Why You Might Want to Think Twice About Your 401(k) Plan

While it isn’t the only retirement account available, 401(k) plans are most people’s bread and butter when it comes to saving and investing for retirement. While some people prefer to be hands-on with their investing, many people prefer to let someone else do the work for them. That’s where target date funds come into play.

As you’re thinking about your retirement financial goals, here is something to think twice about regarding your investment choices.

How target date funds work

Target date funds are mutual funds that periodically rebalance the assets within the fund based on a predetermined time range. Generally, the further away from the designated time frame of the target date fund, the more aggressive the fund is. As it nears the target date, the fund will shift to be more conservative, focusing on preserving the gains made in the account instead of chasing growth, which comes with more risk.

For those who want a hands-off approach to investing and prefer to just set a percentage and go, target date funds are beneficial. Investors can pick one investment vehicle, have their 401(k) contributions invested there, and not have to worry about actively managing the portfolio to their liking.

The emergence of target date funds

With most 401(k) plans, employees are automatically enrolled unless they choose otherwise. Along with automatic enrollment into the company’s specific 401(k) plan, generally a set percentage of an employee’s salary is deducted and contributed to the plan. As of 2020, 69% of people were in plans with automatic enrollment, and of that 69%, 98% of plans chose target date funds as the default investment option.

In 2011, 83% of 401(k) plans offered target date funds. Fast-forward to 2020, and 95% of 401(k) plans were offering target date funds, with 80% of all participants utilizing them. In fact, 67% of 401(k) plan participants who used target date funds were invested in only a single fund. While most people investing in target date funds are doing so thanks to automatic enrollment, it’s worth noting that four in 10 investors chose the funds on their own.

Fees matter

While the increase in people utilizing target date funds is encouraging because it generally means more people are getting access to and utilizing 401(k) plans, target date funds may not be for everyone — mainly because of the fees they come with. At the end of 2020, the average expense ratio for target date funds was 0.52%. This means that you’ll be charged $52 annually for every $10,000 invested into the fund.

While 0.52% may seem like a low percentage, over time this can amount to a lot of money, especially when you consider compound interest. If you had $100,000 in a target date fund earning 10% annually and didn’t make another contribution, here’s how much you could potentially lose out on over time with a 0.52% expense ratio.

Initial Account Balance
Years
Account Value Without Fees
Account Value With Fees
Approximate Difference in Account Value
$100,000
20
$672,750
$611,900
$60,850
$100,000
25
$1.08 million
$962,400
$117,600
$100,000
30
$1.74 million
$1.51 million
$230,000

Data source: Author calculations.

Alternatives to consider

Although the investment options are usually relatively small, most 401(k) plans will have at least three investment options you can choose from: company stock, target date funds, and stock funds. Stock funds are generally broken down by the market cap of companies within — such as U.S. large cap, U.S. mid cap, and U.S. small cap — as well as international or emerging markets.

While it takes more work because you have to actively select what percentage of your contributions you want to go to each fund type, these funds generally have lower fees than target date funds and can potentially save you tens of thousands of dollars over the life of your 401(k). A good rule of thumb is to have the bulk of your contributions go to the large-cap fund because it consists of more stable, established companies.

Here’s an example of how you might choose to distribute your 401(k) contributions:

Large cap: 50%
International: 25%
Mid cap: 15%
Small cap: 5%
Emerging markets: 5%

You can adjust the percentages however you see fit, but generally speaking, this should provide enough diversification within your 401(k) to help you withstand industry-specific downturns and give yourself a chance to take advantage of S&P 500 and hypergrowth companies.

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