Tweet This
Target-date funds are like the slow cookers of the investing world: Investors — particularly 401(k) plan participants — throw their money in one pot, simmer it for a set number of years and eagerly open the lid upon retirement.
But in many cases there’s much missing from that process and its set-it-and-forget-it approach, including a significant tire-kicking of the fund and its fees.
Pitched as a hands-off solution, target-date funds do the work novice investors dread: They’re instant diversifiers that rebalance automatically over time toward a given date that’s designed to match the year investors plan to retire. But they’re not exactly doing those investors a favor: According to new research by NerdWallet, a typical target-date fund with an expense ratio of 0.75% could cost a millennial investor $454,000 over 40 years.
These funds are on track to capture nearly 90% of 401(k) contributions by 2019. If you’re an investor in a target-date fund and part of that growth, it might be time to rethink your strategy.
Investment fees strike a double blow
Investment fees — like the expense ratios charged not just by target-date funds but also by all mutual funds, index funds and exchange-traded funds — are taken out annually as a percentage of your investment. That means that as your nest egg grows, you’ll pay more. Fees effectively hit investors twice: Every dollar you pay toward fees is a dollar that isn’t invested, and that isn’t given the opportunity to compound over time.
In short: The time millennials have to their advantage is also to the advantage of the fund companies raking in those fees. NerdWallet’s analysts compared several investing options for a 25-year-old who has $25,000 in a retirement account, adds $10,000 to the account each year, earns a 7% average annual return and plans to retire in 40 years. After 10 years in a typical target-date fund, that investor lost 4.7% of the account value to fees. After 40 years, that jumps to over 19%. To put that into perspective, imagine setting $1 on fire for every $4 you put into your 401(k).
Fees can’t be avoided completely ...
It’s next to impossible to invest without fees. Even if you stand there stirring the pot — am I taking this slow cooker metaphor too far? — you’ll still pay expense ratios on the funds you choose, and the funds in 401(k) plans tend to skew toward the pricier side. Still, given the choice between a company match and lower-cost investments elsewhere, you want to take that match.
What you can do is take measures to cut down the fees you pay, says Dayana Yochim, an investing expert at NerdWallet who co-authored the fee analysis.
"This firehose of low-cost money management solutions — index mutual funds, ETFs, passively managed target-date mutual funds and robo-advisor-built portfolios — means investors have more retirement savings options than ever,” she says. “It also means that consumers have to be more vigilant than ever to avoid getting fleeced by fees."
What Yochim means: You can’t assume an investment marketed as “low-cost” actually is, just as not all target-date funds are overly expensive. Much of the growth of target-date funds can be tied to the fact that they’re the default option when companies auto-enroll new employees in a 401(k) — an option that those employees frequently fail to change.
When you make the decision to invest, you’re also on the hook to do the work to understand not just what you’re invested in, but also what you’re paying — which means hunting through the fund’s prospectus, or at the very least the first few pages of it, where fees are clearly displayed in a neat table — and the impact on your investment over time. (To get at the latter without digging out your old TI-84, try a 401(k) fee analyzer, which will take a look inside your account to project the total fees you’ll pay by retirement age.)
… but fees can — and should — be limited
If you’re shocked by what you’re paying in fees — and I certainly have been — recognize that there are other options that will allow you to pay less, even without doing more.
This is especially true once you meet that 401(k) match: If your plan’s investment options skew toward the pricey side, direct the rest of the year’s retirement savings dollars into an IRA, where you’ll have a wide investment selection and the freedom to shop around for the lowest costs. Most online brokers have fund screeners, where you can sort through the various fund options and compare by factors like expenses, performance and
And if you’re digging the hands-off approach? You can open that IRA at a robo-advisor, which arguably provides more value and more customization than a target-date fund, for less. These services use a computer to manage customer accounts, rebalancing as needed, for a management fee of about 0.25%. Add that to the fees charged by the funds used (typically low-cost ETFs) and the typical robo-advisor could cost an average $232,000 over 40 years, according to NerdWallet’s research — still a hefty chunk of money, but roughly half as much as a target-date fund.
Arielle O’Shea is a staff writer at NerdWallet, a personal finance website.
