There’s lots of discussion in the financial press about excessive 401(k) fees, which we at O’Brien Greene like to see, since our professionally managed 401(k) plans are much less costly to retirement investors than the conventional plan. The new attention to fees helps plan sponsors and participants see the virtues of investing directly in individual securities through a professionally managed pooled account, instead of through complex and costly mutual funds or variable group annuity contracts.
There is not a lot of discussion, however, about a much greater problem that plagues the conventional 401(k) plan: the do-it-yourself model that requires plan participants to pick mutual funds on their own leads to severe and predictable mistakes that cost retirement investors dearly. Recently Bloomberg reported a new study that shows one instance of this: the misuse of target-date funds. (Ben and I have commented previously on problems with target-date funds.) The presence of target-date funds within 401(k) plans has been increasing rapidly, along with their total assets under management, over the past few years. They are touted by the mutual fund companies and insurance companies that provide them as an automatic solution to investing: allocate your savings to a fund targeted to your retirement date, and forget about it.
Target date funds only work automatically, however, if investors allocate nearly all of their portfolio assets to an appropriate fund. Their purpose is frustrated if investors put, say, just 50% of their savings in the target-date fund and then spread dollops of money into a range of other funds, because this results in unreasonable asset allocations. A new study by Aon Hewitt and Financial Engines shows this misuse of target-date funds is the typical way in which 401(k) target-date fund investors behave: 62.2% of all target-date fund users invested only partially in their chosen funds, i.e., with less than 95% of their investable portfolio assets.
The chart above is from the study and it shows how much of their portfolio assets partial target-date fund investors allocate to their chosen target-date funds. This is important because it shows that target-date fund investors don’t cluster in the 75-95% allocation range; they tend to misuse their target-date funds rather egregiously.
The upshot is that there is a huge mismatch between the operation of target-date funds themselves, and how the funds are used by target-date fund investors. In short, the majority of target-date investors don’t realize the benefits that target-date funds are intended to produce. The effects of investor misuse on investment performance is probably much worse than the effects of excessive fees. The problem lies with the whole do-it-yourself fund picking model at the heart of the conventional 401(k) plan, which requires untrained amateurs to moonlight as asset managers.