Target Funds: One Size Doesn’t Fit All
If you have a 401(k) plan, you were most likely defaulted into a target date fund — one of those “set-it-and-forget-it” strategies based on your expected retirement year. While they may seem like a safe and convenient choice, these funds often come with hidden costs and generic strategies that you could effectively do on your own for a lower cost.
The key term you want to look for on any investment fund is the expense ratio. That is how much the fund charges in fees per year. For example, $100,000 invested in a fund with an expense ratio of 1.15% has $1,150 per year taken out of your returns to pay fees. You don't see this money come out of your account; it is simply subtracted from the returns over the course of a year. While not all funds charge this much, some actually charge in excess of 1.5%. Compare this to basic index funds like Vanguard's S&P 500 Fund that charges as little as 0.03%. Over years of investing, that fee difference can quietly eat away at tens of thousands of dollars from your retirement savings.
By design, target-date funds operate on a cookie-cutter model. For example, everyone retiring in, say, 2050, gets the same asset allocation mix of stocks and bonds, regardless of individual risk tolerance, outside investments, income needs, or market outlook. That might work for some, but for most investors, it’s overly simplistic and may not align with your actual goals or financial situation.
The better approach is to figure out your desired asset allocation model and build it yourself using the low-cost funds available. You don’t need to be a Wall Street pro to do this — many 401(k) plans offer a simple selection of stock and bond index funds that are easy to understand and manage. Start by looking at the expense fees and weeding out the funds with higher fees. For the average person under the age of 50 with more than 10 years until retirement, a portfolio of mostly U.S. stock market index funds could be appropriate.
Target date funds may offer convenience, but that convenience comes at a cost — literally. If you're willing to spend just a little time understanding your investment options, building your own portfolio using low-fee index funds can give you more control, more flexibility, and a similar investment return, with much fewer fees.
