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SKARBECK: Target-date funds aren't always best 401(k) option

July 22, 2017

Ken SkarbeckTarget-date funds have become the most popular “default” option in 401(k) plans. About 60 percent of all 401(k) plans automatically invest employee funds in a target-date fund unless the participant opts to select a different investment strategy. Assets in target-date funds have exploded in recent years, attracting $880 billion in 2016, up from $763 billion in 2015. These funds are also called life-cycle funds or age-based funds.

The idea is that investors select just one fund with a stated target year near their projected retirement date. Then relax and allow your investment plan to operate on autopilot. For example, a 50-year-old worker today who is projecting to retire in his late 60s might select the LifePath Index 2035 fund managed by Blackrock. This target-date fund is a “fund of funds” where investor assets are allocated among seven Blackrock index funds that charge 0.25 percent in expenses and fees. The current allocation is approximately 71 percent in stocks, 10 percent real estate investment trusts, and 19 percent bonds.

During the next 17 years, the fund will regularly “rebalance” its portfolio, moving assets from stocks to bonds, along the “glide path” as the years tick away. As 2035 approaches, the now-older investor’s portfolio will be positioned more conservatively, having less invested in stocks and a larger percentage in fixed-income investments.

While the concept behind target-date funds follows conventional investment norms, not everyone thinks they are the best way to manage your retirement account. One criticism of these funds is assuming that one size fits all. Investors have different financial profiles that might require a more hands-on approach. More 401(k)s now offer a managed-account option through a robo-adviser, asserting that they allow the investor to build a more customized portfolio. These managed options can cost 0.1 percent to 0.8 percent more than target-date funds.

Target-date fund investors also should consider that increasing their allocation to bonds exposes them to losses if interest rates materially rise. Potential losses from the bond component of target-date funds runs contrary to the notion that stocks are the riskier asset.

Perhaps more important, target funds move investors out of stocks over time when, in fact, a higher allocation to stocks might be necessary, even after retirement. Retirees are living longer and will need to achieve higher rates of return to outrun inflation and make their nest eggs last.

Investors also should be aware that some target-date funds charge excessive fees. Because most target-date funds are fund of funds, they often charge two layers of fees—an administrative expense in addition to the fees charged by the underlying mutual funds. Fees as high as 1.5 percent generally will result in poor overall performance in a 401(k) plan. In this case, a 401(k) participant would be far better off directly choosing the index funds himself versus investing in the higher-cost target-date fund.

Fans of target-date funds say they are an improvement over the haphazard way many 401(k) participants invest their funds. For 401(k) participants who want a one-decision choice, target-date funds serve a purpose. For investors who are more engaged in managing their finances, better investment choices are available.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 317-818-7827 or ken@aldebarancapital.com.

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