The 401(k) Investment Rule People Are Breaking

March 6, 2021

A new report concludes that many investors are coloring outside the lines in one area of their 401(k)s and defined-contribution retirement plans. The investment rule they're breaking has to do with target-date funds or TDFs. These funds, designed specifically for retirement savers, are highly diversified and feature risk profiles that gradually become more conservative over time.

If you own a TDF, it should be the only position in your retirement portfolio. And yet, according to a John Hancock white paper, more than 25% of TDF investors are breaking this rule and holding their TDF alongside at least one other type of fund.

TDF: a lone ranger

Target-date funds (TDFs) weren't originally intended to be mixed with other assets in a participant's portfolio.

-- State of the Participant 2021, John Hancock

A closer look at TDFs shows why these retirement-focused funds function best as solo acts. They are balanced funds that cater to your changing investment needs over time. When you're younger, a TDF pursues aggressive growth. As you near retirement, its portfolio shifts to a more defensive approach to protect your wealth.

That progression is very specific, too. Each TDF adheres to a precise asset allocation based on your age -- and more specifically, the number of years left until you plan to retire.

Holding other positions along with your TDF skews those allocations. If you own an S&P 500 index fund and a TDF, for example, your portfolio may be too aggressive for your age. Pair a TDF with a Treasury fund, and your 401(k) may underperform.

A surprising twist

Couple reviews performance of their target-date funds in their 401(k).

Image source: Getty Images.

The John Hancock report also assesses retirement readiness for traditional TDF-only investors and so-called "TDF-plus" investors. And here's where things get interesting.

Nearly 59% of TDF-plus investors are on track for a comfortable retirement. That compares to only 52% of those who take the recommended approach and only invest in TDFs.

That means the rule-breakers are doing better than the rule-followers. What gives?

One theory is that TDF-plus investors save more, because they're simply more engaged with their 401(k)s. To take the TDF-and-then-some approach, you'd have to log in and actively change your 401(k) investment picks. And if you're the type of person who chooses to adjust their investments away from the default settings, maybe you're also the kind of person who will increase your contribution rate.

On the other hand, 401(k) savers who stick with their default TDF investment -- and their default contribution rates -- probably end up saving less.

Be active in your 401(k)

However, the evidence seems to show that with appropriate education and guidance, participants can potentially have success with a "TDF-plus" approach to asset allocation.

-- State of the Participant 2021, John Hancock

The takeaway here is twofold. One, you can follow a TDF-plus strategy as long as you are comfortable with how it affects your risk and growth prospects -- in good and bad market climates. If you're not sure about that, stick with the TDF as your sole position.

Two -- and this one is more important -- be an active manager of your 401(k) to raise your retirement readiness. Budget and then set your contribution rate as high as you can afford. Watch your investment results. Look to understand the positions within your TDF, how they contribute to performance, and how the fund's allocations change over time.

The more you learn about the inner workings of that TDF, the better prepared you'll be to succeed with a TDF-plus strategy. And that's just the beginning. Eventually, you might move away from TDFs entirely and start designing asset allocations that specifically address your unique retirement goals.