Target-date funds befuddle some DC plan participants

Target-date funds — the ultimate set-it-and-forget-it investment for participants in workplace retirement plans — may not be as well understood as they should be, at least by some participants.

While target-date funds should be used as a single investment option, industry experts say that some savers are combining the silver bullet investments with other investment options or selecting multiple vintages of the funds, practices that can dilute the diversification they're intended to achieve.

"In some cases they may be engaged participants making educated decisions, but in other cases, they may just be combining a bunch of options in the plan for the sake of diversification to the detriment of their total asset allocation," said Jeri Savage, retirement lead strategist at MFS Investment Management.

The practice appears to be more pervasive among older workers. In a recent survey of 1,000 U.S. retirement plan participants, MFS found that 59% of respondents over the age of 45 combined target-date funds with other investment options and 22% selected more than one target-date fund. For those under 45, the percentages were 35% and 33%, respectively.

By and large, most investors are correctly using target-date funds as single investments, with 71% selecting only one target-date fund as their sole investment, according to Vanguard's latest "How America Saves Report."

Still, that leaves almost 30% who are using target-date funds in errant ways. Almost 1 in 4 (23%) are combining their target-date fund with other investment options, 2% are selecting two or more target-date funds and 4% are selecting two or more target-date funds along with other investments, according to Vanguard's data. For the 30% not using target-date funds as they were intended, there is concern that misconceptions about funds could be leading investors to make mistakes that could be remedied through education, according to industry observers.

While the majority of plan participants understand that target-date funds are an easy way to diversify through a single fund, more education may nevertheless be needed to ensure that everyone understands their benefits, Savage said.

Savage explained that many participants believe, for example, that target-date funds provide a guaranteed stream of income in retirement and that they provide a guaranteed rate of return. Still others mistakenly believe that they invest entirely in cash or other low-risk investments in retirement.

"Based on our survey data — and because TDFs are default options — we would hope that plan sponsors might take a closer look at TDF education, and use in particular, moving forward," Savage said, adding that sponsors strive to understand where participants may be misusing investment options.

Paula Smith, senior vice president of retirement/college savings product strategy and development at Voya Investment Management, added that misconceptions about target-date funds persist despite participant education on how the funds invest and change over time.

Education is especially important as the use of target-date funds is "now higher than ever before and is ingrained within DC plans," Smith said.

Participant misconceptions might help explain why 59% of the over-45 demographic set are choosing to pair their target-date fund with other investments.

"They think that they're diversifying," Savage said of participants who select additional investments. "They've been taught that diversification is good without quite understanding that a target-date is already a diversified option on its own."

Smith agreed, saying participants might be "trying to hedge their bets" and gain greater diversification by having other investments in the core menu.

Some participants might also choose additional investments to "create an investment portfolio that meets their needs," said Rob Austin, head of research at Alight Solutions.

"A person with a large defined benefit pension plan might want to take on more risk in their defined contribution plan and therefore split the balance between TDFs and equities," Austin said.

The possible reasons participants might select more than one target-date fund can run anywhere from wanting to deliberately choose additional funds that are more or less aggressive to not knowing what they're doing.

Some are consciously opting for vintages other than the one aligned with their anticipated retirement year because they're looking for more or less equity than would be available in the fund for their correct age. They might also use multiple target-date funds to invest for different time horizons, Alight's Austin said.

Some might use their 401(k) accounts for multiple retirement dates, such as a spouse who is several years older or younger, or for estate planning and other non-retirement purposes, and "will pick the TDF vintages that align with the different objectives," Austin said.

One simple explanation is that a participant's expected retirement falls between two target-date vintages, such as say the 2030 fund and the 2035 fund. Someone looking to retire in 2033, for example, might allocate some money to the 2030 fund and some to the 2035 fund to better align with their retirement goals, several sources said.

"I would say this is probably the exception rather than the rule," Savage said, referring to the "I can't find my retirement year" target-date fund scenario.

More often than not, "a healthy number of participants" might select the last target-date fund of the series — the one that is most conservative — along with their age-appropriate fund because that fund is typically referred to as the "income fund," which participants may associate with guaranteed income, Savage explained.

"There's something about the naming convention that confuses participants and far and away you see participants of all ages selecting this fund," she said. "Every time we do this analysis with a plan, you see some young participants, some old participants, some in between, all misallocating to what's usually called the income fund because they don't quite understand what it means."

A 25-year-old who sees an income vintage, for example, might think "that looks great. I want income," she said, adding that doing so would make that participant "way more conservative" than he or she thinks.

"In the extreme, I would say the 25-year-old who has an allocation to both the 2060 fund and the income vintage is misusing target-date funds in the plan," she said.

Alight's Austin attributes the issue partly to a lack of understanding of how target-date funds work.

"When we have surveyed workers in the past, we found that most people don't understand target-date funds. Few know that they are designed as an all-in investment, and the majority indicated that they didn't know anything about target-date funds," Austin said.

Voya's Smith echoed similar views, saying some participants may not always know what to do, with 20% in a recent survey admitting they weren't sure how to invest within their retirement plans.

"I think there's definitely a tendency to pick multiple funds as they're enrolling, which could include multiple vintages of a target-date for sure," she said, referring to participants.

A silver lining is that the selection of funds other than the age-appropriate target-date fund shows that participants are engaged with their plans.

"They are engaged in some way either correctly or incorrectly," Savage said, adding that holders of single target-date funds tend to be so because they were defaulted into the funds.

Smith praised the engagement, lamenting only its misplaced focus.

Participants should be engaged with saving and increasing contributions rather than on investments when "the target-date for the vast majority of participants really does the job," she said.

Target-date funds befuddle some DC plan participants