(Yahoo!Finance) - Investors taking the easy road may be shooting themselves in the foot — and in droves.
Conventional wisdom dictates that as investors get closer to retirement, they should periodically rebalance their portfolio to reduce risk. The idea is simple enough: shift your focus from growth to income as you near retirement. This act, known as rebalancing, usually means increasing the percentage of fixed-income investments in a portfolio and reducing the percentage of equities. But those coasting on auto-pilot should be wary of the expense.
After all, since 1994 investors have been offered a set-it-and-forget-it approach to saving for retirement known as the target date fund. These mutual funds automatically rebalance over time, and presto: investors veer toward a more conservative portfolio as their planned retirement date approaches. Research shows that target date funds are growing in popularity, especially among younger investors. Yet they come with a major caveat: higher fees that can eat into long term returns and deter some investors. A financial advisor can help you determine whether a target date fund is right for you.
While only 19% of 401(k) plan participants held target date funds in 2006, that number surged to 56% by the end of 2018, according to the EBRI/ICI 401(k) database, which includes information on over 27 million plan participants.
It’s no surprise that more plans are offering target date funds. By 2018, nearly 80% of plans had target date funds available, compared to just 57% in 2006. As more companies automatically enroll new employees in their retirement plans, target date funds have become more common, according to a paper written by Sarah Holden and Steven Bass of the ICI and Jack VanDerhei of EBRI.
“The offering and use of target date funds in 401(k) plans have expanded, both as plan sponsors have increasingly offered target date funds in their investment lineups and as automatic enrollment has spread, often using target date funds as the default investment,” Holden, Bass and VanDerhei wrote.
“ICI 401(k) plan participants with shorter tenures will have entered their 401(k) plans at a time when both target date fund offering and automatic enrollment are more common than when longer-tenured participants entered their plans.”
Because 401(k) plan participants with shorter tenures are more likely to have been automatically enrolled in TDFs, younger investors are more likely to be invested in target date funds than older investors who have been in the workforce longer. More than 60% of 401(k) participants in their 20s held a target date fund at the end of 2018. For comparison, only half of participants in their 60s had target date funds in their portfolios.
Convenience Comes At a Cost
With automatic rebalancing, target date funds offer retirement plan participants a greater level of convenience than conventional mutual funds. But this convenience comes at a cost. In 2020, the average asset-weighted expense ratio of target date funds was 0.52%, which is higher than the average asset-weighted expense ratio across all mutual funds and exchange-traded funds (0.41%), according to Morningstar.
Index funds, which track a particular market index, are far more affordable than target date funds. In 2020, the average asset-weighted expense ratio for index funds was just 0.12%, according to Morningstar.
While the difference between 0.52% and 0.12% may seem insignificant, it can add up to lots of money over many years. For example, if a 30-year-old with $25,000 in retirement savings has her money in a target date fund with an average expense ratio, her money would grow to $217,656 over the next 30 years (assuming an average annual return of 8% and no additional contributions). However, if her money were placed in an index fund that earned the same 8% return over the next 30 years, her savings would be worth almost $26,000 more than with a target date fund, after expenses.
Target Date Funds vs. Index Funds Fund Type Principal Investment Expense Ratio Total Investment After 30 Years Total Fees Paid Target Date Fund $25,000 0.52% $217,656 $33,910 Index Fund $25,000 0.12% $243,315 $8,251
It is important to note that expense ratios do not remain static. While mutual fund and ETF fees have dropped across the board, they’ve fallen especially fast for target date funds, going from 0.73% in 2015 to 0.58% in 2019 to 0.52% in 2020.
Target date funds can be convenient and effective tools for those saving for retirement. With more employers automatically enrolling their employees in retirement plans, the number of 401(k) participants with target date funds has soared in recent years. But you should be aware of the fees associated with the funds that you are invested in. Target date funds have higher average expense ratios than the typical mutual fund or ETF. This is especially true when comparing target date funds to index funds, whose average expense ratios were just 0.12% in 2020.
Retirement Planning Tips
How much money will you need to retire comfortably? Are you on track? If you don’t know the answer to either question, try out SmartAsset’s free Retirement Calculator to see how much your savings will be worth by the time you retire.
A financial advisor can help save and plan for retirement. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.