Plan beneficiaries investing in Fidelity and Vanguard target-date funds have lost as much as 3% over an extended period of time compared to the performance of the companies' balanced funds, according to Morningstar.

A new report by the research firm found that a heavier weighting in foreign equities by the investment giants' target-date funds was chiefly responsible for the performance gap.

“Had target-date funds never been invented, and Vanguard and Fidelity had instead placed their 401(k) shareholders into their existing balanced funds, those investors would be significantly wealthier today,” John Rekenthaler, director of research at Morningstar, said in the report.

The performance gap would have cost an investor who, for instance, had $100,000 in Fidelity’s 2020 Freedom Fund more than $53,000 over the 15-year period from 2004 to 2020, when compared to what he or she could have earned in Fidelity’s balanced fund, the report said.

For the purpose of the study, Rekenthaler compared Vanguard Target Retirement series to its Vanguard Balanced Fund (VBINX) and Fidelity Freedom Funds actively managed series to its Fidelity Balanced (FBALX).

Rekenthaler said he chose Vanguard and Fidelity because they dominate the field of 53 target-date funds (TDFs) that Morningstar tracks, managing more than half the industry’s target=date fund assets.

The underperformance applies to five-, 10- and 15-year trailing periods. It also applies to the 26 years and nine months since Fidelity introduced its earliest TDF series and the 19 years and nine months since Vanguard launched its initial TDFs.

“Across the board, the companies’ balanced funds have earned more,” Rekenthaler said.

While critics of target-date funds, which are sold almost exclusively through 401(k) plans, usually point to an under allocation in equities, especially as the funds get closer to the end of their time horizons, but that’s not what caused the studied underperformance, Rekenthaler said in an interview.

“The target-date funds didn’t trail the balanced funds because they chose bad funds or the balanced funds were particularly brilliant. The target-date funds lagged because they had a much greater exposure to foreign stocks during an extended time period when foreign stocks underperformed,” Rekenthaler said.

The average annual return of Fidelity’s balanced fund was 3.09% higher than its 2020 TDF series from January 2008 to December 2022, according to Morningstar.

The Fidelity balanced fund’s outperformance decreases slightly to an average annual return of 2.59% when compared to Fidelity’s 2025 fund, 2.24% compared to the 2030 fund and 1.59% compared to the 2035 fund.

The average annual return of Vanguard’s balanced fund was 1.80% higher than its 2020 TDF for the 15-year period, rising to .36% average annual underperformance for its 2035 TDF.

International equities accounted for about one-third of Vanguard’s and Fidelity’s target-date funds’ stock exposures. Such levels dwarfed those of the balanced funds, according to Morningstar.

“Over the 15-year period, the average large cap stock earned 10% compared to 4% for foreign stocks. That’s a 6% difference, which is huge,” Rekenthaler said.

In contrast, on average only 12% of Fidelity balanced fund’s stock weighting came from outside the U.S. And Vanguard Balanced skipped non-U.S. stocks entirely, he added.

The irony, he said, is that Vanguard’s and Fidelity’s target-date funds invest much more heavily in non-U.S. stocks than do their balanced funds “because the former are vetted by institutional investors, who stipulate that the funds must be international diversified. That’s unlikely to change.”

Michael Roach, head of multi-asset portfolio management at Vanguard, said in an email, “Vanguard believes that global diversification is beneficial for investors and that most investors are well-served by holding low-cost, globally diversified portfolios for the long term. While there is no single solution that fits all investors, a global-market-capitalization-weighted portfolio serves as a helpful starting point in determining the appropriate allocation between domestic and international equities.”

Fidelity did not respond to a request for comment.

James Watkins, an attorney and forensic consultant on ERISA litigation, said that the type of underperformance identified by Morningstar may add to fund companies’ exposure to litigation from plan participants, especially now that the Department of Labor has weighed in.

In February the DOL filed a legal brief siding with Home Depot plan participants in their appeal in the 11th Circuit Court of Appeals seeking to reverse an earlier decision in their class action seeking $9 billion from the company over alleged excessive fees and failure to monitor Blackrock LifePath Target Date Funds and replace them, despite sustained underperformance that put them at the bottom of peers.

“The legal community knows that this going to be a bombshell, because the plan sponsor is not ready to prove they weren’t the reason for the bad investment and they can’t prove it and they know it,” Watkins said.

In contrast, Chris Tobe, an ERISA consultant and founder of Tobe Consulting, said he does not think the findings of Morningstar’s research will add to funds’ liability.

“There were over a dozen 401(k) cases against Blackrock target-date funds (in 2021) because ... of bad five-, 10- and 15-year records because of an underallocation to U.S. equity,” Tobe said in an email.

“Then in 2022, the U.S. market tanks and all of a sudden Blackrock has a relatively good give-,10- and 15-year record and most of the cases are dismissed. This is why I encourage my plan participant clients to focus on excessive fees. Underperformance from fees is consistent and easy to prove. Underperformance in target-date funds is very dependent on market timing of asset classes."