Data & Research March 1, 2016

Convinced They Are Right, Investors Misuse TDFs

Target-date funds may not be a set-it-and-forget-it investment after all, according to a Financial Engines study.
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A combination of investor overconfidence and a desire for greater diversification seem to be driving widespread misuse of target-date funds (TDFs). Although the vehicle is designed as a diversified, age-appropriate investment product for the entirety of an investor’s retirement assets, most participants don’t remain fully invested in them as their balances grow. The vehicle can solve a number of investing behaviors unless they are used incorrectly. But not everyone agrees that the strategy works as a set-it-and-forget-it, and other research shows that education around TDFs is still sorely needed.    

Financial Engines takes a look at why the most participants—only one-quarter (26%) are using the funds as intended—move away from TDFs over time. It’s not a lack of understanding, but investor overconfidence and a desire for greater diversification.

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About two-thirds (64%) of TDF investors hold only a portion of their investments (less than 90%) in the funds, potentially harming their investment returns compared with those who remain fully invested, according to “Not So Simple: Why Target-Date Funds Are Widely Misused by Retirement Investors.” Despite moving away from complete investment in a TDF, a substantial majority (81%) of participants said that they understood that TDFs are diversified by design and that they knew how they worked. By investing outside the TDF, participants were seeking something beyond what their TDF could offer.

NEXT: Participants seem skeptical about TDFs

“While the ‘set it and forget it’ promise of TDFs is appealing to some investors, most participants don’t forget it—they are actively investing away from the TDF in their portfolios,” explains Christopher Jones, chief investment officer of Financial Engines. “Based on behavior patterns of participants analyzed in this research, expecting most participants to stay put in a TDF over their working careers is simply unrealistic. These findings have clear implications for the long-term ability of TDFs to impact retirement outcomes in defined contribution plans.”

Partial TDF users tended to be older and overconfident in their investing ability. Sixty percent of partial TDF users believed that they could “beat the market” to achieve better investment returns than their target-date fund. Past studies have shown that this partial TDF approach can result in 2.11% lower median annual returns, net of fees, than holding all or almost all of an investor’s retirement assets in TDFs.

According to the report, participants who have added other funds to their TDF had greater confidence in how their accounts were invested compared with those fully invested in TDFs. By mixing TDFs with other investments, many participants fail to reap the full benefits of diversified, age-appropriate portfolios.

Ironically, only 23% of those fully invested in TDFs were “very confident” that their assets were appropriately invested compared with 29% of those holding only part of their investments in TDFs and 34% of those not at all invested in TDFs.

NEXT: Complex reasons behind investor behavior

Nearly two-thirds of partial TDF users (62%) cited a desire for greater diversification and a fear of “putting all of their eggs in one basket,” as the primary reasons for moving money away from target-date funds. More than basic investment diversification, these partial TDF users were seeking additional diversification across both investment funds and asset managers. Fifty-four percent cited a desire for greater personalization, especially regarding risk, while 58% of those decreasing their TDF allocation wanted greater personal management and advice on how best to manage their retirement assets.

Target-date funds tend to be more successful with younger investors who have low asset balances and less-complicated financial lives, Jones says. Older participants, on the other hand, with greater assets often seek the greater personalization and access to investing professionals that managed accounts provide. “Target-date funds only address the needs of a minority of participants,” Jones explains. “With a better understanding of how participants actually use target-date funds, plan sponsors have an opportunity to offer other forms of help that meet the needs of investors who are uncomfortable investing their entire retirement nest egg in a target-date fund.

“Prior to this research, it was easy to assume that participants didn’t fully understand how target-date funds worked,” Jones continues. “This research suggests that the drivers behind participant investing behavior are more complex than a simple lack of investing education. Older participants with higher balances require other forms of retirement help that more fully address what they are trying to achieve.”

“Not So Simple: Why Target-Date Funds Are Widely Misused by Retirement Investors” surveyed more than 1,000 full-time employees with access to TDFs in their employer-sponsored retirement plans.  The report can be downloaded from Financial Engines’ website.

Data & Research March 1, 2016

Timing Is Key When it Comes to Social Security

Northwestern Mutual has issued a report to help people develop a strategy.
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The uptick in longevity and the resulting possibility of a longer retirement will create added financial pressures for many workers, according to Northwestern Mutual. 

For many Americans, Social Security is a key component of retirement funding. Knowing how to navigate its intricacies, especially changes under the Bipartisan Budget Act of 2015 taking effect on May 1, 2016, is essential to maximizing the benefit and building a sound financial strategy for retirement.

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This is why Northwestern Mutual has issued a white paper, “Social Security Simplified: Select the right options to help maximize your income.” The points it lays out can be helpful for advisers who wish to work with investors on Social Security strategies.

In its 2015 Planning and Progress Study, Northwestern Mutual learned that the majority of Americans plan to begin taking Social Security between the ages of 65 and 67, “but that may not necessarily be the best path depending on other financial and life circumstances,” says Rebekah Barsch, vice president of planning at Northwestern Mutual. “It should be a priority to ensure that your retirement plan provides sufficient income for as long as necessary, particularly considering rising costs and ongoing economic uncertainty.”

As a first step, Barsch recommends that people become familiar with various Social Security benefits types, distribution schedules and benefit calculators. One example is determining one’s cross-over age—the age at which the total amount of benefits a worker would receive having started distributions after full retirement age (FRA) exceeds the total benefits he or she would receive if they started taking benefits before FRA.

NEXT: Five key factors

According to Barsch, there are five key factors that an individual should consider with regards to when to start taking Social Security.

Savings and investments—If you have enough money saved, it may make sense to use those savings before collecting Social Security at or after FRA. Conversely, if an individual has meager savings, taking Social Security early in order not to incur debt may be a better path.

Health and longevity—For those in good health, it may make sense to continue working and delay taking Social Security to maximize the benefits later. However, if you’re in poor health or think you’ll have a shorter life expectancy, delaying benefits may not make sense.

Taxable income—Social Security benefits are taxed in accordance with a couple’s combined income. However, even at the highest taxable percentage, they compare favorably with distributions from individual retirement accounts (IRAs), 401(k)s or other retirement sources. By delaying receipt of Social Security benefits to FRA or even age 70, one may get a higher level of benefits.

Current and future earnings—The earnings rule sets guidelines around how much income you can earn before your FRA without risking a benefits reduction.

Family status—Social Security has a number of specific rules that apply to current, surviving and divorced spouses. A knowledgeable adviser can guide you on this.

As Northwestern Mutual says in its white paper, “Timing your Social Security benefits may be the most important retirement decision you can make.”

The report notes that individuals who begin taking benefits at FRA receive 100% of their Social Security benefits. Those who delay until after FRA earn 8% in delayed retirement credits for each year they choose to delay, up until age 70. Thus, some retirees can increase their benefits by as much as 32%. Conversely, if an individual retires at age 62, the earliest possible year, their benefits are reduced by 25%.

The “Social Security Simplified” report can be downloaded here.

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