How Investor Error Can Hamper Target-Date Funds

April 1, 2016
DMD Staff

Target-date funds are a popular retirement savings vehicle, but a new study shows investor misconceptions can limit the usefulness of the funds.

Target-date funds (TDFs)—also known as lifecycle funds—have been popular with retirement savers and the companies that employ them for years. Each TDF is designed for investors who plan to retire in, or close to, the year identified in the fund’s name (the “target date”). They are popular investment vehicles for good reason: they are no-hassle by design, and they divide your retirement savings among different asset classes, and then adjust your holdings as you age. Most TDFs are diverse and relatively easy for the novice investor to understand.

But a study by Financial Engines and Aon Hewitt has found that investor error can sap one of the key strengths of a TDF: its ability to achieve diversity without individual investors having to choose different investments on their own. See, TDFs are designed to hold all of an investor’s retirement plan assets. For investors who keep all their funds in the lifecycle fund, the structure eliminates investors’ tendency to try and “time the market” and reallocate funds when they shouldn’t.

Some investors, though, remain supremely confident in their own ability to manage and grow their retirement assets. Thus, they keep only a portion of their retirement portfolio in a TDF, or they keep their entire portfolio in a TDF for only a short period—thus negating the long-term focus of the vehicle they’ve chosen. According to the researchers, those “partial-term” investors have median returns more than 2% lower than users who simply kept their investments in the TDF.

Perhaps most troubling, 81% of those partial-term investors indicated that they knew TDFs were already a diversified investment, but they kept some of their funds out of the vehicle in an effort to diversify. This ill-conceived idea was even present among those who self-identified as being “very knowledgeable” about TDFs.

Be In or Be Out?

It may seem like the take-home message for investors, then, is either to remain fully in the TDF for your whole career or to not choose a TDF to begin with. But, while that’s generally a better strategy than being in investment limbo, it’s a little more complicated than that. In the case of physicians, for example, who are typically high earners, your returns over the course of your career may be higher if you are invested in managed accounts—industry parlance for accounts managed by professional money-managers. Of course, managed accounts lose some of the “set it and forget it” benefits of TDFs, and they can come with pretty steep fees as well.

The key message here is to make sure your actual investment choices are sound and not counter-intuitive—and that they’re working. Take regular stock of your retirement portfolio’s performance, and measure it against the strategies in the road not taken. TDFs aren’t right for everyone, and they may or may not be right for you. But for most, they’ll be much less right for those who stride with brisk, false confidence into poorly conceived strategies.