Beware of ‘Partial’ TDF Users

Even otherwise knowledgeable users of target-date funds seem not to fully understand the diversification benefits of TDFs, leading to the harmful behavior of “partial TDF use.”

A recent report from Voya Investment Management contains a trove of fresh insights into the behaviors and preferences of target-date fund (TDF) investors.

According to Susan Viston, client portfolio manager at Voya Investment Management in New York, there is a lot for retirement plan advisers and sponsors to feel good about in the report, but also a few causes for concern.

First the good news: “One thing that is new here in 2016 that is quite interesting is that participants are really getting more savvy about diversification,” Viston tells PLANADVISER. “They have overwhelmingly told us they prefer funds that contain a mix of active and passive investment strategies. At the same time, only small groups tell us they believe only all-active or all-passive is the most appropriate approach to retirement investing.”

The question is whether this stated interest in active and passive going together implies a deeper understanding of what diversification really is. “I think the answer is yes, absolutely,” Viston continues. “We have now  found in all three updates of this survey that TDF users are increasingly expressing an interest in not only having a broad range of asset classes and even a mix of active and passive—but on top of this they also strongly prefer a multi-manager approach to the design. This just seems more reasonable to them than relying on a single manager to deliver top-quality service across all asset classes.”

For all the positive behavioral improvements measured by Voya, Viston warns there are some persistent challenges. For example, less than one-sixth of TDF-using respondents are putting 100% of their contributions into their retirement plan’s TDF.

“The mean value of the portion of salary deferral going to the TDF was just 47% of contributions,” Viston notes. “Participants may have learned not to put all their eggs into one basket, and they understand TDFs are an important way for unsophisticated investors to achieve better diversification, but they don’t realize that TDFs were designed to offer a well-diversified portfolio in a single allocation. It’s not too hard to imagine how an individual might damage their retirement outlook because of these types of behaviors.”

NEXT: Partial  TDF users are at risk 

So-called “partial” TDF usage has been associated with greater levels of risk and poorer outcomes for participants, Viston explains. In contrast to those putting all (or nearly all) of their retirement assets into a single TDF, partial target-date fund participants had “significantly lower returns,” Voya’s data shows.

“Specifically, participants in all age ranges who invested at least 95% of their savings in TDFs exhibited an average difference of 2.44%, net of fees,” Viston observes. “Deeper education about TDF diversification could prompt participants to reduce the number of their non-TDF investments and perhaps help deliver better investment outcomes.”

Voya’s report goes on to suggest that, as participants are becoming more savvy toward TDFs, so, too, are their plan sponsoring employers.

“In this cut of the survey, we are clearly starting to see at the mega end of the market a pretty big shift towards custom target-date solutions, which has a lot to do with the fact that plan sponsors want to use best-in-class managers across asset classes,” Viston says. “The changes are happening even more quickly because of the large proportion of assets that are now going into target-date funds.”

Because of that, the number of target-date managers that incorporate open architecture has increased and is still increasing, Viston says. This should be a lasting area of industry development and potential new approaches to TDF investing for advisers, sponsors and participants. 

The report predicts TDFs have a bright future tied to their user friendliness and ability to breed retirement confidence: “We increasingly see a confidence gap opening up here, between TDF users and non-TDF users,” Viston says. “In this latest edition of the study, we see 63% of users of TDFs feel confident they can meet their long-term investing goals, up 10 percentage points from the 2011 version of the study and compared with 48% of non-users.

“It’s a very striking difference between the TDF and non-TDF approach,” she concludes. “What we have found, too, is that TDF users demonstrate other success-driving behaviors. For example, they have a median deferral rate that is a full 2% higher per year than non-users. Some other telling numbers include that 28% of TDF users are at an 11% salary deferral or higher, versus only 14% of non-users reaching this level.”