3 Reasons Not to Use Target Date Mutual Funds in a 401k

Target date mutual funds are the latest popular instrument on the block, popping up at the offices of stockbrokers and financial planners all around the country. Many 401k and IRA plans are quick to add them to their offerings. For professional planners, their convenience is unmatched. Just throw in a contribution, and at least according to the name of the fund, you'll hit your target retirement date perfectly.

Most target date funds are sold with target dates ending every five years. A common fund would be a target date 2020 fund or 2040 fund, where the investments held within the fund would be fit for someone seeking to retire in 2020 or 2040.

Target Date Funds Assume You're on the Right Track

Those who are within a period of 20 years before retirement might want to think twice before shipping their cash off to a target date mutual fund. A forty year old investor who seeks to retire at 55 might purchase a 2025 fund, thinking that the fund is balanced perfectly to allow for the growth needed to retire at 2025.

This is not the case. Target date funds are built from the top down. If the assumption is made that investors wish to retire in 2025, for example, the funds are then spread among investments that will provide growth, but also security, as there are only 14 years before the target date is reached. This generally means an asset allocation that is heavy on fixed income securities and light on equities.

These types of funds make a mockery of what should be proper retirement planning strategy. Imagine two clients: a 55 year old investor and a young 25 year old. Both share a big goal of retiring in the next fifteen years.

For the 55 year old to retire in 15 years, he may need only a modest appreciation in his portfolio, and he is likely seeking more downside protection than upside potential. However, for the young 25 year old, a target date fund for his needs would have to be all penny stocks to provide the kind of upside necessary for his 40-year old retirement.

Unfortunately for the 25 year old, which is the age of people who are usually fooled by such funds, this 2025 target date fund isn't built for rapid growth, but instead, asset protection. By 2025, he'll have wasted nearly 15 years saving in mostly safe, boring investments that provide little upside, meaning that he'll have to either take more risk in the future or increase his retirement contribution.

However, the problems with target date funds don't stop with their symbolism.

Target Date Funds Are Loaded with Fees

Financial planners learned very quickly that front-end or back-end sales loads would last only so long. Eventually, investors, fed up with paying 5% to enter or exit a fund, started looking for no-load funds. Today, nearly all mutual funds (with a few exceptions) operate without sales loads, and they aren't nearly as profitable as their predecessors.

Target date funds, for many planners, were there to fill in the void left from a sales load extinction. While the fees may not be obvious at first - as they rarely are - target date funds are some of the most expensive mutual funds you can own. But why are they so expensive?

Target date funds are notorious for being funds of funds; that is, they are mutual funds in which other mutual funds are held.

For example, if you were to buy a 2050 target date mutual fund, it could contain 10 other mutual funds, with five stock and five bond funds. The target date mutual fund charges an expense fee of .75%. While .75% is inexpensive for an actively managed fund, you have to consider that the 10 funds held within your target date funds also charge fees. Thus, a target date fund comprised of funds with a weighted average fee of 1.25% and its own expense of .75% per year would cost a whopping 2% per year from top to bottom!

That total cost of ownership, though outrageous in its own right, makes the upfront 5% sales loads and 1% annual fees of the 1990s look inexpensive! Today, the median target date fund charges just .68%, slightly lower than a .71% annual expense for the median stock fund. However, fees vary wildly from fund company to fund company and from fund to fund. An actively managed stock fund may charge as much as 2%, while an index fund costs less than .25% per year.

Close Dates Aren't Always Safe

The goal of a target date fund is to provide a very basic asset allocation that fits your goals as you near your planned retirement age. While that is a very honest goal, and one that should be achievable, more and more target date funds are missing the mark, preying on the beauty of visibly low annual expense fees and investor's desires for convenience.

Target date funds missed the mark horribly in 2008, relying far too heavily on the equity markets and putting a number of would-be retirees back to work. In 2008, 2010 target date funds were horribly volatile. The best fund lost 3.6%, a reasonable dip for the near depression-like decline of 2008, but the worst fund lost a whopping 42%, making it a worse investment than the all stock S&P500, which lost 37% in 2008 alone.

Perhaps the worst part of the decline is that few investors would even know what caused such a tumble in their assets only two years from retirement. Due to the way target date funds are structured as funds of funds, investors have to first research which funds are held in the target date fund, and then which individual investments make up each mutual fund.

As many may already be aware, mutual funds can be very widespread investments, containing anything from credit default swaps to forward currency contracts. With this kind of exotic exposure, no fund is safe from near catastrophic decline, regardless of what the target date indicates.

How to Use Target Date Funds, If You Must

For some, target date funds are the only option offered through a 401k. While target date funds shouldn't be a go-to investment, there is little logic in passing up an employer match, especially as one nears retirement.

Target date funds are best used for bond exposure, since bond funds commonly have the lowest fees. Ideally, store retirement cash in the closest date retirement fund, and then make adjustments to other retirement portfolios. For instance, if your desired target retirement date is 2040, buy a 2010 fund through a 401k and balance it out with riskier investments in an IRA. Should you ever change jobs, or have the opportunity to move your cash, move it quickly into better, more personalized investments.
Tim Ord
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