Common Mistakes Corporate Employees Make With Target Date Retirement Funds
Target date funds have become very popular in corporate 401(k) retirement plans. Employers began adopting target-date funds with greater regularity after Congress passed the Pension Protection Act of 2006. The legislation gave legal protections for businesses that automatically enrolled workers into the company 401(k) plan and invested their money in target-date funds.1
Because of this legislation, the financial services industry developed target-date funds to provide a simple way of investing towards retirement. Around 80% of 401(k) plans offer a target-date fund. The funds hold 24% of all 401(k) plans, the most of any investment option.1
But there are common mistakes that employees make with target-date funds.
1. Use more than one fund. The whole purpose of a target date fund is to use the one fund for your entire 401(k) plan. Each paycheck is deposited in that target-date fund. The target date fund has a glide path and starts with mostly stocks at around 90% for those 30 or more years from retirement, then moves into mostly bonds by the time the employee approaches retirement.
But research shows that only 67% of 401(k) investors use target-date funds as one-stop shops, and 27% add another fund.1 The problem is that the target date fund alone should be used since it is automatically rebalanced and suited to your retirement goals. The second fund will have to be adjusted and will take more work than just using a target-date fund. My simple recommendation is to only use the target date fund in your 401(k) plan to create the greatest efficiency and maximize performance.
2. Set it and forget it. Another common mistake is that corporate employees first invest in their target-date fund and then don’t change the allocation or the target in their career. Say you started the target date fund 15 years ago, your goals on retirement, and how much you should save could have changed. For instance, you might decide to work later in your career. As a result, a new target date should be chosen. Or you may decide not to use the target date fund right away in retirement, so perhaps another investment option would work. But, again, the message is that set it and forget it is not viable for a successful retirement.
3. Not selecting a target-date fund. Another issue is that investors don’t actually select a target-date fund when they have this option. They, for instance, see one fund in the list of options that has a better return than the target date fund, and they pick that fund. This seems like a rational thing to do to select the fund with the best performance. But this is problematic since the target date fund is specifically designed to have the proper and optimized investment allocation between domestic stocks, international stocks, bonds, and so forth. So, for instance, you might see the S&P 500 fund mutual fund and notice a better historical return, but the risk would be higher by simply investing in American large-cap companies.
Target date funds are one of the marvels of modern-day investing. They have the benefits of automatic rebalancing, ease of use, efficiency, and better performance. In my opinion, target-date funds get better returns than picking your own funds simply because of the ease of use and the automatic rebalancing. Most corporate employees would rather spend time with the children, read, watch movies, and spend as little time as possible worrying about investment choices! Target date funds are designed based on modern portfolio theory, which is the science of investment.
I noted three common mistakes for corporate employees using target-date funds that you should avoid as an employee in your 401(k) plan. It's highly recommended to talk to a financial planner about how target-date funds fit into your retirement goals.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on to avoid any Federal Government tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.