“Zero bias” is a thing—and it could be hurting your 401k.
New research from Iowa State University shows selecting a target date fund that ends in “zero” could negatively impact retirement savings, and plan participants apparently have a tendency to pick TDFs ending in zero as compared to funds ending in five.
The study, published in the Journal of Consumer Research, identified the tendency, which affects the amount people contribute to retirement savings and leads to an investment portfolio with an incompatible level of risk, which can significantly lower total wealth at retirement, the findings show.
Wei Zhang, Kingland Faculty Fellow in Business Analytics and associate professor of marketing in Iowa State University’s Ivy College of Business, and co-authors Ajay Kalra, Rice University; and Xiao Liu, New York University, analyzed data from a global financial investment firm that included 84,600 individual accounts—nearly half of the sample invested in TDFs. The researchers found investors born in years ending in eight or nine tend to select targeted funds that mature earlier than they intend to retire.
According to the results, approximately 34% of people born in years ending with eight or nine select early retirement funds and all of them end up worse off financially. About 29% of people born in years ending in zero through two select TDF dates that are later than they plan to retire and end up better off, except for those who are risk-averse.
TDFs, of course, automatically rebalance portfolios over time, decreasing the percentage invested in stocks and increasing the percentage invested in bonds to reduce the risk as the participant nears retirement.
“Targeted funds offer a ‘set it and forget it’ approach to investing, which is popular for consumers who don’t want to navigate financial decision-making,” Zhang said. “However, that initial decision of selecting a targeted plan has implications.”
The researchers also looked at several demographic factors where the likelihood of “zero bias” was stronger. They found men, older people and those with higher incomes are more likely to demonstrate the bias. Investors who participated in a 30-minute financial planning program were less likely to exhibit the zero bias tendency, Zhang said.
In the paper, the researchers explained how the zero bias affects accumulated wealth:
- Investors contribute less if they select a later-date retirement fund compared to the matching targeted fund.
- Zero bias exposes investors to different risk-return trade-offs: Selecting a non-matching TDF exposes investors to risk that may be incompatible with their stage of life.
- The extent of losses incurred by not choosing a matching TDF can be quite large depending on birth year.
Mitigating the bias
The findings indicate that the bias is a result of imprecise math, specifically rounding up or down to estimate retirement age. The paper says that by understanding this bias and how it relates to birth years, financial advisors can better inform investors of their choices.
“Given that many individuals are choosing targeted retirement funds for their retirement portfolio, the insights from our paper will help financial service companies and consumers to improve investors’ financial well-being,” Zhang said.
