In the beginning, the typical 401(k) plan had three investment options broadly categorized as “stocks,” “bonds,” and “cash.” These represented the traditional asset classes. They were quite digestible to the average employee.

Then, in the 1990s, mutual funds took over the 401(k) roost. The three simple asset classes gave way to the more complicated nine style boxes. The proliferation only continued into the 2000s. By then, many 401(k) plan participants suffered from decision-making paralysis. Indeed, following a few landmark studies, quite a few books found their way into bookstores purporting to deal with this condition.

For 401(k) plan designers, the solution was straight-forward: reduce the number of investment choices. In 2006, Congress passed the Pension Protection Act which encouraged an even better method of resolving decision paralysis: take away the need to make a decision.

Thus sprung the sprig of Target Date Funds (“TDFs”). Over the past decade and a half, this default investment option has blossomed with viral intensity.

That doesn’t mean you still don’t have choices. In fact, many 401(k) retirement savers now have additional methods to choose from when it comes to how their savings are invested.

If you’re lucky enough to participate in a comprehensive 401(k), you likely have three ways to have your money invested: through a traditional TDF; through a “managed account;” or through a “self-directed account.”

Confusing matters further was the initial lack of consistent use of these latter terms. Things have since settled and there is a general consensus on their definitions.

If you’re like most people, by now you’re quite familiar with what TDFs are. Managed accounts and self-directed accounts, on the other hand, can cause at least a little trepidation.

“A managed account differs from a self-directed account in that the managed account has a seasoned professional making the buy/sell decisions of the securities in your 401(k) account, while in the self-directed account, it is your decision as to what securities you purchase for your 401(k) account,” says Erik Sussman, Founder and CEO of the Institute of Financial Wellness in Fort Lauderdale, Florida. “The managed account relieves you from the responsibility of the due diligence investment selection.”

A useful analogy might help further explain the difference between managed and self-directed accounts.

“Think of the difference between using Waze or Google maps to drive yourself from point A to point B, versus hiring an Uber or Lyft,” says Matthew Grishman, Principal, Wealth Advisor at Gebhardt Group, Inc. in Roseville, California. “A managed account is like hiring Uber to get from where you are to where you want to go. You are hiring a professional driver (money manager in this case) to make the turn by turn, day to day, decisions about which investments are best to own at any given time. A self-directed account is one where you are driving the car, or in this case, responsible for making all of the investment decisions by yourself, perhaps with the assistance of some online research that can help guide your decision making (kind of like using Waze to get from point A to point B).”

Metaphors can provide some clarity, but it helps to get into the nitty gritty to see how each of these investing methods actually work.

Of the three choices, managed accounts tend to be the more complicated (though not necessarily the most work). You are required to make a series of decisions with increasing complexity. You may enjoy this. You may be frustrated by this.

“A managed account is typically an account where you choose a third-party entity or person to make decisions on your behalf, as to what and when to buy and sell,” says Brian Stivers, Investment Advisor and Founder of Stivers Financial Services in Knoxville, Tennessee. “Managed accounts vary greatly in their particular focus. Some may focus on risk management, some on growth management and some will be a combination of both. The underlying investments can vary greatly as well, with most consisting of individual stocks/bonds, stock/bond mutual funds or stock/bond ETFs, or at times, a combination. Managers of managed accounts may make their investment decisions in a variety of ways including but not limited to, algorithms they have created, technical analysis, investment committees or a large variety of proprietary management processes. Managed accounts are generally structured very specifically as to what the management firm can invest in, such as it may only be able to invest in equities of a certain index or asset class. There are managed accounts available for virtually every type of asset class and strategy you can imagine, but each individual managed account may be narrow in its focus. Managed accounts have a very defined way of selecting what to buy and sell and when to buy and sell. It is also common that you don’t know exactly what you own at any given time due to the potential complexity of the managed accounts strategies.”

As you can see, choosing the managed account method requires you to learn a lot more about the details of a lot more concepts. Contrast this to self-directed accounts. You can stick to what you’re comfortable with. Still, this option will require the most effort on your part.

“A self-directed account is where you choose your investment strategies, asset classes, type of investments, etc., on your own,” says Stivers. “You choose when to buy, when to sell, what to buy and what to sell. Most investors who have self-directed accounts are more likely to employ a buy-and-hold strategy versus an actively managed account where there are frequent trades based on a defined set of criteria. The self-directed account gives you total control of the day-to-day investment decisions. You are therefore more likely to know exactly what you own on any given day.”

The TDF represents the easiest (although not necessarily the best) approach and has proven to be the most available (if not the most popular) option for many employees. This doesn’t mean you can ignore what constitutes a TDF. In fact, because so many people use them, it’s critically important that you understand what makes a TDF a TDF.

“Target date funds are generally a pre-packaged set of investments consisting of stock and bond-oriented investments,” says Stivers. “They’re a simple way to match a person’s risk tolerance to the investment mix that is appropriate for that risk tolerance. Most target date funds target an approximate time frame until the investor’s normal retirement date. Conventional risk analysis suggests the closer you get to retirement, the more conservative your portfolio should become to protect against catastrophic loss prior to retirement. The TDF, based on the date chosen, will create the appropriate stock/bond ratio to match the risk tolerance a person of that age should adopt. As you get closer to retirement, you will see the bond percentage increase and the stock percentage decrease to automatically become more conservative. The underlying investments generally remain the same (buy-and-hold), but the percentage of each will change with each passing year towards retirement. TDFs are generally offered directly by the investment company itself.”

Now that you know the detailed differences between managed accounts, self-directed accounts, and TDFs, it’s only natural to ask, “Which one is best for me?”

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