Why target-date funds may sabotage your retirement

In one report, New Evidence on the Demand for Advice within Retirement Plans, the authors examined whether defined-contribution plan participants seek out advice with respect to their asset allocation, savings rate and the like.

And what wrote Jonathan Reuter, an associate professor of finance at Boston College’s Carroll School of Management and David Richardson, the head of the TIAA Institute, discovered is this: Some workers saving for retirement in a 401(k) plan seek out advice but not those who invest in target-date funds (TDFs).

“Advice seeking increases with age, account balance, annual contribution level, web access, and changes in marital status,” wrote Reuter and Richardson. “More provocatively, participants who invest solely through target-date funds—the dominant default investment option—are significantly less likely to seek any form of advice throughout the age distribution, raising the possibility that reliance upon defaults crowds out advice seeking.”

Said Reuter in an interview: “It gives me some pause that what’s happening is a loss of engagement.”

And if you set your target-date fund and forget it, what’s going to happen, said Reuter, “is your circumstances change (and) something that may have been a good initial investment may no longer be a good investment. And over long periods of time, that’s problematic.”

In the second report, researchers at Morningstar’s Center for Retirement & Policy Studies found that many 401(k) plans offer off-the-shelf target-date funds designed for participants staying in their retirement plan “through” their retirement even in cases when a plan participant is more likely than average to roll their money out of their plans.

“This mismatch is important because these ‘through’ glide paths typically take on more risk than ‘to’ retirement glide paths, leaving participants with more equity exposure than they would have if their glide path accounted for their propensity to take money out of the plan at retirement or separation from employment,” Lia Mitchell, a senior analyst at Morningstar, and Aron Szapiro, head of retirement studies and public policy at Morningstar, wrote in their report, Right on Target? Plan Sponsors May Not Always Consider Participants’ Behavior or Needs When Selecting Target-Date Glide Paths.

According to Finra, “a ‘to retirement’ target-date fund will, generally, reach its most conservative asset allocation on the date of the fund’s name. After that date, the allocation of the fund typically does not change throughout retirement. A target-date fund designed to take an investor ‘through retirement’ continues to rebalance and generally will reach its most conservative asset allocation after the target date. While these funds continue to decrease exposure to equities throughout retirement, they may not reach their most conservative point until the investor is well past age 65.”

The upshot of the two reports is this: Target-date funds are fine for young workers who are just starting to save for retirement in a 401(k). But what works well at one point in life might not work as well later in life. As workers age, for instance, as they get married, as their financial lives become more complicated, as they invest their money in a variety of different accounts (taxable, tax-free and tax-deferred) as well as different types of investments and products the need for advice grows.

That advice could go a long way toward making sure a worker’s retirement portfolio is appropriately aligned with their goals, time horizon, and risk capacity, and that their asset allocation is right for their facts and circumstances.

Given that plan participants are rolling over their “through” target-date fund over into an IRA when they leave their company plan, the odds of their assets being misallocated, being exposed to more risk than necessary in some cases and not enough in others, becomes even greater, and the need for advice even greater still.

And yet they are not seeking out the advice they might need.

“It’s possible that some participants are in TDFs with a ‘through’ glide path and they should be in a ‘to’ glide path and vice versa,” said Reuter. “And what our findings would suggest is they’re not likely to realize that. They’re not likely to actually find out that, when they get to their retirement age, they may have too much or too little equity relative to what they would want. They’re also not going to know whether the target-date fund that they’re in is the right level risk for them.”

TDFs, said Reuter, are a one-size fits all investment. “And the problem with one-size-fits-all is that if you have heterogeneous people with heterogeneous needs, it probably doesn’t fit any one person particularly well,” he said.

Sure, TDFs are infinitely better than investing only in money market mutual funds or GICs or using the 1/n approach to saving for retirement. “But that doesn’t mean we’ve gotten where we need to get in terms of customization,” said Reuter.

Szapiro echoed Reuter’s point of view. “I just don’t think everyone in America should have exactly the same glide path and that’s kind of what we’re seeing,” he said.

Given that, Szapiro said it’s important that plan participants not just assume that a target-date fund’s glide path is perfect for them. 

“You shouldn’t assume that it is necessarily like other TDFs you might have been using and you should, particularly as you get closer to retirement, really think whether this asset allocation is what you want,” he said. “I think people do need to understand that they may have quite a bit of exposure to volatile assets as they approach retirement. And they may be in a position to defuse that. They may be in a position where they want more exposure. Especially if Social Security is going to replace a lot of your income.”

What are some other findings from the research and the related actionable advice?

If you have access to an online tool to help you with your asset allocation and savings rate, use it. Demand for advice rises with the presence of an online tool to help one determine an appropriate asset allocation and savings rate, Reuter said. What’s more, those who use an online tool are more likely to seek out a financial professional.

A worker doesn’t have to make changes to their retirement plan after getting feedback on one’s asset allocation and savings rate, “but if they don’t know that there’s a possible disconnect between how they’re investing and how they might want to be investing, given their circumstances and preferences, they’re certainly not going to make any changes then,” said Reuter.

Think about seeking advice when life cycle events occur, including marriage, the birth of a child, a new job, divorce, remarriage, the death of a spouse and the like. In their paper, Reuter and his co-author do in fact find that changes in marital status are associated with higher advice seeking.

Consider—starting at around age 45—doing a financial checkup to determine whether you have the right savings rate and investments, and start making adjustments as needed. Also, translate your assets into an income stream, which many 401(k) providers must do anyway. 

Read: How much income will your 401(k) provide?

Also consider using a low-cost, robo-advised managed account if one is offered in your 401(k) plan. With that type of account, a worker is more likely than not to get an asset allocation that is more aligned with their goals, time horizon and other investments they might own outside their 401(k). “I do think that it makes sense to try to provide more customized advice going forward,” said Reuter. 

Read: Is it time to ditch target-date funds in your 401(k)?

Ask your HR department what type of target-date fund is being offered in the 401(k) investment menu, whether it’s a “to” or “through” or customized target-date fund. In some cases, plan sponsors are offering target-date funds where the glide paths are customized to the employee population, and those funds are likely to be a better match for plan participants than off-the-shelf target-date funds.

Szapiro also said there are some takeaways from the Morningstar study for plan sponsors and the Labor Department.

For starters, there’s a convergence of glide paths in target-date funds, a homogeneity, that needs to be addressed. 

“Unless you believe that everybody in America should basically be in, more or less, the same glide path, I think there is some impetus for sponsors to be a little bit more serious about ways that they can either select the right glide path for their population or add varying levels of customization,” Szapiro said.

And two, the Labor Department could recommend that plan sponsors look at the characteristics of the employee population and consider a spectrum of investment options. Plan sponsors, according to Szapiro, should follow a process and, for instance, ask: “Does this glide path really meet the needs of my participants? Are there alternatives that I should be considering?”