Not all target date funds are created equal.
While these prepackaged, risk-reducing portfolios make a lot of sense for retirement saving, you don't know if the funds within them are good choices unless you open them up and peel them apart.
The lowest-cost among them contain index funds that track baskets of securities. While neither a perfect nor risk-free solution, these funds offer an efficient way to invest in the entire stock or bond market without engaging costly active management.
The products are designed to ratchet down stock exposure -- and then hold more bonds -- the closer you get to a planned retirement age or "target date."
Generally, all-index funds are the best place to start when considering target date portfolios because of their lower cost and better diversification. There are only seven fund groups that offer an all-index line-up within their target date offerings, according to Brightscope.com President Ryan Alfred, whose firm tracks and rates 401(k) plans. Here they are:
If cost was all there was to be concerned about, this list could serve as a benchmark for all target date products and we could stop here.
Yet the whole is greater than the parts when evaluating lifestyle funds. To further sort them out, you need to calculate the costs, see how they perform against peers and market averages and assess their "glidepath," which is the gradual reduction of stocks and an increase to income investments as you get closer to your target date. And after you do all that, only one all-index portfolio gets an overall grade of "A" from Brightscope. The winner: Vanguard.
Of the others, they fell short in some of the rated categories, especially lowest costs, risks and most prudent strategies. The JHFunds2 group, for example, only rated a "C" ("A" being the highest) in Brightscope's company evaluation. TIAA-CREF got "Cs" in both strategy and company ratings. Fidelity got "Ds" in those categories.
What do these letter grades mean? According to the Brightscope methodology, it has to do with how the fund managers reduce risk over time. The iShares group, for example, received a "C" from Brightscope because "the funds extend their glidepath an unspecified number of years beyond the target date with 45 percent stock exposure and eventually come down to 33 percent."
Do you want to have nearly half of your money in stocks when you hit retirement age? If not, then choose a glidepath that reduces your stock allocation to less than 40 percent by your target date and beyond. Keep in mind that since these products are on autopilot -- they reallocate every year according to built-in formula -- you can't change how they work.
Also be aware that you're being charged for the service of yearly automatic allocation. The iShares products, for example, are ultra-low cost exchange traded funds (ETFs) that could be individually bought for about 0.18 percent annually. But an "overlay fee" common to target date funds boosts the annual fees to 0.29 percent annually, Brightscope reports (see http://link.reuters.com/wek84s).
Still, that's a relative bargain compared to the average fund expense ratio of 0.75 percent, the company found in surveying 400 individual target date funds. You could do very well expense-wise if you stick with an all-ETF portfolio since the average for stock funds is 0.76 percent and 0.50 percent for bonds.
Keep in mind that individual fund expenses can vary widely -- from an outrageous 2.3 percent to a rock-bottom 0.16 percent -- according to Lipper, a Thomson Reuters company. To save money, you can assemble your own target date portfolio using ETFs.
What if you discover that the target date fund you've already chosen for your 401(k) is overpriced? Lobby your employer to get a lower-cost vendor. There's nothing worse than being locked into an overpriced product that just eats away at your wealth.
Since there are plenty of alternatives, if you're not getting institutional pricing at the lowest-possible rates, ask why and demand action.
When it comes down to evaluating all of these criteria, that group of seven gets whittled down to three. So to save money, you can assemble your own target date portfolio and allocations, or just stick with the top-rated Vanguard, or runners up TIAA-CREF or ING offerings.
--The author is a Reuters columnist and author of The Cul-de-Sac Syndrome. The opinions expressed are his own.
(Editing by Beth Gladstone, Lauren Young and Walden Siew)