Target Date Funds: What Employees Don’t Know Might Hurt Them

Some of the most common questions that I’ve been receiving from employees during recent retirement planning workshops relate to confusion around the proper use of target-date funds.

Ironically, these investment options are designed to simplify rather than complicate the process of saving for retirement. When used correctly, target date funds can help employees allocate and re-balance their investment assets appropriately to achieve their retirement goals with one stop diversification.

In fact, more than three-quarters of all 401(k) plans now offer target-date fund options for plan participants and in many plans, they serve as the default investment for automatic enrollment.

However, the majority of employees do not appear to know how target-date funds actually work. In fact, a recent SEC survey identified some serious concerns about investor knowledge regarding target-date funds.

What are target date funds, anyway?

Fewer than one-third of respondents to the SEC survey knew that the year in the fund’s name (e.g., 2020) refers to an anticipated retirement date. As employees are preparing for such an important life goal such as retirement, the biggest downside of target-funds may be the lack of general understanding as to how they work.

So what exactly are target-date funds? What’s their big appeal? And most importantly, are they a good fit for employees and their retirement investments?

Target-date funds are mutual funds designed to be a one-stop shop. They include a mix of different asset classes such as stocks, bonds, and cash equivalents that are put together with retirement savings in mind.

They do this with a “glide path” that takes investors from aggressive when they’re younger to relatively conservative as they approach retirement age by investing a smaller portion of the money in stocks and more in bonds and cash each year. That’s because younger investors have time on their side and an easier time dealing with the expected volatility of a portfolio more heavily weighted in stocks so their portfolios will be more aggressive.

When employees don’t really understand

Target date funds then automatically become increasingly conservative as the target retirement date approaches, such as 2020 or 2030. This is not a bad investment option to consider if employees are seeking the convenience of a one stop shopping experience. This convenience means that once employees determine their most appropriate fund, they can essentially “set it and forget it” by picking the fund that matches when they plan on leaving the workforce.

When employees don’t understand this, they tend to invest in other funds in addition to the target date fund. The problem is that since the asset allocation decisions and re-balancing strategies are determined by the fund’s management team, adding other funds is not only unnecessary but can actually defeat the whole purpose of the target date fund by throwing off the mix of investments. That can mean taking more risk than is necessary or being too conservative to get the growth that is needed.

Target-date funds do not provide risk-free guarantees. Like most investments in stock and bond markets, target-date mutual funds provide absolutely no guarantee of performance or income during retirement.

One of the most troubling aspects of the SEC study was that it revealed that 30% thought that target-date funds actually provide guaranteed income in retirement. They do not. Thinking otherwise can cause employees to take a lot more risk than they normally would.

Finding the right risk tolerance

Target-date funds do not eliminate the need to complete a risk tolerance assessment. Employees shouldn’t just blindly accept a risk tolerance approach based solely on their expected year of retirement.

Taking the time to understand their tolerance for risk and the strategy that best fits their age, goals, and time horizon should remain a key part of their annual financial checklist. (One easy way to assess risk tolerance is to complete the following investment risk tolerance quiz or our brief risk tolerance assessment.)

This is because even if employees pick the target date fund that most corresponds to their anticipated retirement date, the asset allocation guidelines for that particular risk tolerance may be very different. Not everyone retiring in 2025 needs to have 70 percent of their retirement portfolio in stocks. For others, 70 percent may be too little stock exposure.

One simple solution is to choose a fund with an earlier target retirement date than the actual retirement date for someone that’s more conservative or a later date if they’re more aggressive.

Some may not like target-date funds

Target date funds aren’t for everyone. Finally, some employees may not like the mix of investments in the target date funds, how that mix changes over time (known as the “glide path.”), or the fees that the funds charge. For employees that prefer to manage their own investments or have a personal investment advisor, a target date fund may not be right for them at all.

The same is true for those that want to stay at a certain level of risk. In that case, they can invest in a balanced fund that matches their risk tolerance or put together a customized portfolio and re-balance it once a year.

With all of the uncertainty surrounding investment options and with the growing realization that the burden of saving for retirement increasingly rests on the shoulders of the employee, it is comforting to know that vehicles like target-date funds are around to help simplify the process of saving for retirement.

But if your employees are given the opportunity to contribute to a target-date fund, it is important to help them fully understand these valuable investment options. After all, simple doesn’t always mean safe and not all target date funds are created equal.

This was originally published on the Financial Finesse blog for Workplace Financial Planning and Education.