Using Target-Date Funds
Sponsored Content – American Century Investments
Overview
Defined contribution plan sponsors have an opportunity to improve retirement readiness for participants by rebooting their existing plan using target-date funds as a qualified default investment alternative (QDIA). This is made possible by the Pension Protection Act of 2006, giving certain diversified, long-term investment products QDIA status. Since 2006, a growing number of sponsors have made changes to their plans to incorporate target-date funds—also known as TDFs— using re-enrollment and auto-enrollment strategies. Rebooting a plan and auto-enrolling participants into a TDF allows employers to improve plan participation rates and overall asset allocation while also benefiting from the fiduciary protections laid out under QDIA guidelines.
Asset Allocation- click here
Participants invested in target-date strategies are much more likely to have age-appropriate diversification and risk levels compared with employees who invest on their own. TDF investors have also been shown to have lower abandonment rates; that is, employees invested in target-date products tend to stay the course and not overreact to market events. In sum, plan participants in TDFs have a significantly improved likelihood of outperforming employees who go it alone. These factors make a compelling case for reevaluating existing retirement plans for a potential reboot using target-date products as a default investment option.
Key Terms Defined
QDIA— Qualified default investment alternatives are defined by the Department of Labor as “a single investment capable of meeting a worker’s long-term retirement savings needs,” and include target-date portfolios, risk-based portfolios, and managed accounts. “Defaulted” plan participants are those that fail to direct their investments in the plan. Significantly, these so-called “safe harbor” investments protect employers from liability relating to losses suffered by employees automatically enrolled in these designated investment strategies.
Auto-enrollment— An ongoing process that places new plan participants into a default investment option providing for salary reduction contributions at a predetermined percentage of pay. Auto-enrollment is particularly useful for increasing plan participation rates, and does not require written employee approval provided certain criteria are met.
Re-enrollment— A one-time change to a defined contribution (DC) plan, effectively restarting the plan from an investment perspective. Often also called a plan “reboot,” re-enrollment is best suited for changing the asset allocation characteristics of an existing DC plan.
Participants Need Investing Help
A recent Arnerich Messina paper highlighted research by Michael Falk, cataloging the massive deficit in investment knowledge and expertise that stands in the way of retirement success for many plan participants. Most participants have only a cursory understanding of investment basics, to say nothing of “second level” investing concepts, such as diversification, maximizing risk-adjusted performance, and changing risk tolerances over time. Indeed, fully 65% of plan participants Falk surveyed did not even know bond prices can go down; a whopping 44% believe that money market funds include stocks; 50% do not have an asset allocation plan; and 20% did not know that stocks can go down in value.
While these statistics are alarming, they should perhaps not be surprising—plan participants are experts in their chosen field of employment, but not necessarily in the complex world of investing. And it is encouraging that many workers, to borrow a phrase, know that they don’t know and need help if they are to achieve a secure retirement; a recent Employment Benefit Research Institute study indicated that nearly three-quarters of workers surveyed are less than sanguine about their ability to meet even basic expenses in retirement.
Sponsors Heeding the Call
At the same time, retirement plan sponsors are expressing an increased sense of responsibility for the retirement success of plan participants. Growing pessimism about employee retirement preparedness is motivating an evolution of DC plan enhancements. As Deloitte’s 2009 401(k) Benchmarking Survey makes clear, “employers are clearly concerned about employee readiness for retirement and plan to take steps to address the issue.” In addition, retirement plan benefits may be seen as a key plank in an employee recruitment and retention strategy. Add it all up, and employers are motivated to take steps to further the retirement investing success of their employees. To be sure, plan sponsors also enjoy considerable protection under the law for making such changes.
With that in mind, a growing mountain of evidence indicates that plan sponsors are able to provide their employees better results, higher satisfaction, and achieve broader plan participation by using the tools at their disposal since the Pension Protection Act of 2006 formally created three permissible long-term QDIAs: age-based (target-date) portfolios, risk-based (or “lifestyle”) portfolios, and managed accounts. Within those investment options, TDFs are the predominant default investment vehicle commonly used for new participants. Indeed, in separate studies, nearly two-thirds of respondents in Deloitte’s Survey and Towers Watson’s 2009 Defined Contribution Plans Report indicated using a target-date fund as the default investment election for automatic enrollment.
TDFs Are the Investment Vehicle of Choice
The popularity of TDFs in retirement plans rests on the fact that many of the strategies’ benefits—including professional management, portfolio diversification and rebalancing, avoiding extreme allocations, and managing the changing asset allocation or “glide path” over time—address the most frequent, major failings of individual plan participants. A number of studies have attempted to quantify the effect on investment performance of favoring professionally managed target-date portfolios over a do-it-yourself approach to retirement plan investing. A telling analysis, “Red, Yellow, and Green: A Taxonomy of 401(k) Portfolio Choices” by Mottola and Utkus, found investment gains of 60 to 350 basis points per year from addressing errors in portfolio construction and asset allocation (a basis point equals 0.01%, so 60 to 350 basis points equal a range from 0.60–3.50%).
