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4 Common Mistakes When Investing in Target-Date Retirement Funds

If you’ve had a 401(k) plan any time in the last 25 years, chances are you’ve had the option to invest in a target-date fund…

Articles by Nick Holeman, CFP®

By Nick Holeman, CFP®
Financial Planning Expert, Betterment  |  Published: April 12, 2017

If you are going to use a target-date fund (TDF), you should consider using it for at least 90% of your retirement account.

Make sure you are on track for retirement by also factoring in cash flow and taxes to your overall retirement plan.

Look underneath the hood of your TDF to make sure it matches your goals and risk level.

Don’t forget about your other accounts when calculating your overall risk.

If you’ve had a 401(k) plan any time in the last 25 years, chances are you’ve had the option to invest in a target-date fund (TDF)—a specialized mutual fund that adjusts its risk level as you approach retirement.

While target-date funds certainly feel like straightforward retirement investments, there are still plenty of ways investors make mistakes. In fact, one study by Financial Engines showed that investors who used target-date funds for less than 90% of their portfolio earned 2.11% lower returns than investors who used their TDFs correctly.

So, what are the most frequent mistakes people make when choosing target-date funds? Below I highlight the four most common mistakes I see with TDFs and a solution for each.

1. Combining TDFs with Other Investments

If you’ve driven a “stick shift,” you know how startlingly simple it is to operate a car with automatic transmission. For many people, it’s almost too simple, and they prefer the nuanced control they get with their five gears and clutch.

In a way, a TDF is the automatic transmission of most 401(k) plans. It takes all the complexity of choosing different stocks and bonds and automates those decisions in one clean wrapper called a target-date fund.

Target-date funds are designed to be the large majority—if not the entirety—of your retirement account. They can do this because, underneath the hood, TDFs actually hold multiple mutual funds. This makes them highly diversified, even as a single investment selection. While it might sound “too simple” to have only a single fund selected in your 401(k), that’s really how they’re designed to be used.

Unfortunately, many people use a TDF as only part of their account, while also investing in other mutual funds. One SEC-sponsored survey showed that 51% of target-date fund owners held less than half of their investable assets in the TDF. Most of the time, investors do this because they mistakenly believe that by owning more funds, their assets are more diversified. But in nearly every case, TDFs are designed with built-in diversification that actually can be counteracted by holding other investments.

Solution

If you choose to invest in a target-date fund, you should consider holding at least 90% of your account in that fund.

2. Forgetting Other Areas of Retirement Planning

Choosing a proper investment portfolio is critical to your overall retirement plan. But it is only one part. You must also factor in savings and taxes.

The average American saves only 5.5% of his/her income. I often tell customers, “Great returns don’t matter if there’s no money in the account.” How much you save is the most important factor in achieving your retirement goals. Choosing an appropriate TDF is not enough.

Don’t forget about taxes either. Taxes don’t end once you stop working. Most withdrawals from traditional 401(k)s / IRAs will be taxed as ordinary income, just like a paycheck. This is why a proper retirement plan should factor in your current tax bracket and your projected bracket in retirement.

Solution

In addition to a target-date fund, use a retirement planning tool that factors in how much you need to save, and which accounts to save in to help minimize taxes.

3. Assuming All TDFs are the Same

There are currently over $880 billion invested in target-date funds, and growing. As TDFs increase in popularity, more and more investment companies are getting in on the action. Vanguard, Fidelity, JP Morgan and many others each have their own TDFs. Overall, this competition is good for investors, but it can also lead to confusion.

It helps to look at an example to see just how different target-date funds from these companies can be:

Let’s take somebody who plans to retire in 2020. If they choose the Fidelity 2020 Fund (FFFDX), they will hold about 60% stocks. The JP Morgan 2020 Fund (JTTIX) has 49% stocks, while the Wells Fargo 2020 Fund (WFLPX) has only 30% stocks. Three very different approaches for the same retirement date.

Solution

Look up how your target-date fund did in September 2008 to see if it aligns with your risk tolerance. If you wouldn’t have been able to stomach the drop, it might not be the right fund for you.

4. Ignoring Other Accounts

As you go through life, you will likely change jobs—possibly many times. One Bureau of Labor Statistics study found that Baby Boomers held over 11 jobs from age 18 to 48.

This job switching can leave a trail of discarded retirement accounts, all with different fees and investments. Choosing a target-date fund for your current 401(k) can be a great step, but it won’t fix the rest of your accounts.

You can, and should, check on your other retirement accounts to make sure they are also invested properly. One way to make this easier is to consolidate your accounts. Most new employers will let you roll over your old 401(k) into your new one. Another option is to consolidate your old 401(k)s into a single IRA.

Solution

Double check that your overall retirement portfolio, not just your current 401(k), is invested appropriately, and consider consolidating old accounts.

All Tools Have Limitations

Overall, target-date funds are a great tool for investors. But financial success is more about behavior than math. To be successful, it’s important to use TDFs correctly and understand their limitations.

Like an automatic transmission in your car, TDFs simplify your investment selection process, but it’s important to understand that not all TDFs are made equal.

The key is to take a more holistic approach to your savings by setting goals and making sure your accounts are setup to meet those goals.

Check out Betterment’s Retirement Savings Calculator below to better assess how well your goals for retirement align with what you can reasonably expect based on your current savings.

 

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