Target date funds are wildly popular in 401(k) plans and are found in almost 80% of plans today. The little-known secret? They can be among the most expensive funds among the investment options. According to Morningstar, quoted in today’s Wall St. Journal article on target date funds, the average operating expense ratio (OER) of the 2,200 target date funds in existence is 0.903%.
Now, most sophisticated plan investment committees want expenses on funds to average below 0.65% if that includes actively managed funds and much less if the plan lineup is heavy on index funds. Yet target date funds on average are almost 50% higher than that.
Even worse, some fund families like American Funds, a very popular provider of 401(k) plans, have some target date funds with a higher expense ratio than the individual funds that make it up! Say what? The difference is pure gravy, more money in the pocket of fund companies and less money for plan participants, especially since target date funds are likely to be the most popular choices of plan participants.
I can build a custom target date fund from index funds and come in at 0.25% or less, depending on the mix.
You may not think saving 0.65%/year on expenses using custom target date funds amounts to much. Well, over 30 years, for a person starting with a $10,000 balance and contributing $5,000/year including the employer match, the difference is nearly $80,000 more at retirement (assumes 7.65% vs. 7.00% return). If that’s the average experience, multiply that by all the people participating in the plan and you are soon talking about millions of additional dollars for your workforce at retirement. That’s the tremendous value of lower fund expenses translated into better performance.
Don’t even get me started on the fact that many plan participants are pretty far off on what they think the allocations are in the target date funds near the target date. When they think they know what they have and are wrong, that’s a potential disaster in another big market downturn.
Consider having me replace your target date funds with custom target date funds using the best funds of each category rather than settling for off-the-shelf target date funds with high expenses. It can make a tremendous difference in how well your employees retire, including you.
Dave Hoshour AIF, MBA, MA
Cornerstone Investment Services
A Fee-Only Investment Advisor Specializing
in Company Retirement Plans
10800 Sikes Place Suite 300
Charlotte, NC 28277
Note: This is part of my series on the biggest problems facing 401(k) plans today.