While combining target-date funds with other investments may not seem problematic at first glance, a new study argues that it can diminish a TDF’s potential benefit.
More than 10 million DC plan participants now combine a TDF with other plan investments, commonly referred to as “mixed target-date fund investors.” But while an investor may feel this creates a diversified portfolio, doing so is likely to have the opposite effect, according to Morningstar’s “Mixed Target-Date Fund Investors: Is There a Method to the Madness? report.
The paper explores the allocation decisions of 30,516 mixed TDF investors to determine which types of investors are more susceptible to mixing TDFs and how they mix them.
David Blanchett, Morningstar’s Head of Retirement Research and author of the study, argues that TDFs are best used as an “all or none” investment option, since mixing TDFs with other plan investments significantly diminishes – and potentially eliminates – their value. Blanchett notes that mixed TDF investors have attributes that would suggest they are “more sophisticated” than investors who use the default investment and tend to be older, with higher salaries, balances and deferral rates. When comparing mixed TDF investors to other self-directors, mixed target-date investors appear to be “slightly less sophisticated” and tend to be younger, with lower plan tenures, deferral rates, salaries and balances, he observes.
In addition, while mixed TDF investors overall appear to have relatively diversified portfolios, they are more aggressive than the average TDF would be for a given age, especially at older ages. In fact, Blanchett notes, their allocations are consistent with a retirement year that is 10 years later than the actual vintage they should be in.
Average Allocations
Mixed TDF investors tend to have less than half of their portfolio in the TDF and overwhelmingly combine the TDF with equity funds, according to the study. For example, the average allocation is 37% TDFs, 49% equity funds and 13% bond funds. The non-TDF weights are relatively constant across different levels of target-date fund holdings, the study further notes.
There are many reasons why participants in DC plans mix TDFs, the study explains. For example, Blanchett points to a 2016 study by Financial Engines that found that participants who were mixed TDF investors thought that doing so:
- could lead to outperformance;
- were concerned about “putting all their eggs in one basket;” or
- were seeking greater personalization than the TDF alone could provide.
Another key reason, the paper explains, is because TDFs typically appear as a single investment option on a plan website or participant statement, similar to other equity or bonds funds, and investors are not aware that TDFs are actually diversified options designed to be held by themselves. “For many participants, target-date funds appear to be a ‘black box’ – the lack of understanding exactly how the product works, how it is allocated, and so on, likely leads many participants to combine it with other investments on the core menu,” Blanchett says.
Alternative Solutions
He acknowledges that the “damage” caused by mixing TDFs with other plan investments obviously varies by participant and is going to be driven by a variety of factors. “An investor who would like a more-aggressive allocation would generally be better off moving along the target-date fund glide path by selecting a vintage (or target-date year) with a higher risk level than mixing the target-date fund with equity (or bond) funds from the core menu,” he writes. For example, he notes, if a participant thought the equity allocation in the 2025 TDF vintage was too conservative, he or she could select the 2050 vintage to achieve this more aggressive risk level.
“While moving along the glide path results in a mismatch between the actual and expected target dates, it keeps the participant entirely in a professionally managed portfolio,” Blanchett emphasizes. Alternatively, he suggests that the plan sponsor could “nudge those participants” who are not allocating to the TDF in its entirety toward some type of in-plan advice solution.
