Hidden fees, poor investments can hurt your 401(k)
Target-date mutual funds are fast becoming the most popular investment inside a 401(k) plan. But such target-date funds, or TDFs, aren’t getting much love these days.
Indeed, at least one critic is blasting such funds for charging high fees. “I like target date funds but am concerned about current offerings being packaged for profit, rather than the good of the beneficiary,” says Ronald Surz, president of Target Date Solutions, a pension and investing-management consulting firm.
(Watch Surz’s webinar on the risks and rewards of target-date funds. And read the recent MarketWatch RetireMentor column “Target date funds drive up 401(k) fees.”)
What’s more, 401(k) fiduciaries—those folks charged with overseeing the funds in your 401(k) plan—apparently don’t know what their target-date funds really hold and could benefit from improved transparency, according to a just-released paper. That paper is Raising the Bar on Target Date Due Diligence, a collaboration between Manning & Napier, an investment-management firm, and Strategic Insight, a company that provides clients with mutual-fund industry research.
Given the negative press about TDFs of late, we asked experts what you might consider if you have designs on investing in TDFs in your 401(k), or if you already own such funds. Here’s what they had to say.
The luck of the draw
The sad reality about the TDFs is this: You likely don’t have much say in the matter of fees. You might have a say in whether you invest in such funds. And you might have a say in how much you invest in such funds. But how much you pay in fees is a function, in large part, of which series of TDFs your employer chooses to offer you in your 401(k).
So, if you’re lucky, your TDFs will come from those firms that tend to charge less. And if you’re unlucky, your TDFs will come from those firms that tend to charge more. Those that tend to charge less than the average include, according to Morningstar, the Vanguard Target Retirement Series, where the asset-weighted expense ratio is 0.15%; Fidelity Freedom Index Series (0.19%); the TIAA-CREF Lifecycle Index Series (0.23%); Fidelity Freedom K Series (0.57%); and the TIAA-CREF Lifecycle Series (0.6%).
And those TDFs that tend to charge more than the average include the Legg Mason Target Retirement Series (1.47%); Franklin Templeton Retirement Series (1.36%); State Farm Lifepath Series (1.27%); and Invesco Balanced-Risk Retirement Series (1.19%).
For what it’s worth, Morningstar reports that TDF fees are (thankfully) falling. The asset-weighted average expense ratio was 0.91% in 2012, down from 0.99% in 2011 and 1.04% in 2008. “We definitely recommend lower-fee TDFs, all other things being equal,” said Josh Charlson, a funds-of-funds strategist at Morningstar. “Having lower fees provides an edge over time.”
For his part, Surz recommends investing in low-cost TDFs from Vanguard, Fidelity, and T. Rowe Price, the latter of which has as an asset-weighted expense ratio of 0.79%. That makes T. Rowe Price the 11th least expensive of the 39 TDF series that Morningstar tracks. (Those three firms, by the way, control three-fourths of TDF assets, which now stand at $500 billion, according to Morningstar.)
“You can’t be faulted for choosing one of the big three, because that’s who everyone else is choosing,” Surz said. “Common practice is good fiduciary practice.”
If your employer doesn’t offer low-cost TDFs, experts suggest you write to those charged with managing your employer’s 401(k), the fiduciaries and the investment committee. Ask them to justify why they are using high-cost TDFs, and request that they consider adding low-cost TDFs to the investment menu. Consider asking your co-workers to write, as well. After all, not only is there safety in numbers, there’s power.
“It would be worth raising that issue, especially if the (TDF) they have is on the more expensive side,” said Charlson.
If you can’t get your plan sponsor to add a low-cost TDF, Charlson said, you have to weigh the benefits of a high-cost TDF against creating a portfolio of potentially lower-cost funds that might be available in your plan. With a TDF, even a high-cost TDF, you get diversification, automatic rebalancing, and what’s called a glide path. The glide path refers to how TDFs tend to reduce the percentage invested in equities the closer the fund gets to its target date, which presumably correlates with the year in which you might retire.
