Last week “The Oregonian” ran an article regarding the investment manager change Intel is making to its target date and global diversified funds. Intel has hired AllianceBernstein (AB) as the investment manager for these funds within 401(k), retirement contribution and SERPLUS accounts. As the investment manager, AB will “design, monitor and adjust each fund’s asset mix.”
The author reached out to us for our thoughts and quoted us in the article. (The Oregonian article is not longer on their site, you can view a copy here).
However, as you can imagine, we had more insight than just one quote could adequately represent, so we wanted to dive deeper into the change taking place and our perspective on it.
Target Date Funds
Target date funds are a popular choice in 401(k) accounts, and for good reason. Participants need and want help when it comes to investing for retirement. Many people don’t have the time, desire or willingness to do the necessary homework in order to build the level of knowledge needed to design their own investment allocation from separate individual funds.
The popularity of target date funds is showcased in the steady pickup in assets year over year, with more than $650 billion invested in these funds as of March 2014 (via Morningstar).
However, Intel’s choice of AllianceBernstein is curious. According to Morningstar’s target date fund research, AB target date funds have some of the highest fees in the industry and poor past performance.
For example, the AllianceBernstein 2040 Retirement Strategy fund has five-year performance of 9.1% versus 11.6% for Vanguard Target Retirement 2040. In addition to better performance, Vanguard’s average cost for its target date fund lineup is 0.17% versus 1.03% for AllianceBernstein.
From our perspective, the benefits of switching to AB (which according to Intel, are to “Improve efficiency of day-to-day fund management” and “deliver market commentaries”) don’t offset the disadvantages.
The Cost of Target Date Funds
This specific change aside, the problem we see with many target date funds across the board is their high cost. This is largely due to the fact that many funds are using more expensive active managers—despite the overwhelming evidence suggesting no net benefit to paying up for this.
It’s a bit like hiring a Formula One pit crew to come to your house and change the tire on your car. They’ll get the job done, sure, but it’s overkill. It’s going to cost you a lot more than heading down to the local Les Schwab for this simple fix. You still get a professional to do the work, but it’s right-sized for your needs.
But this isn’t even a perfect example, since, presumably, the Formula One pit crew would change your tires better and faster than the local tire shop. However, with actively managed funds, this isn’t the case. The data show that you actually get worse performance and higher costs with actively managed funds.
Other Pitfalls of Target Date Funds
A higher expense ratio is only one of the issues with target date funds; other issues include:
- The lost chance to asset locate for those with both taxable and tax-deferred accounts: Asset locating is placing higher tax investments, like bonds (due to the higher tax rates on income vs. long-term capital gains), in tax-deferred accounts.
- Using target date funds typically introduces separate allocation in each account. This makes it difficult to determine how much risk you are taking overall with your investment assets.
- The higher trading costs and cash drag of actively managed funds, which are often used in target date funds: John Bogle, the founder and former CEO of Vanguard, in a recent paper estimated these add up to another 0.65% annually in additional expenses for actively managed funds. This is in addition to higher management fees.
As we see it, there are three potential solutions:
- If you have an interest and willingness to do your homework, you can build your own portfolio out of the individual investment options in the Intel 401(k) account for much less than the target date funds. Right now, the expense ratio in Intel’s target date funds ranges from 1.28% to 1.37% annually. By designing an allocation on your own with five separate funds in the Intel 401(k) account, you could get access to U.S. large cap stocks, U.S. small cap stocks, international stocks, emerging market stocks, and U.S. bonds—more than 22,000 holdings in total—for an average of 0.06% annually.
This 1.22% annual difference may not seem like a lot at first, but due to the magic of compound interest, it would increase your wealth by 27% over a 20-year retirement horizon. If you start with with a $200k portfolio, this would result in a quarter of a million more dollars.
- Hire an advisor to create an allocation on your behalf. With a good advisor, you will get not only an allocation like the target date funds provide, but also advice in the areas of financial objectives discovery, building a financial plan, tax-loss harvesting, tax location and performance reporting across all of your accounts. Often, you can get all of this by working with an advisor for a similar cost as the target date funds by themselves.
- For those still interested in target date funds, we would like to see Intel add target date funds utilizing an indexed investment approach. For example, the Vanguard target date series is a collection of index funds with a low expense ratio and good performance. Currently, without utilizing the BrokerageLink option that is available within the 401(k), a low cost target date fund is not available.
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Cordant, Inc. is not affiliated, associated or endorsed by Intel.