How would you feel if you visited a fine restaurant with excellent reviews, ordered a complete prix-fixe meal, and when it arrived you needed a research project just to figure out what ingredients were in the dishes? Or whether they were healthy, or local, or even edible? Worse, what if you had no real idea what this spread was costing you – not when you order it, or ever?!
Target date funds (TDFs) are a little like that. The promise was that they’d be both effective and cheap. We’ve always had real concerns about that first part. A one-size-fits-all approach can’t serve all investors equally well. Among other considerations, a too-short glide path may bring returns down to earth too soon for a retiree who needs significant earnings to continue through a long retirement. Alternately, a too-long path may expose investors to inappropriate levels of risk.
The fact that TDFs bundle so many assets under a single manager creates another kind of risk from a fiduciary point of view. Until now, there’s been a long-term trend in 401(k) toward greater diversification among fund managers. TDFs represent a big step backwards.
The dollar menu
Ok, but at least they’re inexpensive, right? Sadly the story here isn’t much better. According to a Morningstar report target date fees are all over the map, from an impressive asset-weighted expense ratio of 15 basis points (Vanguard) or less (a few all-index funds) to whopping fees of well over 100 (Legg Mason, Franklin Templeton, and Invesco, among others).
This might not be a problem if investors were well-informed and could simply choose lower-cost funds. But unlike retail clients, or retirement plan participants who get access to traditional funds through a brokerage window, plan investors typically don’t have a choice of TDFs. They’re stuck with whatever fund family the plan offers.
One expert goes so far as to suggest the target date concept is an attempt “to create an oligopoly in the market to dominate market share and maximize fees for a handful of firms.” He even refers to the decision to allow TDFs as a QDIA “the Fidelity Enrichment Act.” His interpretation of motives may be a bit paranoid. But considering that three firms control 75% of TDF assets, the outcome looks uncomfortably close to the truth.
Just in case anyone still thought fees weren’t important, a recent AARP analysis found that excessive investment fees can cost the typical worker $100,000 over a career. To put that in perspective, AARP notes that this individual would have to delay retirement by at least three years to make up for the loss.
The performance of the underlying funds is yet another issue with TDFs. We’ll mention it only in passing, since we believe actively-managed funds are mostly inappropriate for the average plan investor anyway. What all these concerns about TDFs have in common is really a lack of transparency.
Let the sunlight in
In most cases the cure for a transparency problem is simply disclosure. Let sunlight shine on fees, or anything else, and market forces will take care of the rest.
Retirement investors, however, don’t always behave like an efficient market. They routinely act against their own best interest. They’re also notoriously information-averse when it comes to financial matters. We believe that all the transparency in the world can’t solve the problem, because investors don’t want to know the details. They want someone they trust to handle them.
The optimal answer
The simple answer to a host of problems with TDFs is affordable, professionally managed accounts. In a managed account the components of the portfolio are selected not only for an optimal allocation of assets along the Efficient Frontier, but also for tax efficiency, and yes, for the lowest cost in fees – which according to our data are equal or less than comparable TDFs. Because the difference in value is proportional to assets, target date funds might be just fine for young workers with a minimal assets. But that value breaks down right when it really matters: when account balances get bigger.
Rather than being doctrinaire about any one factor such as fees, however, the manager seeks to maximize retirement income over the lifetime of the account, in perfect alignment with the investor’s own goals. Because the advisor is independent (or should be), there’s no concern about whether in-house funds are overly expensive or low-performing. And because the advice is fully personalized and based on best practices, it offers what many retirement investors value above all else: peace of mind.
Bundled services, whatever they may include, are simply not the same as professional management. It’s like comparing a bag of groceries and a gourmet meal – the difference is much bigger than just having to do your own dishes.