If you've set your 401(k) on auto-pilot with a target-date fund (TDF), it could be a ticking bomb.
While TDFs are vehicles of convenience -- they invest in several mutual funds in one package -- they may be loaded with inappropriate amounts of risk.
Ron Surz, president of PPCA, a firm that counsels financial advisers, has been warning about TDFs for years.
He says you have to look under the wrapper of the TDF to know exactly what you're getting.
They (your employer or fund company) must tell you the "glidepath," or mix of stocks, bonds and other vehicles from now until your "target date," which, for most people is the year in which they hope to retire.
There are a number of nuances that could spell disaster if the glidepath is wrong for you.
First and foremost, you have to ask if you're taking too much risk, that is, what is the fund company doing to prevent a massive loss ala 2008? Can you afford to take a hit now?
Ultimately, you need to know how much the TDF will decline if there's a sell-off in either the stock or bond markets.
With the prospect of higher interest rates increasingly likely, don't forget that you can get hurt if you're stuck in bonds, particularly long-maturity government bonds, which get pummeled when interest rates rise.
How to Defuse the Bomb
Here are some questions that Surz recommends you ask to avoid a 401(k)/TDF implosion:
1. Who has the broadest diversification at the long dates?
Broad diversification includes global stocks, global bonds, global real estate, commodities, natural resources, etc. That means if your TDF is invested exclusively in US stocks and bonds, you aren't diversified enough and the risk level is too high.
2. Who has the least amount of risk?
There is a wide range of stock mixes across TDFs at the target date. Where do you want to be at your target date? Do you still want to be 60% or more in stocks? Keep in mind that TDFs may also take you "through" retirement. That means you will need to take some stock market risk to counter inflation and pay bills well into your ninth decade. There's also risk in bonds and cash, which don't keep up with inflation. Bonds lose value when rates rise.
3. Are the fees reasonable, with all-inclusive costs below 0.50% annually?
Keep in mind that fund companies are charging you extra for the service of managing and packaging multiple mutual funds. You can find individual exchange-traded funds that charge less than 0.15% annually that will do the same thing. What if you look under the hood of your ETF and are not happy with what you see?
You can either invest outside of your 401(k) or ask your employer to make changes.
"Most participants in TDFs are there by default, in their 401(k) plans," says Surz, "and they should complain to their employer if the 3 critical criteria are not being met. If they’re choosing their own TDF, they should focus on the 3 critical criteria, and not buy a fund that charges more than 0.80% annually."
