Considering the immense popularity of target-date funds among participants in defined-contribution plans, it's important to understand why participants are picking these funds and what they understand about them. Do participants actually know what they've selected and what target-date funds can and can't do? Do they know the level of risk surrounding target-date funds?
I recently had the pleasure of participating in a study with AllianceBernstein that addressed these issues. The results indicated that a great deal of education is needed on target-date funds. There are some widely held misconceptions that could lead to disappointed investors and suboptimal behavior.
To test their knowledge, 368 participants who said they invest in target-date funds were presented with six statements regarding the fundamentals of these funds and asked to indicate whether each statement was true or false or whether they just couldn't venture a guess, that is, didn't know.
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Let's start with what participants seem to be most aware of about target-date funds. Regarding the glide path, 72% of participants answered correctly by saying the funds become more conservative as one gets closer to retirement and they are invested in an age-appropriate mix of stocks and bonds. However, 28% either said this was false or that they couldn't venture a guess regarding the statement's accuracy.
Target-date funds become more conservative as you get closer to retirement.
At retirement, target-date funds are invested in an appropriate mix of stocks and bonds.
The level of knowledge drops precipitously from there. Disturbingly, only 44% answered correctly — that it's false — whether target-date fund balances are guaranteed to never go down. Almost as many (38%) said that was true, and 18% said they had no idea.
If you invest in target-date funds, your account balance is guaranteed to never go down.
Only 37% answered correctly — that it's false — regarding the statement about TDFs being guaranteed to meet their income needs in retirement.
Target-date funds guarantee that you will meet your income needs in retirement.
Almost half of those (45%) who incorrectly answered that this was true said the target-date year indicates when the account is guaranteed to be sufficiently funded. With multiple responses allowed, 41% also said the materials they received on target-date funds indicated that this was the case, and 39% said the representative from the investment firm indicated as much.
Another popular misconception is that TDFs are invested only in cash at the year designated in the name. This is not as serious a misconception as the others, and to some extent respondents may have been equating "100% cash" with risk-free investments.
At retirement, target-date funds are invested 100% in cash.
The lowest level of understanding related to government insurance on target-date funds. Only 33% responded correctly that the federal government does not insure the funds in a way that's similar to the federal insurance on bank accounts. Importantly, 45% said this statement was true, as opposed to saying they didn't know.
Target-date funds are insured by the federal government, like bank accounts.
A very high percentage of DC plans use target-date funds as the default investment. We know defaults are very effective, primarily because many participants view them as a signal that the defaults are the correct investments to make. The overall findings of this brief experiment indicate a vast level of misunderstanding about target-date funds.
It is not only the specific details about TDFs that are important — these misconceptions can have negative impacts on behavior.
Participants with the wrong information are underestimating the risks involved with target-date funds. They may also be under the impression that all one has to do is adopt TDFs and one's successful journey toward retirement is guaranteed. It's arguable that the level of education surrounding these funds needs to be substantially improved.
Warren Cormier is executive director of the Defined Contribution Institutional Investment Association's Retirement Research Center.