Overconfidence Drives TDF Misuse

Participants may need even more education surrounding target-date funds and account choices to avoid misusing the investment, says a new Financial Engines study. 

A combination of investor overconfidence and a desire for greater diversification seem to be driving widespread misuse of target-date funds (TDFs). Although the vehicle is designed as a diversified, age-appropriate investment product for the entirety of an investor’s retirement assets, most participants don’t remain fully invested in them as their balances grow. The vehicle can solve a number of investing behaviors if they are used correctly. But not everyone agrees that the strategy works as a set-it-and-forget-it, and other research shows that education around TDFs is still sorely needed.    

Financial Engines takes a look at why most participants—only one-quarter (26%) are using the funds as intended—move away from TDFs over time. It’s not a lack of understanding, but investor overconfidence and a desire for greater diversification.

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About two-thirds (64%) of TDF investors hold only a portion of their investments (less than 90%) in the funds, potentially harming their investment returns compared with those who remain fully invested, according to “Not So Simple: Why Target-Date Funds Are Widely Misused by Retirement Investors.” Despite moving away from complete investment in a TDF, a substantial majority (81%) of participants said they understood that TDFs are diversified by design and they knew how they worked. By investing outside the TDF, participants were seeking something beyond what their TDF could offer.

NEXT: Participants seem skeptical about TDFs

“While the ‘set it and forget it’ promise of TDFs is appealing to some investors, most participants don’t forget it—they are actively investing away from the TDF in their portfolios,” explains 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 TDF over their working careers is simply unrealistic. These findings have clear implications for the long-term ability of TDFs to impact retirement outcomes in defined contribution plans.”

Partial TDF users tended to be older and overconfident in their investing ability. Sixty percent of partial TDF users believed that they could “beat the market” to achieve better investment returns than their target-date fund. Past studies have shown that this partial TDF approach can result in 2.11% lower median annual returns, net of fees, than holding all or almost all of an investor’s retirement assets in TDFs.

According to the report, participants who have added other funds to their TDF had greater confidence in how their accounts were invested compared with those fully invested in TDFs. By mixing TDFs with other investments, many participants fail to reap the full benefits of diversified, age-appropriate portfolios.

Ironically, only 23% of those fully invested in TDFs were “very confident” that their assets were appropriately invested compared with 29% of those holding only part of their investments in TDFs and 34% of those not at all invested in TDFs.

NEXT: Complex reasons behind investor behavior

Nearly two-thirds of partial TDF users (62%) 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 TDF users were seeking additional diversification across both investment funds and asset managers. Fifty-four percent cited a desire for greater personalization, especially regarding risk, while 58% of those decreasing their TDF allocation wanted greater personal management and advice about how best to manage their retirement assets.

Target-date funds tend to be more successful with younger investors who have low asset balances and less-complicated financial lives, Jones says. Older participants, on the other hand, with greater assets often seek the greater personalization and access to investing professionals that managed accounts provide. “Target-date funds only address the needs of a minority of participants,” Jones explains. “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."

The implications for employers designing retirement plans for their workers are clear, the report says: adding advisory services, such as managed accounts, to a retirement plan can ensure that the more complex needs of mid-career employees with average-sized nest eggs can be met.

“Prior to this research, it was easy to assume that participants didn’t fully understand how target-date funds worked,” Jones continues. “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.”

“Not So Simple: Why Target-Date Funds Are Widely Misused by Retirement Investors” surveyed more than 1,000 full-time employees with access to TDFs in their employer-sponsored retirement plans. The report can be downloaded from Financial Engines’ website.