To determine if defaulting employees into Target Dated Funds or Glide Path Funds is a good thing, one must first examine the alternatives. An examination of the history of asset allocations by employees before Target Dated Funds were the default option tells us that it is.
Left to Their Own Devices
In the past, employees were left to their own devices, and unfortunately their allocations to conservative investments predominated their selections. This was a bad thing because the risks associated with making too little on your savings were so high that employees seldom achieved the required rates of return in order to retire. They would avoid aggressive investments such as stocks and thus they were defeating the purpose of the 401(k) plans.
Target Dated Funds have partially solved this employee behavioral problem or risk aversion. Because many employees have no idea what the guts of a Target Dated Fund look like, the asset allocation, they naively assume the funds are managed for their benefit instead of for the benefit of the Target Dated Fund providers. This naivety or unsophistication allows the Target Dated Fund provider to heavily allocate a younger employees portfolio to stocks, which is a very good thing, since funds starting in 2040 and running to 2055 have approximately 90 percent of the money allocated to stock index funds.
Unfortunately, this creates needless costs for younger employees because if instead they were to have 90 percent of their money in the exact same stock index funds that the Target Dated Fund uses, they would save the overlay management fee that the Target Dated Fund charges for something they could do themselves with a click of a button. These overlay fees can be punitive and we have seen Target Dated Fund fees that rob the employee of as much as 1 percent of their return every year.
How Does It Work?
Let’s assume a typical employee goes to work at Google. I use Google because they have a smart young demographic. Yet these smart young employees aren't very sophisticated as investors and are throwing money away needlessly. Based on the data provided from Brightscope, a top 401(k) research provider, about half of the Google workforce is in Target Dated Funds. An examination of the 2040 and beyond Target Dated Funds within Google's 401(k) plan show that the allocation to stocks is about 90 percent.
So why are smart young employees paying the extra fees associated with a Target Dated Fund when they could simply allocate 90 percent and in our opinion 100 percent of their money to the exact same stock index fund the Target Dated Fund uses?
The answer is they just don’t know any better and no one is pointing out the obvious. They are smart, but not so smart in our opinion. Not to pick on Google, this goes on at every company and non-profit organization and many have far unnecessary fees than Google. This simply exacerbates the problem.
Ok, so younger employees are better off investing in a 100 percent stock index fund, because they will save fees and the difference between 90 percent stocks in a Target Dated Fund and 100 percent on your own is negligible. What about employees that are middle aged and beyond? These folks might be retiring in 2020 or 2025 or 2030 and the Target Dated Fund industry starts to incrementally reduce the allocation to stocks in these portfolios until they get to approximately a 50 percent allocation to stocks.
This is called a Glide Path. This is a bigger disaster.
The Glide Path Disaster
The idea of a Glide Path Fund, where you reduce risk as a person ages, seems logical and intuitive. However, research shows the exact opposite or a Reverse Glide Path is a better solution. Why is it a bigger disaster? Because, these employees are paying high fees for low returning investments and in most cases, they haven’t saved enough money in order to retire. They too need growth and they are not getting it. These allocations are cookie cutter allocations and while it lets the employee think they are being nurtured, they are actually creating an environment where the employee becomes complacent and this hurts their chances of retiring the way they imagined. Needless to say, Target Dated Funds or what we call set-it and-forget-it investments are not the best. What’s better?
There is no doubt the Target Dated Funds are an improvement over the past. However, they aren’t the best option, they aren’t the cheapest option, they aren’t the best performing option and they force you to work many more years than necessary-in some cases, up to a decade longer than with a stock index fund. Mathematically and based on the historical returns of the stock market from 1900 through 2015, the better default option would be a broad based stock index fund. Stock index funds have lower fees and higher returns. It would be the default option we would recommend. If anyone is interested in a more detailed explanation of why this is a superior option, they can download our research paper entitled How to Build Wealth in Your 401(k): The Trampoline Effect.