Similarly, a report by retirement plan consultants Burgess and Associates looking at the performance of asset allocation funds over time found nearly 200 basis points of outperformance per year for lifestyle (static-risk portfolios similar in construction and allocation to TDFs) investors over non-lifestyle investors (see Figure 1). The authors found that “a large majority of non-lifestyle participants (84.2%) would have fared better in a single risk equivalent lifestyle portfolio than they fared by selecting their own investments.”
One important reason for this outperformance over time is that TDFs typically offer significant advantages in terms of their asset allocation, giving them better risk-adjusted return profiles than the majority of portfolios constructed by go-it-alone plan participants. A large 2010 study by consultants Hewitt Associates and portfolio advice provider Financial Engines titled “Help in Defined Contribution Plans: Is It Working, and for Whom?” found that investors using target-date funds, managed accounts, or some form of online advice improved their diversification and risk profiles as they neared retirement (see Figure 2).
Similarly, Mottola and Utkus estimate that nearly a third of retirement plan investors construct portfolios containing “egregious errors,” defined as having either zero equity exposure or an over-concentration in employer stock. Roughly another quarter of investors have portfolio allocations the authors deemed too conservative or too aggressive to maximize their opportunity for retirement investment success. It is worth noting that this asset allocation challenge persists even into retirement. Indeed, we find that many investors under-allocate to equities early in retirement, presenting “longevity risk”—that is, the risk that plan participants run out of money in retirement. On the other hand, investors are most vulnerable at retirement and too high an equity allocation introduces unwanted market risk. TDFs resolve this tension between longevity and market risks over their lifecycle because their asset allocation “glide path” gradually becomes more conservative over time.
Target-Date Investors Are Less Likely to Overreact to Market Events
There is another key area in which target-date funds produce demonstrably better outcomes to those of go-it-yourself investors—abandonment rates. This refers to the risk that investors will react to negative market events by eliminating their equity investments and moving entirely to cash, abandoning their investment strategy entirely. Our own recent analysis of academic and industry literature suggests that investors are prone to bailing out of portfolios that have incurred one or two years of losses. Similarly, Dalbar’s Quantitative Analysis of Investor Behavior 2009 found that in the 20 years ended in December 2008, the average equity investor dramatically underperformed not just the market (as represented by the S&P 500), but also inflation. This is directly attributable to poor market timing decisions—a pitfall TDF investors tend to avoid.
Indeed, Morningstar’s 2010 Target-Date Fund Survey analyzed investor behavior in the aftermath of the financial crisis of 2008, finding that investors in target-date funds “bucked a fund-industry trend in which investors tend to pull their money at market lows and chase investments close to their peaks.” The Morningstar authors go on to write that “shareholders like the set-it-and-forget-it nature of target date funds; and as a result, did not panic during the 2008 market crisis.” Essentially all the research we have seen on this topic supports the conclusion that TDFs encourage shareholders to stay the investing course despite the vagaries of the market.
Total Reboot
There is a persuasive case for TDFs being attractive options for plan participants ill-equipped to make complicated financial decisions about portfolio construction, asset allocation, and rebalancing over time.
Now we must answer the question, What is the best way to incorporate this strategy into an existing plan? This is a crucial question, as how the strategy is incorporated and introduced to the plan makes a significant impact on how broadly the TDF is adopted—and therefore, how broad the reach of the intended benefits across the plan. Let us consider the three main options at plan sponsors’ disposal: a TDF may be added to an existing suite of investment offerings (no special enrollment preference); the TDF may be designated as a default investment option (QDIA); or plan participants may be automatically enrolled in the TDF as part of a total plan reboot (allowing for voluntary opt-out provisions). These gradients of change stand on a spectrum from “least invasive” (passive addition to plan) to “most proactive” (active movement of participants out of existing investments into TDFs).
Inertia: Making It Work
Research and extensive industry experience tell us that only a small fraction of participants make active investment decisions, a phenomenon referred to as “inertia.” That is, the majority of plan participants default into the automatic investment option and rarely make adjustments to their asset allocation. By rebooting the plan and automatically directing participants toward a target-date based product, fiduciaries put that inertia to work for their plan participants.
This point cannot be made enough—a plan reboot improves asset allocation across the entire plan in a way that a gradual change of asset mix by adding funds over time does not. Data show a slow initial uptake for new retirement products because adding an investment option requires participants to actively select the strategy—they must voluntarily “opt in” to receive the diversification and other benefits TDFs offer. This is the equivalent of swimming against the inertia tide, while a reboot would put inertia at investors’ backs, working for their ultimate benefit.
For these reasons, re-enrollment and auto-enrollment policies are particularly effective tools to remake a plan’s asset allocation and improve retirement readiness precisely for employees most in need of help. But it is important to clarify that the two policies work best when used in conjunction with one another. Simply adding more investment options to an existing menu contributes to “choice overload” in which consumers freeze in the face of multiple, even seemingly simple alternatives. Indeed, one widely quoted 2003 study showed that as investment alternatives increased, plan participation rates actually decreased (Iyengar, Huberman, and Jiang, 2003).
