The set-it-and-forget options in your retirement plan may become more interesting and less expensive in 2017.
Target-date funds are pre-mixed portfolios that automatically invest more conservatively over time. Here's how they work: Investors select funds near their estimated date for retirement, say 2050. That 2050 fund typically starts out with 90 percent invested in stocks and gradually shifts to a portfolio with roughly 40 percent allocated to stocks and 60 percent to fixed income more than three decades later.
These funds are popular because they are usually the default investment option for retirement plans that automatically enroll participants. For example, Vanguard estimates that 69 percent of its retirement-plan participants invest in target-date funds.
Several fund sponsors have modified that basic target-date formula in hopes of attracting more investors and improving returns:
The new target-date funds face an uphill battle to gain market share, said Jeff Holt, an analyst for mutual fund research firm Morningstar. Three asset managers dominate the market for target-date funds — Vanguard, Fidelity and T. Rowe Price. (See chart below.)
"There is a race to the bottom among target-date fund families to become the low-cost provider," Holt said.
Average target-date fund expenses have dropped for seven years in a row from 1.03 percent in 2009 to 0.73 percent last year, according to Morningstar. (Vanguard's most expensive target-date fund currently charges an annual fee of just 0.16 percent.)
Chris Brown, a principal at financial services research firm Sway Research in Newton, New Hampshire, expects the low-cost trend to continue because more large employers are switching their retirement plans to collective investment trusts.
Collective investment trusts are like mutual funds but are only available in retirement plans and have lower costs because they aren't subject to the same regulations and disclosure requirements as traditional funds.
Investors hold roughly 30 percent of the $1.1 trillion in target-date portfolios in collective investment trusts instead of mutual funds, according to Sway Research. In fact, since 2010, the majority of new target-date funds in retirement plans have been collective investment trusts.
The changing structure of large retirement plans isn't the only thing keeping costs down.
"The [Department of Labor] and lawsuits continue to put the spotlight on target-date fund fees," Brown said. For example, Well Fargo employees recently sued the bank because they claim that its propriety target-date funds in the retirement plan performed poorly and cost 2.5 times more than similar funds from Fidelity and Vanguard.
Target-date investors tend to be more hands-off than other fund investors, Holt said. That lazy approach to investing has served them well.
The dollar-weighted return, which takes into account fund flows to measure the gains that investors actually experience, shows that investors generally earn better results than their target-date funds' published total returns, Holt said.
Meanwhile, investors in other types of mutual funds tend to lag their funds' total returns because they time the market poorly during its ups and down. (See chart below.)
Target-date funds are designed to be an all-in-one solution. Yet many investors don't use them that way.
About half of retirement plan participants who use target-date funds invest in other funds, according to a recent analysis of about 100 large retirement plans by Aon Hewitt, a human resources consulting firm. Adding more funds to your portfolio when you use a target-date fund can mess up your asset allocation, giving you more or less risk than you expected.
That is still not entirely all bad: Even if plan participants are not fully invested in target-date funds as intended, Aon found that the median five-year annualized rates of return of those who are at least partially invested in target-date funds had better results than those who aren't invested in them at all.
Despite their drawbacks, expect more changes to target-date funds in the future.
"We are going to continue to see lots of innovation with target-date funds," Brown said. "The growth in these funds is substantial, and asset managers want to compete for those dollars."