Target Date Funds are the Real 401(k) problem

I am not a fan of 401(k)s and 403(b)s.

I do invest in them when my company offers them, but usually only up to the company match. There are issues like lack of liquidity, penalties, long lockup periods, vesting schedules that act as golden handcuffs.

But, let’s look at the real problem though: Target Date Funds.

By default many providers invest you in Target Date Funds. The reason this is bad is because their expense ratios are very high compared to other index funds.

Let’s take a look at an example.

Fidelity’s 2035 Target Date Fund, FFTHX, has an expense ratio of 0.73%. What that means is that for every $1,000 you contribute, Fidelity will take $7.30 as a management fee. This is deducted from your principal regardless of whether you make money or not.

Let’s compare this with their index fund that tracks the S&P 5.00. FXAIX has an expense ratio of 0.015%. For those math-inclined readers, that is 48x the fee of FFTHX. i.e. instead of $7.30 per $1,000 you are only paying $0.15 per $1,000 invested. If you have a meaningful amount of savings, that is a HUGE difference. And that difference compounds over time.

The reason these companies do this is because the 401(k) administration business is highly competitive. They will compete upfront with your employer on admin fees, but stick you with higher fund fees on the default funds that are selected on your behalf. Since many people aren’t financially savvy, they stick with those funds forever. Companies like Fidelity factor this into their pricing models, effectively helping your company with upfront fees and screwing you with fund management fees. The administration fees are a loss-leader.

If you are one of those with Fidelity as your provider. I’d suggest taking a look at what the Target Date Fund is comprised of and manage it independently with significantly lower cost index funds. You’ll save a ton of money over time and hopefully force competition with a better provider like Vanguard.

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