Do-it-yourselfers like to do it themselves, until they don’t. The sudden onslaught of a sustained market drop brings penance and appeals from clients for financial professionals to do something (anything!) to help stem the portfolio bleeding. 401(k) plan participants’ use of target date funds is no exception.
A new report from Financial Engines looks at why the majority of participants move away from target-date funds over time. It found that investor overconfidence and a desire for greater diversification—not lack of understanding—are behind target-date fund misuse.
According to the report, “Not So Simple: Why Target-Date Funds Are Widely Misused by Retirement Investors,” only one quarter (26 percent) of plan participants are using the funds as intended. Two-out-of-three target-date fund investors hold only a portion of their investments (less than 90 percent) in the funds, potentially harming their investment returns compared to those fully invested in target-date funds. Despite moving away from being fully invested in their target-date fund, 81 percent of participants said that they understood that target-date funds are diversified by design and that they knew how they worked. By investing outside of their target-date fund, participants were seeking something beyond what their target-date fund could offer.
“While the ‘set it and forget it’ promise of target-date funds is appealing to some investors, most participants don’t forget it — they are actively investing away from the target-date fund in their portfolios,” explained Christopher Jones, chief investment officer of Financial Engines. “Based on behavior patterns of participants analyzed in this research, expecting most participants to stay put in a target-date fund over their working careers is simply unrealistic. These findings have clear implications for the long-term ability of target-date funds to impact retirement outcomes in defined contribution plans.”
Overconfidence in Investing Ability Can Harm Performance
Partial target-date fund users analyzed in the report tended to be older and overconfident in their investing ability. Sixty percent of partial target-date fund users believed that they could “beat the market” to achieve better investment returns than their target-date fund. Past studies have shown that a “partial target-date fund” approach can result in 2.11 percent lower median annual returns, net of fees, than holding all or almost all of an investor’s retirement assets in target-date funds.3
According to the report, participants who have added other funds to their target-date fund had greater confidence in how their accounts were invested compared to those fully invested in target-date funds. By mixing target-date funds with other investments, many participants fail to reap the full benefits of diversified, age-appropriate portfolios.
Ironically, only 23 percent of those fully invested in target-date funds were “very confident” that their assets were appropriately invested compared to 29 percent of those holding only part of their investments in target-date funds and 34 percent of those not invested in target-date funds at all.
“Prior to this research, it was easy to assume that participants didn’t fully understand how target-date funds worked,” explained Jones. “This research suggests that the drivers behind participant investing behavior are more complex than a simple lack of investing education. Older participants with higher balances require other forms of retirement help that more fully address what they are trying to achieve.”
A Fear of Putting All Eggs in One Basket and a Desire for More Personalized Help
While target-date funds are designed for participants to invest all of their retirement assets in a single, age-appropriate fund, 62 percent of partial target-date fund users cited a desire for greater diversification and a fear of “putting all of their eggs in one basket,” as the primary reasons for moving money away from target-date funds. More than basic investment diversification, these partial target-date fund users were seeking additional diversification across both investment funds and asset managers. Fifty-four percent cited a desire for greater personalization, especially with regard to risk, while 58 percent of those decreasing their target-date fund allocation wanted greater personal management and advice on how best to manage their retirement assets.
“Target-date funds tend to work well for younger investors with low asset balances and less-complicated financial lives, while older participants with more assets often seek the greater personalization and access to investing professionals that managed accounts provide,” explained Jones. “Target-date funds only address the needs of a minority of participants. With a better understanding of how participants actually use target-date funds, plan sponsors have an opportunity to offer other forms of help that meet the needs of investors who are uncomfortable investing their entire retirement nest egg in a target-date fund.”