More and more companies are taking advantage of the 401 K auto-enrollment. This allows companies to increase the participating rate of their company 401 K plan. The auto-enrollment will automatically sign new employees up for the 401 K Plan. Of course, someone has to make the investment selection. Don’t worry, the company takes care of that important detail. They just select target date funds for the new employees.
Target date funds are becoming a staple in 401 K plans. They are advertised as a way to manage for risk. They encourage the investor to just invest, go on autopilot, and not pay attention. The target date mutual fund manager invests the money in the fund based on your age. The closer to retirement you are the less risk that the fund takes. The further away you are from the more risk you to take. The fund adjusts for risk as you age.
For example, if you turn 66 in 2040, you would invest in a Target date 2040 fund. Since you are so far away from retirement, you would take a lot more risk. This is an investment philosophy preached by the mutual fund industry. The industry says you are crazy if you are young and you don’t take a lot of risk. Obviously the more time you have the more risk you can afford to take. Unfortunately, it is a flawed concept because it disregards a person’s individual risk profile which is more complex than just there age. What if you are young, and you are conservative?
FinaMetrica, just released a study that shows the younger generation doesn’t have the risk tolerance that the industry claims. The study also exposes the flaws in this practice of auto-enrolling into target date funds.
Their study (consistent with other studies) suggests that the millennial generation (those who were born between 1980 and 2000) hoard cash and are very risk averse. In the U.S., the average risk tolerance score for this generation was 52.3 out of 100. Said another way, the younger generation is more comfortable having 43 percent to 63 percent of their portfolios in equities and not 90% to 100% invested in stocks as their target date fund would suggest.
The mutual fund industry needs to wake up and realize that the financial crisis of 2008 has completely shifted how investors of all ages view risk. Besides, basing a risk level purely on age misses the point. A person’s Prudent Money DNA is much more complex these days. It is yet an example of one more outdated philosophy on how to invest.