Time to Rethink TDF Use in Retirement Plans: Financial Engines

Plan sponsors’ favorite default investment isn’t appropriate for all of their participants, and education isn’t enough to change their behavior

Target-date funds were designed to hold all of an investor’s retirement plan assets, on the premise that investors would be tempted to reallocate at inappropriate times if left to their own devices. However, a study by Financial Engines and Aon Hewitt found that rather than parking their retirement savings in a TDF to slowly de-risk as they approach retirement age, 62% of TDF users have only part of their assets in the fund and are managing the rest on their own.

Furthermore, only 57% of respondents who did put most of their assets in a TDF kept them there for five years. As a result, partial-TDF users had median returns that were more than 2% lower than other TDF users.

That behavior can be explained by the demographics of TDF investors, and plan sponsors may need to redesign their investment menu to overcome these behavioral flaws, Financial Engines suggested.

“The high incidence of partial-TDF usage, and the evidence that such partial-TDF users significantly underperform more appropriately diversified investors, calls into question the efficacy of relying solely on TDFs to achieve retirement security for plan participants,” according to the paper.

The solution: Introduce managed accounts to meet the more complex needs of partial-TDF users.

Financial Engines, an independent investment advisor focused on retirement plans, surveyed more than 1,000 full-time workers with access to a target-date fund. It broke them into four cohorts: those who have 90% or more of their plan assets in a TDF; those with between zero and 90% of assets in the TDF; those who don’t use a TDF at all; and those who used to use a TDF but have moved all or part of their assets out of the fund.

The survey found just 25% of respondents were full TDF users, three-quarters of whom were defaulted into the fund. They may also be new to the plan, as full-TDF users tend to be younger than the average participant and have lower income, lower assets and lower contribution rates. They also tend to have lower levels of confidence, the report found.

Partial-TDF users, which make up the majority of respondents, were older, in the middle of their careers and had higher account balances than other users; managed account users have a similar profile.

Confidence levels among those who decreased their TDF allocations were pretty high, with 62% saying they thought they could get better returns investing on their own than in the TDF.

Despite 81% of partial-TDF users saying they know TDFs are already a diversified fund, two-thirds still said they allocated only a portion of their assets to the fund because they wanted to diversify. “They appear to be seeking diversification beyond investment diversification,” the paper noted, “for instance, diversification across investment funds or asset managers.”

More personalization in their portfolio, especially as it regards risk tolerance, was a key justification for partial-TDF users and decreasing TDF users, as well.

Because 90% of partial users said they understand TDFs very or somewhat well, the paper suggested that behavioral flaw among mid-career savers to spread their assets across multiple funds or managers may not be corrected by more education. Instead, Financial Engines concluded that target-date funds may be appropriate for younger investors at the beginning of their career, who should move into managed accounts when they reach higher account balances and more complex needs.

More than 40% of retirement plan investors are invested in a target-date fund as of 2012, according to the Investment Company Institute and EBRI. Cerulli Associates found that 72% of plan sponsors use them as the QDIA in their plan.

Financial Engines cited research from Fidelity Investments that shows 59% of investors enrolled in a managed account did so to maximize their account growth; 49% to achieve diversification based on their goals; and 45% to work with a professional.

A report last year by Vanguard found investors in managed accounts had higher expected returns and reduced risk as a result.

Financial Engines stressed that managed accounts are a “crucial complement” to TDFs, not a replacement. “Managed accounts should be made available for mid-career participants with average asset balances and outside investments, while TDFs remain a strong solution for employees who are younger and those with less complicated finances.”

Plan sponsors should introduce regular re-enrollment programs to their retirement plans to default older participants, including older new hires, into managed accounts, while continuing to use TDFs as the default for younger participants, the paper suggested.

--- Read How to Pay School Loans and Save for Retirement at the Same Time on ThinkAdvisor. 

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