access to target-date mutual funds from only a single provider. If your choices are severely limited, you, as an astute investor, can’t shop for the lowest fund costs let alone the ones with better returns.

The average target date retirement fund had a 0.73% expense ratio in 2015, according to a Morningstar report.
They went on to state that target-date funds also often charge higher fees than other types of mutual funds, because these funds will pass through the fees charged by the underlying fund options that comprise the fund as well as its own management fees. This can substantially reduce the return posted by the fund over time. Investors who bypass target-date funds and invest directly in the underlying funds can avoid some of these fees, although they will be responsible for manually reallocating the funds to match the glide path of the target-date fund over time.

Target-date funds can provide hands-off investment management for many investors, but buyers should do their homework on the particular fund that they choose before investing. Although these funds can effectively put a retirement portfolio on autopilot, they often reward you with lower returns in the long run.

“Target-date funds don’t necessarily mirror the performance of the larger stock and bond markets. Instead, their returns depend on the mix of their individual portfolios, and in some years, their returns may be very disappointing.”

Higher fund costs and poor exit timing
Investors who purchase target date mutual funds outside of an IRA or qualified plan will unexpectedly realize capital gains (and thus trigger capital-gains taxes) on a regular basis as shares of the funds that have performed well in the target-date portfolio are sold off and moved into shares of funds that have not performed so well. Because of this disadvantage, target-date funds are commonly used inside tax-deferred retirement plans in order to avoid this problem.

The glide path (the transition from an aggressive portfolio to a conservative one) can also vary substantially from one target-date fund to another, which means some funds are exposed to a great deal more risk than others by the time their target date arrives. Some will still have 70% of their portfolios invested in stocks at the target date, while other target date funds will only have 30% of their assets still held in equity funds. If you’re considering using a target-date fund, first take a close look at the allocation of a target-date fund from the same fund family that is about to mature or has already matured. This can help you to determine whether the target-date fund you’re looking at will match your risk tolerance at the target date.

Fund timing may be incorrect for you
Because the glide path changes the fund asset allocation over time, a target-date fund may end up selling at lows and buying at highs.  Investors are then less likely to recoup their losses than if they held the same investments outside of a target date fund and waited to sell until the market improved.

Why is this so important?
Why should an investor care about target-date mutual funds, their fees and transparency? Well, the big reason is this: Many plan sponsors are automatically enrolling their workers into 401K plans and then automatically investing their money into certain types of default investment alternatives (or QDIAs) in the absence of participants directing their own investments. And more often than not, target-date mutual funds have emerged as the dominant QDIA selected by plan sponsors.

Many investors also leave their money in cash, either because it was the default option when they opened their employer 401K and they never changed it or because their unfamiliarity with investing makes them too afraid to do anything else. In fact, the Target Date Retirement mutual funds which have become a staple on most employer sponsored 401K plans were inspired as a default placement for new enrollees. Target Date Funds not only give investors an easy, no research choice but also help reduce the liability claims towards the plan sponsors when cash was previously the sole default choice.

As more young workers get defaulted into target-date mutual funds and these funds become the primary retirement investment vehicle, it benefits 401K investors to pay some attention to whether your plan sponsor has picked appropriate TDFs for you, for the plan and whether that suits your personal retirement goals and investor profile.

“These (target date) funds are also not immune to some well-worn fund and 401K maladies, including possibly high fees and a presumptuous belief that active management can consistently beat passive indexing.”
– New York Times

Most Target-Date Fund Managers Won’t Even Invest In Their Own Funds!!
Morningstar went on to report the stunning fact that “only three (target-date mutual fund) managers invest more than $1 million of their personal assets in the target-date mutual funds of the series they manage. More than half of the industry’s target-date series are run by managers who have made no investments in the target-date funds they oversee”.
Ponder that statistic for a moment. If the majority of fund management won’t even invest in their own target-date retirement funds….why should you?

“A vast majority of 401K’s offer only funds run by the plan provider. For the providers, keeping all assets in-house makes plenty of business sense. But for plan sponsors, who have a fiduciary responsibility to run the plan for the benefit of employees, being able to pick and choose among different managers would offer the chance to package a target date mutual fund made up of best-in-class funds. ING reports that only 6 of the 21 largest target-date funds now use nonproprietary funds.”
– New York Times

Need A Consultant?

So, should you invest in your employer’s 401K account if you’re confused and looking for help with your retirement?  We can manage your 401K, TSA, TSP, Simple Plan or Pension Plan.   If your portfolio lost more than 10% in the last recession, you need to take another look at how you are managing risk.  Consulting with a professional investment advisor at Research Financial Strategies will help you to make important 401K decisions.

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Jim Streight James Streight Chief Marketing Officer