Getting to Yes: TDF Reboot Made Easy
Our every interaction with plan sponsors, and all the data we have seen, suggests that fiduciaries are genuinely concerned about their employees’ preparedness for retirement and are actively looking for ways to help. And yet, many balk at making plan modifications because of concern about potential costs or difficulties in executing these strategies, or perhaps out of fear that participants will be resistant to change.
Certainly, it is true that it requires administrative skill and effort to successfully execute and communicate modifications to an existing plan. But no firm is alone in this undertaking—modifying a QDIA or undertaking a plan reboot involve the plan recordkeeper and investment manager. These two service providers will have a wealth of knowledge and past experience with successfully executed re-enrollment, auto-enrollment, and QDIA changes.
Perhaps the best time to pursue a plan re-enrollment is when other changes are in the works—sponsors looking to introduce a TDF as the plan QDIA will need to communicate these and other changes to plan participants. Rather than make piecemeal changes, a one-time plan reboot can be an attractive option.
Conclusion
Our analysis indicates that re-enrollment and auto-enrollment into a TDF used as a QDIA can be highly effective strategies to improve retirement outcomes, increase participation rates, and improve asset allocation across a DC plan. In addition, using a TDF as a qualified default investment assures that plan sponsors benefit from QDIA protections under the law. Indeed, a growing body of evidence suggests that TDFs are attractive investments for the vast majority of plan participants—TDF investors demonstrate age-appropriate diversification, have lower abandonment rates, and better retirement outcomes than employees that go it alone. The most immediate way to effect these changes across the entire plan is to reboot and automatically enroll employees into the appropriate TDF. It is crucial to use these policies together to make a positive of participant inertia—the reluctance of employees to make changes to investments over time if left to their own devices. Finally, changes to a retirement plan need not be excessively complicated or costly, particularly when done in conjunction with other plan modifications, and when working together with the plan record-keeper and investment manager.
Selected Bibliography
Arnerich, Tony, Howard Biggs, Vincent Galindo, Jacob O’Shaughnessy, and Jillian Perkins, “Conservation of Choice: Simplifying Investment Options to Better Serve Participants,” Arnerich Massena & Associates, Inc., April 2010.
Burgess + Associates, “Outcomes of Participant Investment Strategies 1997-2006,” Study Commissioned by John Hancock Retirement Plan Services, October 2007.
DALBAR, “QAIB 2009: Quantitative Analysis of Investor Behavior,” 2009.
Deloitte Consulting, “401(k) Benchmarking Survey: 2009 Edition,” 2009.
Falk, Michael, “An Evolved Solution: Participant success hinges on plan design,” Defined Contributions Insights Magazine, March/April 2002.
Financial Engines and Hewitt Associates, “Help in Defined Contribution Plans: Is It Working and for Whom?,” January 2010.
Helman, Ruth, Mathew Greenwald and Associates, and Craig Copeland and Jack VanDerhei, Employee Benefit Research Institute, “The 2010 Retirement Confidence Survey: Confidence Stabilizing, But Preparations Continue to Erode,” Issue Brief, Employee Benefit Research Institute, No. 340, March 2010.
Huberman, Gur, Sheena Iyengar, and Wei Jiang, “Defined Contribution Pension Plans: Determinants of Participation and Contribution Rates,” Journal of Financial Services Research, 31 (1), 2007.
Jacobsen, Brian, Christian Chan, and Olivia Barbee, “Balancing Longevity Risk and Market Risk: The Impact of the PPA on Target Date Funds,” Journal of Pension Benefits, 2009.
Lewis, Nigel D., “Making Ends Meet: Target date investment funds and retirement wealth creation,” Pensions, Vol. 13, (2008).
Morningstar Fund Analysts, “Target-Date Investors Stick Around, Earn Better Returns,” Fund Spy, March 16, 2010.
Mottola, Gary, and Stephen Utkus, “Red, Yellow, and Green: A Taxonomy of 401(k) Portfolio Choices,” Pension Research Council Working Paper, The Wharton School, University of Pennsylvania, June 2007.
Poterba, James, Joshua Rauh, Steven Venti and David Wise, “Lifecycle Asset Allocation Strategies and the Distribution of 401(k) Retirement Wealth,” NBER Working Paper No. 11974, January 2006.
Towers Watson, “Managing Defined Contribution Plans in the Current Environment,” 2009 Defined Contribution Plan Trends Report, Originally Published by Watson Wyatt Worldwide, 2010.
The opinions expressed are those of Rich Weiss and Nancy Pilotte and are no guarantee of the future performance of any American Century Investments portfolio. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice. Material presented has been derived from industry sources considered to be reliable, but their accuracy and completeness cannot be guaranteed. Past performance is no guarantee of future results. This information is not intended to serve as investment advice. The principal value of the target-date fund is not guaranteed at any time, including at the target date. It is possibleto lose money by investing in TDFs.
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