Looking for a boost for your retirement savings accounts? Target-date funds (TDFs) are supposed to provide precisely that.
But misusing TDFs has the opposite effect – it stymies the growth of your nest egg.
The lesson? Use TDFs the right way. Of course that means understanding how target-date funds are supposed to be used. That means using them by themselves and not diluting their benefit by using them in addition to other investments, unless you know what you’re doing. Mixing and matching TD funds with other investments willy-nilly can slow the growth of your account while you’re young.
The idea behind TDFs is that they help investors avoid parking their money in the types of investments that don’t grow fast enough. Too many inexperienced investors – hello, young workers, this means you – tend to put their retirement plan contributions into cash and bonds, then leave them there for years, decades even.
IBD’S TAKE: If you’re an experienced investor who owns a target-date fund in a retirement account, run its holdings through Stock Checkup . Some might rate highly enough to consider buying. Also see if any are a member of Leaderboard and ripe for buying.
They do that because they think cash and bonds are safer. What they are is less volatile in the short run. But they are more dangerous in the long run because as groups they don’t grow as fast as stocks tend to. And your goal during your working decades is to make your nest egg grow as big as possible.
Especially while you’re young and if you’re an inexperienced investor, it’s self-defeating to put some of your retirement contributions into a TDF and some of them into cash or bond funds.
But many such workers may still be making that very mistake.
Fewer than half – 49.7% – of workers who kick in money to 401(k)-type accounts use nothing but TDFs. If they’re young and using, say, all-stock mutual funds in addition, there should be little if any risk to their ability to make their balance grow as much as possible by retirement.
That means that a slight majority, 50.3%, of 401(k)-type plan members are using other investments – either in place of TDFs or in addition to them.
That’s likely to hurt the growth of their nest eggs the younger those workers are and the more they use slow-growth assets as their non-TDF investments.
Look at a 20-something plan member who uses nothing but TDFs. The median annual return for his or her account over the five years ended Dec. 31, 2015, was 8.9%, according to a new study Aon Hewitt.
That rate of return falls to 8.7% for the younger plan members who do not devote their entire account to TDFs.
It tumbles to 4.5% for younger plan members who do not use TDFs at all.
A similar pattern was found for workers in their 30s and 40s.
“The underperforming accounts held by those age cohorts tend to have overweightings in cash, bonds and other conservative investments,” said Rob Austin, director of retirement research for Aon Hewitt. “That hurts their returns.
So, any of the 50.3% of those workers who divert some of their contributions into cash and bonds before, say, their late 50s or their 60s could be making a strategic mistake.
Workers in their 50s and 60s who rely heavily on TDFs also outperform retirement plan members who do not use TDFs.
But for those age groups, the exclusive commitment to TDFs does not pay off as well as it does for younger workers.
Plan members in their 50s, for example, who use nothing but TDFs had a median annual return of 7.4% during the past five years. Plan members who use other investments in addition to TDFs beat that with a 7.8% median yearly gain.
Why didn’t returns by TDF-only plan members reign supreme the way it did for younger workers? It’s because a lot of the non-TDF investments owned by those workers consists of stock in their respective employers. Company stock, like shares in any individual company, can be volatile – either up and down. And in the past five years, that volatility has benefited plan members by scoring more gains than losses overall, Austin says.
“People closer to retirement are older,” Austin said. “So they’ve had more time to accumulate company stock. In general, enough of that company stock has gained slightly more value in the past five years than target date funds have on average. So plan participants who hold company stock as well as target date funds in their retirement accounts have done a little better than people in their same age cohorts who held just target date funds.”
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.