Anytime you utilize a 401(k), it's a good thing. However, there are ways to utilize a 401(k) more efficiently to ensure you get the most from your investments. One of these ways is by cutting back on how much you're paying in fees. One of the increasingly popular 401(k) investment options, target-date funds, can be an under-the-radar culprit of high fees.
Target-date funds are funds put together based on your projected retirement year. As you near retirement, the fund automatically reallocates its holdings to become more conservative (more bonds and cash, fewer stocks). While this hands-off approach seems ideal, there's a cost to this convenience.
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Fees add up over time
The average target-date fund expense ratio at the end of 2021 was 0.34%, according to Morningstar. For perspective, the iShares Core S&P 500 ETF -- which tracks the stock market's most important index -- has an expense ratio of 0.03%.
Let's compare the difference in value between a 0.34% and 0.03% expense ratio on an investment if you were to contribute $500 monthly for 25 years, averaging 8% annual returns.
| Monthly Contribution | Expense Ratio | Investment Value | Amount Paid in Fees |
|---|---|---|---|
| $500 | 0.34% | $417,400 | $21,200 |
| $500 | 0.03% | $436,700 | $1,900 |
Calculations by author. Rounded to the nearest hundred.
A target-date fund and the iShares Core S&P 500 ETF isn't quite an apples-to-apples comparison because target-date funds contain several investments, but it still shows the power of a slight difference in expense ratios. In this case, paying just over three-tenths of a percentage point more annually in fees accounted for more than $19,000 more paid in fees.
This is on the lower end, too. Investing $500 monthly is just over a quarter of a 401(k)'s annual contribution limit; higher investments would make the difference in fees paid much greater.
Go around target-date funds
Target-date funds are "funds of funds," so they must charge to account for the fees of the investments they hold. Instead of using a target-date fund, you can sidestep it and essentially invest in the type of funds it holds (or a close enough comparison).
In many cases, it only takes four types of index funds for a well-rounded retirement stock portfolio: large-cap, mid-cap, small-cap, and international. How much you allocate to each should depend on your age and risk tolerance, but here are baselines you can use and adjust accordingly to fit your personal preference:
Younger than 40
Someone younger than 40 can afford to take on more risk because they have more time to bounce back from poor investments or prolonged down periods in the stock market. In this age range, a portfolio could be all stocks broken down as follows:
- Large-cap: 50%
- Mid-cap: 15%
- Small-cap: 15%
- International: 20%
Age 40 to early 50s
You don't have to become too conservative in this age range. You may not have 100% of your portfolio in stocks, but most of it should be. One solution could be an 80%/20% split between bonds and stocks, broken down looking like this:
- Bonds: 20%
- Large-cap stocks: 48%
- Mid-cap stocks: 8%
- Small-cap stocks: 8%
- International stocks: 16%
Age 50 into retirement
This is the age where you want to begin prioritizing preserving the money you've made. You don't want to abandon stocks, but you should up your stake in bonds and cash. Here's a potential breakdown:
- Bonds: 30%
- Large-cap stocks: 35%
- Mid-cap stocks: 2.5%
- Small-cap stocks: 2.5%
- International stocks: 10%
- Cash: 20%
Be sure to do what you're comfortable with
Like regular ETFs, target-date fund expense ratios can vary widely. Vanguard, for example, offers options with 0.08% expense ratios. At the same time, Fidelity has options with 0.75% expense ratios. Sometimes, the performance warrants a high expense ratio. Oftentimes, it doesn't.
What's most important is that you're well aware of the fees you'll be paying and the long-term implications that could have.
It's also important to remember there's no one-size-fits-all method for saving and investing for retirement. You may decide you're perfectly fine with target date funds' higher fees instead of reallocating your portfolio yourself, and that's understandable.
Target-date funds didn't become popular by accident; many people enjoy the hands-off approach. I only suggest that before you decide reallocating your portfolio yourself isn't doable, you understand how relatively simple it can be. You can do it by logging into your 401(k) account and adjusting the percentages of your investment elections.
With a little bit of time every few years, you could save yourself thousands.
