Auto-enrollment has proven to be an effective way for employees to save for retirement, with 91 percent of those who are auto-enrolled in a defined contribution plan (like a 401(k)) remaining opted in to the program, according to a 2018 report from Fidelity.
But that has implications beyond more people saving for retirement—it also affects what funds and investments employees enroll in. Auto-enrollment plans work on inertia. Because 98 percent of employers offer target date funds in defined contribution plans and 89 percent use them as the default investment option, that means more and more everyday investors are putting ever more of their investments into target date funds.
In fact, “68 percent of millennials are 100 percent invested in a target date fund, due in part to being auto-enrolled in their 401(k) and defaulted into the option,” reports Fidelity. Overall, more than 30 percent of 401(k) assets are in target date funds, a dramatic increase from around 10 percent in 2008. And 403(b) plan participants have an even greater portion of assets invested in TDFs.
So, is that a bad thing? Not necessarily—but it depends on who you are and what your goals are.
Target Date Funds Are Easy to Use
Essentially, TDFs take an investor’s age and projected retirement year into account when picking investments. For beginning investors, they are an easy and manageable way to ensure exposure to an array of investments and spend less time researching and picking out individual funds. They have low minimum initial investments, automatic rebalancing and adjust asset allocation for you over time. They’re simple and don’t require a lot of investing savvy.
“Target date funds are a ‘turn off my brain’ kind of thing, but when we turn off our brains bad things happen”
But beyond that, TDFs lose some of their luster. Once you’ve started building your assets, you should look into switching out of them. For one, because “when you’re in a TDF, you are not in control of how that fund is invested,” says D. Keith Lockyer, investment market manager at PNC Wealth Management. Your individual risk tolerance is not taken into account, meaning, especially for older investors, that your portfolio is likely too conservative (you could also argue this is the case for young investors who don’t need as much exposure to bonds as they’re likely getting). Outside of a TDF, you or a professional can tweak things how you’d like, in “better” funds.
“Target date funds are a ‘turn off my brain’ kind of thing, but when we turn off our brains bad things happen,” says Scott Tucker, President of Scott Tucker Solutions in Chicago, Ill. “People are using target date funds for growth, and the problem is those target date funds have a lot of bonds in them and bonds lose value when interest rates rise.” Meaning people looking to retire soon (say by 2025 or even 2030) are potentially losing out on a lot of growth by staying invested in them.
When to Opt Out of Target Date Funds
They’re also actively managed—which LH advises against—which means they can come saddled with more fees than your typical index fund. One big fee difference: The expense ratio. The Motley Fool reports that the difference between a target-date fund’s annual expense ratio and an index fund’s is “0.51 percent vs 0.09 percent on average, according to the Investment Company Institute.” That might not sound like a lot to get worked up over, but take this simple example:
You put away $5,500 a year for the next 30 years. Your funds earn 7% annually above inflation before fees (around the stock market’s historical average). In the index fund scenario (that is, a 0.09% expense ratio), you end with just over $511,000. If you pay that higher 0.51% expense ratio then, all other things being equal, you’ll have a little over $474,000 in savings instead — a loss of about $37,000 because of those extra fees.
That said, fees for these funds can easily reach one percent or higher, which will eat away even more of your money. You always need to check the fees before investing in any product.
One solution for older investors (59 1/2-plus) and those who have left a job is to roll their 401(k)s into IRAs, says Tucker. You have better investment options that way. And young investors should choose the highest retirement year on the target date funds that they can, he suggests, even if that’s not necessarily the year they want to retire, so that they’re more heavily invested in equities and have less in bonds.
“We’re trying to make investing simple for people with target date funds, but investors are going to want to look under the hood,” says Tucker. “The easy button isn’t always the best option.”