Target date funds (TDF) have proven to promote better participant behavior in times of market turmoil, something 401(k) advisors are watching.
“We heard around 1999 and 2000 how supposedly 401(k)s were deficient, investors would be the first to crack, that the savings vehicle wasn’t structured properly and it wouldn’t hold up,” John Rekenthaler, Morningstar’s vice president of research, said. “But the opposite was actually true. TDF’s were strongly positive through 2008 and 401(k) investors stayed put more so than other types of investors.”
It’s just one reason for their stratospheric rise, especially since the passage of the Pension Protection Act of 2006, which designated target date funds as a qualified default investment alternative (QDIA).
“In 2006, 32% of large 401(k) plans offered target date funds,” according to the Investment Company Institute and BrightScope.
In the ensuing decade through 2016 (which included the financial crisis), “that number had risen to 80% of plans. Similarly, the percentage of participants that were offered target date funds increased from 42% of participants to 83% between 2006 and 2016.”
[Related: What to do About ‘Forgotten’ 401k Target Date Fund Participants]
Company-specific research is just as compelling, with the latest benchmark report from T. Rowe Price reporting that plan adoption of target date products reached an all-time high among its 2 million participants for the second year in a row in 2018, up from 94% to 95%.
Referring to the target date “norm,” the Baltimore-based investment behemoth noted that, “Participant usage increased across all age groups, although investment is highest among younger workers. The percentage of participants who invest their entire balance in a target date product grew by over 20% from 2014 to 2018 (48% to 58%).”
Vanguard’s bellwether benchmark report, How America Saves, found much of the same, adding that nine in 10 plan sponsors offered target date funds at year-end 2018, up one-third over the previous decade when compared with year-end 2008. Nearly all Vanguard participants (97%) were in plans offering target date funds, and 77% of all participants use target date funds.
“An important factor driving the use of target date funds is their role as an automatic or default investment strategy,” Vanguard explained. “The qualified default investment alternative (QDIA) regulations promulgated under the PPA continue to influence the adoption of TDF. That said, voluntary choice is still important, with nearly half of single target date investors choosing the funds on their own, not through default.”
Phenomenal Forward-Looking Fund Use
Not surprisingly, the wild run target date funds are experiencing is only likely to continue, due mainly to an increase in the number of target date options.
“We anticipate that by 2023, eight in 10 Vanguard participants will be solely invested in an automatic investment program,” Vanguard wrote.
“These numbers will likely continue to grow as new employees enter the workforce and are defaulted into a target date investment by their plans,” T. Rowe concurred, adding that the availability of set-it-and-forget-it target date products might be leading to fewer participants seeking investment guidance.
“Respondents to T. Rowe Price’s participant surveys reported that while most participants turn first to their 401(k) provider for financial advice, only 21% want investment help.”
Potential Participant Problem
Of course, the product is not without controversy. Debate has long raged over the TDF’s role in the portfolio, and whether including other target date funds—and/or completely different investment vehicles—reduces the effectiveness of the retirement plan overall. It’s something with which the industry wrestles, especially one that’s consistently preached the benefits of diversification (by asset class and product type) and the dangers of concentrated positions and portfolios. But for many, it doesn’t appear to be an issue.
“Two-thirds of participants owning TDF have their entire account invested in a single target date fund,” Vanguard found, and “52% of all of its participants are wholly invested in a single target date fund, either by voluntary choice or by default.”
A Mixed Message
Nonetheless, David Blanchett, Morningstar’s head of retirement research, recently attempted to settle the question once and for all.
“There are potentially over 10 million participants in defined contribution plans today combining a TDF with other plan investments, commonly referred to as ‘mixed target date fund investors,’” Blanchett wrote in a research report last summer titled, “Mixed Target date Fund Investors: Is There a Method to the Madness?”
“TDF are best used as an ‘all or none’ investment option since mixing target date funds with other plan investments significantly diminishes, and potentially eliminates, their value,” he added.
Blanchett argued that participants who require a more aggressive allocation are “better off moving along the target date fund glide path” to a year with a higher risk level, rather than mixing in other equity or bond funds.
He also found the typical mixed TDF investor had attributes that would suggest “they are more sophisticated than investors who use the default investment (for example, they have higher salaries and higher balances), but less sophisticated than participants self-directing their accounts and not using target date funds.”
Additionally, mixed target date fund investors appeared to have relatively diversified portfolios, but are more aggressive than the average target date fund would be for a given age, especially at older ages.
“The average allocation of mixed target date fund investors is 37% target date funds, 49% equity funds, and 13% bond funds,” Blanchett added. “The non-target date fund weights are relatively constant across different levels of target date fund holdings.”
Plan advisors and sponsors, therefore, “should encourage participants who are not interested in using the TDF in its entirety to use some type of in-plan advice solution, such as advice or managed accounts.”
Comfort in Custom Target Date Strategies
Another potential solution to the “all or nothing” target date dilemma is the rise of custom target date fund strategies.
“As target date strategies continue to become more prevalent in defined contribution (DC) plans, more plan sponsors are contemplating custom offerings that can be tailor-made to meet the specific goals and objectives of individual plan sponsors,” Daniel Oldroyd, CFA, CAIA, head of target date strategies for multi-asset solutions with J.P. Morgan Asset Management, argued.
More specifically, custom target date strategies can be precisely designed to meet specific plan requirements.
“These strategies can take into account employee demographics and particular plan design features (for example, a prohibition against plan loans or pre-retirement withdrawals),” Oldroyd added.
Yet the comfort more customizable solutions provide might be offset by their communication and transparency issues.
“Effective communications are critical when implementing a custom strategy,” Oldroyd cautioned. “While participants in an off-the-shelf target date strategy can access relevant information about their strategy’s funds on fund company websites, participants in a custom strategy may have only one source of information about their retirement funds: the communications they receive from their plan sponsor.”
Thankfully, this lack of available information when custom strategies are compared with their off-the-shelf counterparts is something that hasn’t gone unnoticed, and the Defined Contribution Institutional Investment Association (DCIIA) has taken up the cause, with the advocacy organization launching a custom TDF research initiative in 2017.
“While there is a great deal of publicly available information on packaged (as in, mutual fund and collective investment trust) target date strategy performance and asset allocations, little to no comparative information exists on custom target date strategies,” DCIIA noted upon the release of its inaugural custom target date survey in 2019.
It found that the total custom TDF market was estimated at $430 billion at year-end 2017, with the DCIIA sample accounting for roughly 80% of the total market.
As one would expect, a majority of the custom strategies’ exposure was allocated to equities and fixed income, with the average allocation to equities for 2060 funds was 85%, falling to 28% for income funds, while the average allocation to fixed income increased from 7% for 2060 funds to 52% for income funds.
“The central focus of this initial study is to better understand the asset allocation approaches among custom TDF strategies,” the authors—including Capital Group’s Brett Hammond and T. Rowe Price’s Joshua Dietch—concluded. “Looking beyond this first iteration of its custom TDF research initiative, DCIIA looks forward to completing the custom TDF universe and expanding the data set.”