IanSalisbury

A decade ago, target-date mutual funds were a niche product; today they¹re a staple of the retirement-savings industry. The funds, which automatically rebalance to become more conservative as an investor gets closer to retirement, are now available in more than 80% of big 401(k) plans, but they aren¹t without their flaws. In its April 2012 cover story, Fix Your 401(k), SmartMoney Magazine examined the pros and cons of these set-it-and-forget-it investments.

Americans now hold $343 billion in target-date funds, up threefold in six years, and they’re buying them mostly through their retirement plans. These funds are the cafeteria lunch of mutual funds: They include all the basic food groups, so investors don’t have to order à la carte. The funds invest in a mix of stocks, bonds and other investments that gets more conservative as an investor’s retirement, or target date, approaches, rebalancing automatically for investors who prefer not to or don’t know how to do it themselves. Congress passed a law in 2006 making it easier for employers to use target-date funds as a default 401(k) option, and 81 percent of large employers now offer them.

But for some cost-conscious investors, the expenses built into target-date funds are a growing peeve. Most such products are funds of funds that spread assets among multiple other investment vehicles. As a result, target-date-fund expenses span an unusually wide range. Vanguard’s target-date products, which rely heavily on index funds, have average expenses of $18 a year per $10,000 invested; at the opposite extreme, Oppenheimer uses actively managed funds and charges $168 per $10,000. And investors at smaller companies are more likely to face fees at the higher end of the range. The differences can add up. According to human resources consultant Towers Watson, an increase of just $50 per $10,000 in target-date-fund fees could cost a high earner the equivalent of eight years’ worth of retirement savings over the length of his career.

Target-Date Funds: What to Ask

How did you do in the crash?

Planners say that anyone considering a target-date fund should see how that fund fared during the 2008-09 financial crisis. Among target-date funds geared for workers who planned to retire in 2010, the average fund lost 22 percent in 2008, but some lost as much as 40 percent.

Am I the kind of investor you target?

Target-date funds have a lot of assumptions about investor behavior baked into their structure. Many hold plenty of volatile assets, like stocks, even as they pass their retirement target dates, assuming investors won’t need to tap the money right away and can take some risks with it. Others are already filled with bonds, assuming that investors will cash out the day they retire. Savers whose needs or plans don’t match a fund’s assumptions might not find the funds to be a good fit.

Can I get your funds separately — and cheaper?

Some investors and advisers check a target-date’s overall expense ratio, then compare that fund’s individual components to similar index funds in the same 401(k) plan. In some cases, employees find they can build a comparable portfolio at a fraction of the cost.

Do you diversify me?

Some investors say it can be worth holding on to a target-date fund if it offers investments that you can’t get elsewhere in your 401(k), like commodities or REITs, which can smooth returns in rocky markets.

To be sure, some investors say it’s worth paying more for the convenience of the all-in-one funds; what’s more, the funds sometimes have access to assets like gold or foreign stocks that employees can’t get elsewhere in the plan. Still, some do-it-yourselfers are opting to cook from scratch rather than accept the cafeteria tray. Atlanta adviser Jeffrey Baumert, who helps small-business owners design plans, says he’ll sometimes encourage folks whose plans include Fidelity’s Freedom funds to try an alternative. Freedom funds’ expenses average $74 per $10,000, and Baumert says his clients can do better — they can get exposure to large-cap stocks, for example, through the inexpensive Fidelity Spartan 500 Index fund. Do you really think that all their fund managers in every category are going to be the best? he asks. (Fidelity says its active management is designed to deliver better returns in the long run.)

Some advisers advocate an even simpler rule of thumb: When possible, use only index funds. That’s because the typical 401(k) fee structure makes the substantial expense gap between indexes and active funds even wider. Packagers — companies like Fidelity, Vanguard or other middlemen — collect a substantial share of their 401(k) plan revenues from active funds. Active large-cap stock funds, for example, route an average of $21 per $10,000 invested to cover back-office expenses like accounting and record-keeping, according to human resources consultancy Aon Hewitt (a firm which itself sometimes acts as a packager). The average large-cap index fund, in contrast, routes just $6, and at least half such funds don’t charge those fees at all. Ultimately, investors in actively managed funds are subsidizing their coworkers, says Dave Gray, head of retirement plan product development at Charles Schwab; using index funds means getting that subsidy, instead of paying it.

Comparing Plans on Cost

Soon, employers will be required to make more detailed disclosures of their plans’ costs. But for more data, experts say, investors will still have to dig into companies’ regulatory filings.

Cheap: IBM

(Plan run by Fidelity)

The sheer size of the plan, which has more than 200,000 participants, helps keep costs down, since bigger 401(k) programs usually get heftier discounts on fund expenses. But the plan also emphasizes cheaper index funds, including index options for real estate investing and inflation-protected bonds.

Average: Abercrombie & Fitch

(Plan run by Fidelity)

Members of the fashion retailer’s plan have access to some index options, but most of the choices are more costly, actively managed funds, including Fidelity’s target-date funds. (Fidelity says the active management of those funds gives investors a long-term performance edge.)

Expensive: Take-Two Interactive Software

(Plan run by The Principal Group)

Most funds in the video-game maker’s plan are more expensive than average. To use the main stock index fund, employees pay $42 per $10,000 invested, more than twice what an all-but-identical fund costs outside the plan. Principal says the costs are typical for a plan of this size.

Data as of latest federal filings.

Sources: Brightscope; Federal Filings