Is Your 401(k)’s Default Investment Steering You Wrong?
Target-date mutual funds are among today’s most popular investment choices, and it’s easy to understand why. Their appeal is their simplicity: Realizing that many people don’t understand how to build a portfolio based on their optimal asset allocation, they do the work for you.
Just choose a fund that has the year closest to your intended retirement date as part of its name — for instance, if you expect to retire in 2030, you might choose the Fidelity Freedom 2030 fund — and your assets will be invested in what the fund company thinks is the ideal mix of stocks and bonds for that retirement date. It will even automatically alter that mix over time, becoming more conservatively invested as you near retirement.
In many cases, your company’s 401(k) plan will have such a plan as your default investment option, meaning that if you don’t make any changes, your contributions will be invested in such a fund. But target-date funds are not without their downsides.
If you’re not careful, target-date funds’ main benefit can also be a danger, with their “set-it-and-forget-it” reputation lulling you into a false sense of confidence and complacency. Just because a fund has the year of your intended retirement in its name, there’s no guarantee that it’s actually well suited to your unique investment time frame and temperament — the two most important factors in determining your optimal asset allocation.
During the Great Recession of 2008, some investors in 2010 target-date funds lost a lot of money when the market fell by nearly 40 percent. They probably expected their funds to be invested more conservatively, since a 2010 fund was aimed at people who intended to retire in just two years.
That highlighted a key watch-out for target-date funds. Take multiple companies that offer target date funds designed with the same retirement date in mind and you’ll find different asset allocation designs — sometimes very different.
For example, a review of target-date 2040 funds offered by the top 10 target-date fund families by assets under management found equity allocations ranging from 71 percent all the way up to 95 percent.
The Best Fund for You
Whether you are already invested in a target-date fund or are just considering one, take a few minutes to determine your optimal asset allocation using a free online tool, such as Vanguard’s Investor Questionnaire.
Then, if you’re limited to one particular fund family — as may be the case if you are investing through a workplace 401(k) plan — find the target-date fund that most closely matches that allocation. It might not be the one with the year of your intended retirement in its name!
For example, let’s say you’re 35 years old and plan to retire at age 70 — that is, around the year 2052. You might assume you should invest in a 2050 fund since that date most closely matches your intended retirement date of 2052. If you only have access to Vanguard target-date funds, its 2050 fund’s asset allocation has a 90 percent/10 percent stock/bond allocation.
But that might be too aggressive an asset allocation for you. An investor questionnaire like Vanguard’s might suggest an 80 percent/20 percent stocks/bonds asset allocation based on your answers to questions about risk tolerance. To get that 80 percent/20 percent allocation, you’d have to choose Vanguard’s 2035 fund. On the other hand, if your workplace plan uses American Funds, its 2040 fund most closely matches your optimal asset allocation.
A target-date fund will get you in the right asset-allocation ballpark, but the exact asset mix will vary from company to company, so it’s on you to do the research and pick the fund that best fits your needs.
Scoring the Lowest Fees
If you’re free to choose among multiple fund families — maybe your 401(k) plan gives you access to a brokerage window, or you’re investing through an IRA — go one step further. Find target-date funds from several fund families that match your optimal asset allocation, and then look for the one with the lowest expense ratio.
Among the top-10 target-date 2040 funds, expense ratios range from a low of .16 percent all the way up to .94 percent. For every $1,000 invested, that translates into annual costs of $1.60 to $9.40. Not surprisingly, a comparison of how those 10 funds performed in 2016 showed the one with the highest expense ratio performing much more poorly (a 5.2 percent return) than the one with the lowest expense ratio (an 8.7 percent return).
Target-date funds definitely serve a helpful purpose in simplifying asset allocation decisions. However, don’t let their simplicity lull you into a false sense of confidence. Choosing a fund just because it has the date of your intended retirement as part of its name is not enough. Take the time to determine your optimal asset allocation and then choose a fund that’s designed accordingly.