Are You Using Your Target-Date Fund Incorrectly?
Here are some issues that can arise as well as some potential solutions.
Potentially over 10 million retirement investors are misusing their target-date fund. Are you one of them?
A new Morningstar study, "Mixed Target-Date Fund Investors: Is There a Method to the Madness?" finds that many investors supplement their target-date fund with other investments in their 401(k) plan.
Some investors might not understand that target-date funds are diversified portfolios that are designed to be held alone. Or maybe they're holding other investments alongside target-date funds intentionally, whether it benefits them or not.
Whether it's an intentional choice or not, mixing your target-date fund with other investments could have unintended consequences. Here are some issues that can arise, and potential solutions (especially if you want to remain a mixed investor).
Target-Date Funds Are Designed to Be Held Alone
A target-date fund is a one-stop shop for retirement savings. When you buy one, you're really buying many mutual funds, each with securities in different slices of the investment universe. You select a target-date fund based on your projected retirement year (approximately age 65), and the investment mix dynamically shifts throughout your working years. As you approach retirement, your dollars carefully shift from riskier funds (stocks) to less-risky funds (bonds).
Target-date funds are intended to be an all-in-one portfolio, but many investors don't use them that way. The most likely reason investors supplement target-date funds with other funds is they don’t understand that they are supposed to be held alone. Although it's a fully diversified portfolio, it might feel to an investor like they're putting all their eggs in one basket.
Others might be mixing their target-date funds with other funds intentionally. A 2016 Financial Engines study indicates 62% of mixed-target-date-fund investors want to avoid "putting all their eggs in one basket" despite 81% understanding the funds' diversification properties. These investors are likely avoiding a different type of risk--namely, putting all their money in one asset manager.
What Issues Can Arise If You Mix?
Mixed target-date fund investors are frequently taking on more risk. That’s because equity funds are often the main supplements. This becomes especially meaningful after age 40, when our report indicates mixed investors begin significantly increasing risk.
That's because adding other funds into the mix throws off your target-date fund’s precise allocation. Target-date funds have a professionally optimized asset allocation and glide path (the means by which the portfolio gradually becomes less aggressive over time). Holding other funds dilutes the allocation and interferes with the glide path, which can ultimately hurt your investment strategy.
Of course it can be nerve-racking to place your entire retirement in one asset management firm or fund manager's hands, but that’s why Morningstar manager research analysts give Morningstar Medalist ratings to only the best target-date funds with strong, deep management teams and well-positioned, ethical asset management firms.
What Can You Do to Fix These Issues?
If you hold other funds alongside a target-fund because you didn't know they are optimally held alone, consider selling your other investments and moving all of your money to the appropriate target-date fund. If that's not an option, consider these options:
Have a question about money or investments? Drop us a line at The.ShortAnswer@morningstar.com.
Michael Schramm does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.