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

Target date funds would be great if managers could foresee the future. The actual returns from these products may surprise everyone.

Financial professionals and management firms are not always as forthcoming as they should be about the subtle but material details that you should know before investing in their funds. Some products have significant flaws that negate any benefits but they may be hard to identify unless you know what to look for. This article will discuss one such flawed investment product called a “Target Date Fund.”

Investing Scams: Target Date Funds

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.

A target date fund essentially automates a portfolio reallocation strategy for you based on some date you set in the far future so that you don’t have to do it yourself.

This all seems reasonable but it rests on an 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 at the end towards your target date?

In the last case you will have maximized your losses and minimized your gains by using a target date fund! The real problem is that 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 but doesn’t results in the same kind of fees. Rather than reallocating your exposure each year of your investing life you could hold your exposure to each asset class constant.

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 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 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, the average fees for a target date fund is a full 1% higher than a good index fund. If we were to include that in our calculations you would have effectively given away almost 17% of your total portfolio through additional fees to managers, over the target period. These managers cannot show that they are providing any value to justify those fees. This flaw should be disclosed to investors but isn’t.

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