When building your portfolio, you are typically left to rebalancing on your own and managing your own glide path. Charlson speculated that if you have an expensive TDF in your plan, it’s quite likely that other actively managed funds in your plan are expensive relative to industry averages as well. “So the best option would be to assemble a portfolio of index funds if those are available to you,” Charlson said.
What’s in your TDF?
And that brings us to the issue of transparency. According to the Manning & Napier/Strategic Insight report, fiduciaries admit that they don’t know what their TDFs own. And that uncertainty comes from a lack of complete and comparable disclosure among the funds.
To get around this, the paper’s authors recommend that fiduciaries question whether the underlying securities of TDFs are appropriate to meet the retirement-saving needs of plan participants.
To be sure, examining funds in such detail is a challenge, but that’s what fiduciaries are charged with doing regardless of complexity. “Investment-option due diligence is a fiduciary responsibility that must be carried out to ensure that assets are managed prudently for the benefit of the plan participants,” the report notes.
Given that, experts suggest that plan participants also question the fiduciaries of their TDFs about what their TDFs own and whether those funds are being managed prudently for their benefit.
Workers investing in TDFs might also ask the fiduciaries of their 401(k) plan whether the underlying holdings for each target-date fund are revealed, if all levels of portfolio management coordinate with each other, and whether the target-date fund is over- or under-diversified.
According to the Manning & Napier/Strategic Insight paper, plan sponsors and advisers—and by extension, plan participants—may benefit from requesting information from TDF providers related to:
- Total number of underlying holdings;
- Total number of distinct holdings;
- Who specifically is making asset-allocation decisions;
- Who specifically is making security-selection decisions;
- The level of active share of the target-date family’s most equity-oriented fund, relative to its benchmark
“Full transparency on the underlying investments in a target-date fund should allow plan sponsors and advisers to better perform their fiduciary duties of due diligence on target-date funds at a level similar to that of more traditional core funds on the investment menu,” the paper’s authors write.
For his part, Charlson agrees that transparency is an issue for TDFs. “They are designed to be simple, but they have a complex design structure in terms of the underlying funds being used and asset classes,” he said. “It can be a challenge.”
His advice to participants is this: “It pays to be aware as much as possible of how your target date fund is designed and the basic philosophical principles at work.” For instance, get a sense of the TDF’s glide path, whether it’s made up of actively managed funds or index funds, and the like.
Review the glide path
According to Charlson, the details of your funds’ glide path might not matter when you’re in your 20s or 30s, but they will matter the closer you get to retirement. Check what percentage of your TDF will be invested in equities at the fund’s target retirement date and throughout retirement, because there’s a big variation among TDF funds. “It pays to look ahead,” he said. “What is the fund’s philosophy? Ask yourself, ‘Do I want 60% of my assets in stocks at retirement or do I prefer a more conservative approach where just 30% is invested in equities?’”
Fiduciaries (and perhaps by extension, plan participants) ought to take advantage of available outside sources of information to evaluate TDFs. Information on TDFs may be obtained directly from plan administrators (recordkeepers), target-date fund providers (asset managers), financial advisers and consultants. In addition, the Manning & Napier/Strategic Insight paper noted that several thoughtful, detailed and objective research reports have emerged over the past several years that can serve as valuable reference tools for target date due diligence, including the Annual Target Date Fund Report by Morningstar. Read, for instance, this Morningstar Target-Date Series Research Paper.
Why is this so important?
Why should we and you care about TDFs, their fees and transparency? Well, the big reason is this: Many plan sponsors are automatically enrolling their workers into 401(k) plans and then automatically investing their money into certain types of default investment alternatives (or QDIAs) in the absence of participants directing their own investments. And more often than not, TDFs have emerged as the dominant QDIA selected by plan sponsors.
“As more young workers get defaulted into TDFs and TDFs become the primary retirement investment vehicle, it pays to pay some attention to whether your plan sponsor has picked appropriate TDFs for you, for the plan and whether that suits your personal retirement goals and investor profile,” said Charlson.