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The Short Answer

Is My Target-Date Fund Layering On Extra Fees?

Some funds that invest in other funds charge additional fees, and here's how you can tell.


Question: I've heard that some target-date funds layer on additional management fees above what the underlying fund holdings charge. Can you clarify if and when this is done?

Answer: The growing popularity of target-date funds has been among the biggest stories in the retirement-planning industry over the past decade. From 2005 to the first quarter of 2014, net assets in target-date funds grew from less than $100 billion to more than $650 billion. Those numbers received a major boost by passage of the Pension Protection Act of 2006, which allows employers to default their workers into their retirement plans' target-date funds unless the worker chooses a different investment option or not to participate in the plan.

Part of the appeal of target-date funds is that they provide one-stop shopping for retirement savers. Target-date funds typically hold a well-diversified portfolio of funds that invest in stocks, bonds, cash, and perhaps diversifiers such as real estate. They also feature allocations designed for investors who plan to retire in or close to a given year and that generally reduce their exposure to stocks as that year draws nearer. So, a target-date fund designed for investors who plan to retire in or near 2020 might have an allocation heavy in lower-risk securities, such as bonds and cash, as compared with one designed for investors retiring in or near 2045, which might have a higher allocation to stocks due to their potential to deliver higher returns but also higher risk.

Many target-date fund series, including those offered by the three biggest providers--Fidelity, Vanguard, and T. Rowe Price--are built using only the firm's own funds. That's because many large fund families offer a well-diversified selection of funds that provide exposure to U.S. and foreign stocks, bonds, and other asset classes. Of course, sticking to its own stable of funds also benefits the fund company by allowing it to keep all the revenues associated with operating the target-date fund. 

Layering Less Common Today
Some investors bristle at the thought that fund companies may be charging an additional layer of fees on top of those charged by a target-date fund's underlying holdings, but often that's not the case.

Janet Yang, director of multi-asset class strategies for Morningstar, says that these days fund companies generally do not layer on additional fees for their target-date funds. Indeed, a check with Fidelity, Vanguard, and T. Rowe Price found that none of them charge extra fees for management of their target-date series above what the underlying holdings charge.

Yang says it hasn't always been this way. "When target-date funds first came out, managers argued that they were providing an added service that deserved to be compensated," she says. "Market pressure generally made that fee go away over the years."

Yang says that some firms, including American Funds, technically still charge extra management fees for their target-date funds but waive those extra fees. Others, such as Manning & Napier, continue to charge shareholders extra for management of the target-date fund, sometimes called an overlay fee.

How to Tell If Your Target-Date Fund Charges an Overlay Fee
Unfortunately, some fund companies don't make it easy for shareholders to tell whether a target-date fund's expense ratio includes an overlay fee. If it's not clearly spelled out in the target-date fund's prospectus, or if the disclosure information is written in language that's tough to understand, you may want to call the fund company and ask to have it explained to you.

For a clue as to whether your target-date fund charges an overlay fee, Yang suggests looking at both the annual report net expense ratio and the prospectus net expense ratio, both of which can be found under the Expense tab on fund pages on Target-date funds that don't charge an overlay fee generally have an annual report net expense ratio of zero and a prospectus net expense ratio that represents a weighted average of the expense ratios charged by the underlying funds. This prospectus net expense ratio represents what investors pay annually to own the fund. For most target-date funds, an annual report net expense ratio that is more than zero represents an overlay fee above and beyond the cost of owning the underlying funds and is included in the prospectus net expense ratio.

For example,  Manning & Napier Target 2040 (MTTIX) has an annual report net expense ratio of 0.05% and a prospectus net expense ratio of 0.87%. This means that investors are being charged 0.05% above and beyond the cost of the fund's underlying holdings to own them through a target-date fund.

Layered Fees and Other Fund-of-Fund Types
This approach also typically works for other fund-of-fund types, meaning those whose portfolios consist mainly of other funds. So, if you own a stock, bond, or allocation fund that invests in other funds, you might want to check out the expense ratios we've just discussed to see if you are paying anything above and beyond what the underlying funds cost.

A related investment vehicle that typically does charge overlay fees is a 529 college-savings plan. However, Yang says there's little uniformity across states and plans with regard to what these fees are called or how they're used. These added fees may be charged by the fund company and/or the state sponsoring the plan and may be used to cover the plan's administrative and distribution costs. Yang recommends reading a 529 plan's offering statement for more details on its overlay fees.

Charging a little bit more for the convenience of owning a full portfolio of funds through a single holding--especially one designed to adjust its allocation over time to meet the investor's needs--isn't necessarily a bad thing. In fact, the Manning & Napier target-date series mentioned earlier carries a Morningstar Analyst Rating of Silver due, in part, to its deep and experienced management team, and many 529 plans charge overlay fees and still come highly recommend by Morningstar's analyst team. But as investors, it's always good to know not only how much we're paying to have our money managed, but also what it is we're paying for.

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Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.