The hefty fees imposed by target date funds and their lackluster performance have not decreased their popularity, even though they have failed to outperform the S&P 500.

These funds were created to give investors an opportunity to simplify their decision-making in allocating and diversifying their assets. Viewed as a panacea by investors who have a passive approach to their retirement portfolio, an individual who plans to retire in 2035 would have a lower percentage of risky assets such as stocks and more conservative ones such as bonds compared to someone retiring much later in 2055.

Target date funds are increasingly becoming the default option in 401(k) plans, which means an even greater number of employees could become more complacent about their retirement funds, relying solely on options their companies chose which often carry expensive fees.

"Target date funds are used by participants in 401(k) accounts that either didn't know how or didn't want to bother with creating their own retirement portfolio," said Bill DeShurko, president of 401 Advisor, a registered investment advisor in Centerville, Ohio.

High Fees and Confusion

The fees investors pay for TDFs are extremely expensive with expense ratios topping 1.50%, and the funds often have expenses in the 70 to 80 basis points range, said David Twibell, president of Custom Portfolio Group in Englewood, Colo. At the core, TDFs are merely a diversified mix of other publicly available ETFs or mutual funds.

"That's a lot to pay for a target date fund," he said. "Sure, buying one catch-all fund is easier than investing in each of its individual component funds, but is the convenience really worth paying so much in additional fees?"

Vanguard, which has $221.7 billion in volume of target date funds, charges an average expense ratio of 0.125%, including both 401(k)s and IRAs, while Fidelity Investments, which has $171 billion in assets has an average expense ratio of 0.884%, as of January 31, 2016, according to Morningstar, a Chicago-based investment research firm. The third largest provider of target date funds is T. Rowe Price, which manages $126.8 billion and has an average expense ratio of 0.84%.

Many of the fees are misleading, especially when one financial institution offers several funds with the same investments, but charge different fees. American Funds offers 13 different versions of TDFs from 2010 to 2060 in five year increments, based on when you might retire.

What may not be obvious to investors is that each fund holds identical investments and only differ by the fees being charged, said DeShurko who analyzed several target funds. The highest fee choice, their "C" class shares charge a 1.45% annual expense, a 1% annual 12b-1 fee (a marketing fee which is paid to brokers) and a 1% redemption fee if shares are sold within 12 months of purchase. On the opposite end of the spectrum, the company offers an "F2" share class with only a 0.42% annual expense or a "R6," which is only available to retirement plans with a 0.36% annual expense.

Fidelity Investments doesn't charge loads on their Fidelity Advisor Freedom Funds like American Funds. While American Funds "may be the overkill champion," Fidelity does have four separate fee choices per fund for their advisor offerings, he said. Their expenses range from 2.64% for their "C" class down to 0.64% for their "I" share class. There are two more choices for the regular Fidelity Freedom Funds with a 0.56% or 0.64% fee option.

"If you're keeping track at home, that's six different fee options for the same fund," DeShurko said.

Vanguard only offers two choices, an institutional class for investors with over $100 million to invest and their standard investor class.

What most investors do not realize is that they are in fact paying fees twice without getting additional insight from a fund manager. A large majority of target date funds are passively managed, meaning there isn't a portfolio manager researching and choosing the stocks and bonds. Many of them are only "rebalanced" every five years, which is when the shift toward more bonds and less stocks occurs.

The target date funds consist of funds of funds which invests in a portfolio of mutual funds, not in stocks or bonds directly such as the S&P 500.

"This means that each underlying mutual fund also has its own expenses," he said.

All of the TDFs from American Funds invest in a portfolio of American Funds mutual funds in the "R" fee class. This means American's "R6" class of their growth fund would add 0.46% to the expenses. The Fidelity Growth Fund found in many of the Fidelity TDFs adds another 0.74% of expenses to the investment.

Poor Performance

Investors are drawn to these funds, because they claim to lower the amount of risk and volatility from the stock market, but this strategy does not always hold true.

The S&P 500 dropped by 50.17% during the Great Recession from October 2007 to February 2009. The target date funds generated a smaller loss - American Fund's A share 2010 target date fund lost 36.35%.

"It is significantly less than the S&P 500, but if you owned a fund designed for someone retiring in less than a year, would you be satisfied with 'just' a 36% loss right before retirement?" DeShurko said.

Fidelity Freedom 2010 fared slightly better, but lost 31.42% during the same period. Vanguard's 2010 lost 29.02%.

For an investor who had $500,000 in his 401(k) plan on September 30, 2007 and invested in the Fidelity Freedom 2010 fund, the balance fell to $340,000 on February 28, 2009.

An investor who wants to retire in 2035 or 28 years after the recession would have seen his investment in the Fidelity Freedom 2035 Fund drop by 47.8%, which is not a large improvement than just owning a S&P 500 mutual fund, he said.

An actively managed fund, the holding funds chosen by Fidelity should outperform the S&P 500 over the longer term, but not always.

The 10-year average annual return as of October 31, 2016 of the S&P 500 is 6.70%, while the Fidelity Freedom 2035 Fund's average annual return has been 4.43%, DeShurko said. American Funds does not have a 10-year average annual return figure.

While an index fund charges minimal fees to the investment company, many target date funds "double dip on fees by charging for the target date fund and for the underlying funds," he said.

Since bonds lose value as interest rates rise and in this rising interest rate environment, investors need to look at the target date they chose for retirement. Many of the funds could be too conservative and do not account for the 20 to 25 years a person needs the money after their retire.

The Fidelity Freedom 2035 Fund only has 3.5% of assets in U.S. bonds, so as interest rates rise, the effect on the overall fund's performance is nominal. This is not true for someone seeking to retire sooner since the 2020 Fund holds 26.3% of its assets in U.S. bonds.

If interest rates rise by 1%, the portfolio loses 1.3%. While it sounds like a small amount, the expenses of the funds is 0.67%, add the underlying fund expense of 0.45% and the interest from the bond holding of 3.73%, the gains are "nearly wiped out," DeShurko said.

"Target date funds intentionally buy investments that mathematically lose value as the investor moves closer to retirement," he said. "The conundrum, which is faced by all investors, is that by diversifying into bonds as you approach retirement you are at best creating 'dead' assets with very little potential for a positive return."

Having a large allocation in stocks means investors are facing a "potential catastrophic loss" similar to what occurred in the aftermath of the financial crisis.

Investing in a S&P 500 fund is likely to generate larger returns than TDFs. An investor who has $20,000 and adds $5,000 a year for 30 years accumulates $466,350 at a 5.32% average annual return or $611,000 with a 6.58% annual return. Vanguard's Target Retirement 2045 Fund has a 10-year average annual return of 5.32%, so the index fund generates a 31% higher return.

"It's also pretty clear that Vanguard's performance advantage comes from their low fee structure of 0.16%," DeShurko said. "The risk reduction offered by TDFs is greatly exaggerated and does not come close to offsetting the probable lower capital accumulation that is likely compared to investing in an all equity portfolio that can reasonably be expected to meet or exceed the total return of the S&P 500 index."

Options to Target Date Funds

A simple solution is to assemble your own TDF by pairing a diversified, low-cost equity ETF with a similar bond ETF and add in a handful of other low-cost funds of asset like international stocks and real estate, said Twibell.

"You've got your own DIY target date fund at a fraction of the cost," he said. "Each year rebalance your portfolio and periodically shift a small portion of your equity holdings into bonds."

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