Summary

• Target-date mutual funds are among the most popular for 401(k) participants.
• Target-date mutual funds dramatically underperform the S&P 500.
• There are many better choices than target-date funds for 401(k) participants.

When 401(k) participants must decide how to invest their hard-earned wages, they are faced with a bewildering array of choices. Most rank-and-file workers do not have the background or experience to understand what is likely to be the best choices for them. According to the mutual fund trade association (NYSEARCA:ICI ), about 41% choose target-date mutual funds, and this number is expected to grow to over 50% in the coming years.

Target-date mutual funds seem to be the best bet for many workers for the simple reason that they have an idea of what year they are likely to retire, and picking that year makes the most sense to them when they have no other benchmark to compare one investment choice to another.

Target-date funds are set up to shift between equities and fixed-income securities (such as government bonds) over time, so that as the target date is approached, a smaller percentage of the total portfolio is in equities and a greater percentage is in fixed income, presumably less-risky choices. The higher percentage in equities is deemed most suitable for the furthest-out years, since those folks are younger and can handle a higher degree of risk (and have more years to recover from a market correction).

Let’s check out how target-date funds stack up against an investment in the S&P 500, which is generally considered to be the market. Every year, McGraw-Hill Financial publishes the S&P Target Date Scorecard, which reports the average performance of target-date funds for the prior year, as well as the three-year and five-year numbers.

For 2013, the S&P 500 (NYSEARCA:SPY ) had one of the best years in history, gaining 32.42% (including dividends). Here is how this number compared to the average target-date fund performance:

Which target-date fund would you prefer to have owned, compared to the S&P 500? Clearly, the answer is none of them. Since the longest-out funds (2055) contain a larger percentage of equities, they lagged the S&P 500 by the least, but even the best of the target-date funds came up short of the overall market by 23%.

Given these figures, why would anyone own a target-date fund? It just doesn’t make any sense to me.

Maybe 2013 was an exception to the norm. Let’s check the chart for the last three-year annualized returns for the S&P 500, compared to the target-date fund performance:

The average annual gain for the S&P 500 over the past three years was 16.79%. Once again, these are considerably better years than the average. (Over the past 13 years since the beginning of this century, the S&P 500 has gained only about 3% a year, roughly equivalent to the rate of inflation.) The 3-year chart shows the best target-date fund (2055) lagging behind the S&P 500 by 28%, while the worst (2010) fell behind by a whopping 61% (since these funds were primarily in bonds or money-market investments with negligible returns these days).

So how about the 5-year averages? Do the target-date funds hold up any better over a longer time period? Here are the numbers:

The target-date funds performed better over the 5-year time period, but there was not a single instance where they did as well as the S&P 500. The best-performing target-date fund lagged by 18%, and the worst fell 43% behind. (There is no 5-year average for the 2055 target-date funds, because they have not been in business for that long.)

If an investor wanted to buy the S&P 500 rather than a target-date fund, there are several ways to accomplish it. The easiest and most flexible way to buy in might be to purchase shares of SPY, the tracking stock of the S&P 500 index. There is a 0.09% management fee, however.

A better way to go might be to buy the roughly-equivalent TIAA-CREF Equity Index fund (TIQRX — no minimum), which has an expense ratio of 0.32%, or the Vanguard 500 Index fund (VFNIX — $3000 minimum), which has an expense ratio of 0.50%, or if you have $10,000 to invest, the Vanguard Institutional Index Fund (MUTF:VINIX ), which charges only 0.17%.

Morningstar has reported that the single-biggest predictor of mutual fund performance is fund expenses. A fund with high expenses must earn back its fees before it can make money for you. It has a higher hurdle to overcome to move into positive territory. (U.S. News:Money. March 17, 2014).

Index funds such as those listed above can charge low management fees because they blindly follow the composition of an index, such as the S&P 500. They don’t have to pay for expensive MBAs to pick the best stocks for you. Target-date fund costs are much greater for two reasons. Not only are expense ratios as much as 5 times higher to compensate those highly-educated and brilliant stock-pickers, but the shifting from largely equities to largely fixed-income investments over time results in expensive transaction costs (commissions, high-frequency trading skimming, bid-ask trading penalties, etc.). In many cases, according to an article in the Wall Street Journal. trading costs are as much as two or three times as costly as expense ratios (The Hidden Costs of Mutual Funds , March 1, 2010).

Index funds involve extremely low trading costs, because they buy and hold securities forever, as long as the company remains in the industry. Target-date and other equity mutual funds involve turnover rates averaging as much as 100%, in many cases.

Target-date funds consistently come up short because of higher expense ratios and trading costs, but an even greater explanation, particularly for the earliest dates (for recent or about-to-be retirees) is that a sizeable portion is invested in money market or bond securities that are delivering below-zero returns (adjusted for inflation).

Bottom line, a large portion of 401(k) money is placed in investments such as target-date funds, which are great for Wall Street fund managers but not so great for the workers who buy them. In fact, 401(k) plans, in general, have come up short for many reasons. In my book, Coffee Can Investing. I prove that for the first 13 years of this century, you would be far better off (after taxes) with cash in a coffee can stuffed under a mattress than you would be in a mutual fund inside of your 401(k) plan. The difference between the two investments is not a minor one — it is huge. I also make specific and in many cases, unconventional, suggestions on how to maximize retirement savings, inside of or out of a 401(k) or IRA.

I understand that any criticism of 401(k) plans or investing in the stock market in general is sure to result in a lot of negative comment (and few sales of my book). People don’t like to have their cherished beliefs about investing challenged in any way. Instead, they do as Mark Twain advised — Get your facts first, then you can distort them any way you want. I have reported some of the facts in the above tables. What you do with them is up to you.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.