In psychology, there is a concept known as the “tyranny of choice.” The idea here is that when people are presented with too many choices, they don’t make any decisions at all.
This inaction, however, is not what you are thinking. It’s not that savers are not saving. They are. But the way in which they are saving can still be improved.
In 401ks and other workplace retirement plans today, many savers are automatically defaulting into so-called target-date mutual funds, where they only need to “show up.” Using the employee’s age, the plan suggests a fund that “targets” his or her prospective retirement year.
Opening a 401k at age 30 this year? Your target date fund probably has the year 2050 in its name.
These funds have been a good thing to get savers saving. And target-date funds are often the best choice inside the options available for a 401k. But when it comes to IRAs and taxable accounts, you can do better.
Technology can help.
A short, but flawed, history
Over the past eight years, target-date funds have grown to $500 billion of workplace retirement plan assets (more than 13%, according to Morningstar), largely on the back of a 2006 Federal law that required employer retirement plans to offer a Qualified Default Investment Alternative, or QDIA—a fallback investment for those who don’t want to make a choice, or did not do so for whatever reason.
Let’s look more closely at the high-level issues with target-date funds.
First, it’s very difficult to explain to the average investor the various investments and risks rolled into these funds. (Even the SEC has taken up the case.) Second, they are too simple and their one-size-fits-all portfolio allocations do not serve any individual investor very well. Lastly, fees—target-date funds are often far more expensive for consumers compared to similar alternatives.
The forcing question: age or risk level?
The underlying principle of all target-date funds is that investors either select—or are defaulted into—a fund that approximates the year in which they expect to retire. (Some retirement plans also offer even simpler options with portfolios for aggressive, moderate or conservative investors, along with target-date funds.)
The ideal choice for a retirement investor, however, is a portfolio that can be updated based on the individual investor’s stated goals and actual balance.
Yet the fund companies can’t even settle on what the “target-date” is targeting. Some funds are built to be liquidated (sold) and converted into an annuity when the investor retires; others are intended to be held through retirement. Such confusion and product proliferation is exemplified by some asset managers like T. Rowe Price, which offers two sets of “retirement” funds, one called “Retirement Funds” and another called “Target Retirement Funds.”
Not all glide paths are created equal
Built into the plumbing of target-date funds is a mechanism known as a “glide path.” This structure is intended to automatically reduce the riskiness of the portfolio over time, shifting to more bonds and income producing assets and away from volatile areas of the stock market as the investor approaches retirement.
The glide path you get in your target-date fund, however, is determined by the fund company. Unfortunately each fund company, as tracked by Morningstar, has a different view on the expected return of different asset classes and whether the funds are built to stop at your expected retirement date or continue “through” retirement. This tremendous disagreement in stock allocation across glide paths means they are far less standardized than consumers might think.
When you look under the hood…
If you do unpack most target-date funds, you’ll notice a variety of asset classes and sectors, but one thing stays the same: the fund company. What’s inside Fidelity Freedom 2040, you ask? All Fidelity funds and more—from Fidelity! (Do you really need redundant U.S. growth funds with similar holdings?)
For the most part, few individual fund companies excel at investing across every sector and asset class—even in index funds—and that its funds would be chosen independently for each option. So why should we expect that as the default in target date funds? A lot of target-date funds have started to look like a parking lot for lackluster funds to gather assets.
Fortunately, some plans are course correcting by hiring independent advisers willing to create custom target-date portfolios or hiring an automated investment service to optimize participants’ choices within the plan. At Betterment, we choose funds for our portfolio that are simply the best ones available—vetted by cost, tracking error, and liquidity among other criteria.
they are too complicated…
Advisers and fund companies approach target-date portfolio construction differently: some use only index funds, some go for pure active management, others opt for even more complex investing strategies.
For example, some target-date funds have begun to use more active trading strategies to make “tactical” shifts, also known as market-timing. Others are trying to “hedge tail risk,” which means they may be using derivatives to mitigate against a loss. And others even use long/short hedge-fund like strategies throughout the portfolio. But it’s incumbent on investors to find out on their own.
and are actively managed
In too many cases the investment choices also tend to be high-cost actively managed mutual funds, with index funds slipping in on occasion. But are actively managed funds serving investors better?
Research published in the peer-reviewed Journal of Indexes, authored by Alex Benke, CFP® and a product manager at Betterment, and Rick Ferri, CFA, founder of Portfolio Solutions, in January 2014 demonstrated that over a 16-year period, an all-index fund portfolio outperformed a portfolio of active funds 83% of the time.
…and they are very expensive.
Target-date fund fees can be excessive. For four of the top five providers of target-date funds, annual expense ratios range from 0.78% to 1.15%, according to Morningstar data. At Betterment, by comparison, management fees are between 0.15% and 0.35%, in addition to the average expense ratio of 0.14%, for an all-in cost between 0.29% to .49%.
Moreover, when these ready-made retirement solutions are purchased outside a retirement plan, they sometimes even tack on sales loads—commissions paid simply for the privilege of buying the fund! Even the automated retirement portfolio options within 401k plans can add as much as 0.5% on top of the funds’ own expense ratios with commissions or other fees.
At Betterment, we take the good idea behind target-date funds—using a time horizon to set allocation advice—and do it better. How? We make it transparent, objective, and quantitative.
Today, Betterment’s software can provide tailored allocation advice (much like the glide path offers), but more importantly provide advice based on exactly what you, the investor, need personally. We start with allocation advice based on your goals and time horizon (our Major Purchases goal glide path shown below) and then help you stay course by letting you know if you veer away from your target.
That means we can make target-date style investing available for shorter investment terms. Even though retirement is the biggest investment goal many people have, it is hardly the only goal for which investing is the right way to grow money.
Shorter-term target dates—for example, saving for a house down payment or education fund in 10 years — can also benefit from the kind of gradual allocation plan that a glide path offers.
But mainstream target-date funds are not set up to allow customers to do this well—their offerings are not customizable to your individual needs or integrate savings advice. This is where technology, the kind Betterment has pioneered, works to consumers’ benefit. Our goal-based platform allows any investor to create a personalized TDF-like investment portfolio based on your exact needs— whether it’s a five-year term or a 40-year term.
To be sure, one of the benefits of mainstream target-date funds is that they curb human behavior. But perhaps they go too far. We think technology can mitigate the downside of human behavior, without removing an investor from the scenario altogether.
At Betterment, we use behavioral cues to guide your investing—we monitor your investing progress to make sure you are on track to reach your goals. When you’re not on target, we provide actionable advice to get you back on the road to investment success. All of this for a fraction of cost of most target-date funds.
While target-date funds have been a useful innovation to get more Americans onto a managed savings path, with better technology, we can help you save even more.
Dan Egan contributed to the post.