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The American retirement savings crisis has widened over the past 30 years with the demise of private-sector pensions. Defined contribution plans like 401(k)s and 403(b)s place the burden of saving and investing on the worker, but lack of financial education or experience has presented a major challenge to individual retirement savers. Policymakers have periodically attempted to address the crisis by encouraging plan sponsors to include automatic enrollment in packaged "set it and forget it" investment options like target date funds. These auto-piloted vehicles now predominate default options in most plans but are poorly understood, can be costly and vary considerably among fund companies that provide them.

For those disinclined to take action, a target date fund is far better than nothing. But it is still important to understand the basics before trusting your retirement security to any single Wall Street product.

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The Pension Protection Act of 2006 created a class of safe harbor investment vehicles that employers could select as default options for workers who did not enroll in their 401(k) or who neglected to select any investment options. One of these default options was the target date fund, a type of "fund of funds" that adjusts the mix of stocks and bonds over the working life of the investor up to and sometimes into retirement. These are easily recognizable by the target date in the fund's name, generally intended to coincide with the investor's estimated retirement date.

As an example, a 2060 TDF may start out with around 90-95% allocation in stocks. Over the lifetime of the fund, the allocation shifts gradually toward less risky investments like bonds and may end up with 30% or less in stocks by the target date. This gradual ramp is known as the glide path, and every fund adopts its own parameters for beginning, ending and intermediate asset allocation and timing. That makes comparisons especially difficult.

With the 2006 regulatory changes, the popularity of TDFs has exploded. In 2021 roughly 40 million Americans held $1.75 trillion in target dates funds. Fully 80% of all 401(k)s include TDF options, and about a quarter of all plan assets are invested in them. Yet confusion reigns.

Consider the results of a 2021 survey by investment firm AllianceBerstein. For starters, less than 40% of retirement plan participants even knew what the date signified in a target date fund. Even more troubling, 42% of actual TDF holders believe the value of their fund is guaranteed not to go down, and a whopping 68% understood their fund to be FDIC insured. Perhaps most egregiously, 21% said their financial representative told them their fund was guaranteed. Of course, none of those are true, and TDFs are subject to the same market risk as the underlying mutual funds making up the pool.

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Then there is the cost. Because TDFs are generally collections of individual funds, usually managed by the same fund company, fees are often layered upon fees. Overall expense ratios vary dramatically among fund families and range from a miserly 0.08% to well above 1% per year and average 0.55% according to Morningstar. Giving up an additional half percent each year to the fund company will cost you thousands in retirement.

If you are searching for a target date fund on your own in an IRA or Roth for example, you can shop around. But within most employer plans, TDF offerings are limited to one fund company so you may not have a cost-effective option. In that case, do a little basic investigation before defaulting into a sub-optimal investment that you intend to ignore for the next 40 years. Look carefully at the expense ratio. If you do not have a low-cost option, consider doing it yourself.

Most plans offer tools to help you decide on an allocation among available individual funds, or you can even replicate the allocation of a target date fund on your own using low-cost index funds (each TDF publishes its allocation mix and glide path) and adjust over time as necessary. Respected researcher Robert Arnott maintains that in statistical simulations, even a simple 50/50 balanced portfolio outperformed an average hypothetical TDF net of fees over any 41-year period dating back to 1871.

Furthermore, target date funds cannot consider critical individual parameters other than age. In the real world, dozens of other factors like risk tolerance, economic cycles, personal wealth and income, and so forth that contribute or may even predominate.

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The adoption of target date funds as a default option was a good step in addressing the chronic retirement savings deficit. Competition has driven costs lower, but many funds carry high fees that sap returns. Yet there is no free lunch, and for savers who can't or won't take control, target date funds are clearly superior to doing nothing.

Christopher A. Hopkins is a chartered financial analyst in Chattanooga.

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