In “Target Date Funds and Portfolio Choice in 401(k) Plans,” researchers from The Wharton School, University of Pennsylvania, studied the effect of using target-date funds (TDFs) as the default investment for a worker’s portfolio over a 30-year career.
The researchers concluded that “the adoption of low-cost target-date funds may enhance retirement wealth by as much as 50% over a 30-year horizon. Including these funds in retirement savings menus raised equity shares, boosted bond exposures, curtailed cash/company stock holdings and reduced idiosyncratic risk.” Idiosyncratic risk is a type of investment risk, uncertainty or potential problem native to an individual asset (such as a particular company’s stock), or group of assets (such as a particular sector’s stocks), or in some cases, a very specific asset class (such as collateralized mortgage obligations).
The paper notes that TDF assets in 401(k)s have grown exponentially, from $5 billion in 2000 to $734 billion in 2018. The Pension Protection Act of 2006, which permitted TDFs to be used as default investments in 401(k)s, was largely the cause of that growth, the paper says.
Citing Investment Company Institute (ICI) data, the researchers say in 2018, 80% of 401(k)s offered TDFs, and 66% of plans used automatic enrollment, with TDFs being the primary default investment.
Importantly, the paper says, “in terms of portfolio effects, adoption of target-date funds had sizeable effects on equity share and risk factor exposures. Participants’ equity share rose an average of 24 percentage points for pure investors [i.e., those invested only in one TDF] and by 13 percentage points for mixed investors [i.e., those invested in a TDF and other funds]. As a result of increased equity and bond market exposures, expected factor returns for pure investors rose by 2.3% per year and for mixed investors by 1.7% per year.
“Accordingly,” the paper continues, “the introduction of target-date funds produced an important shift away from participants’ 401(k) plan portfolio selections and toward the target-date managers selected by employers. This change will have sizeable benefits. We estimate that improved returns could raise retirement wealth by as much as 50% over a 30-year savings horizon for a pure investor in a low-cost target-date series. Employees who [were] moved into the target-date funds could have previously made the portfolio changes on their own and realize potential benefits—yet they did not.”
The researchers say that a 30-year-old earning $35,000 a year, who makes annual deferrals of 10% a year into a retirement plan, and assuming a mean excess return of 5.4% would amass nearly $300,000 in savings over a 30-year period. However, the result would be 50% higher for pure TDF investors and 33% higher for mixed investors, “given a low-cost, well- diversified target-date series.”
In conclusion, the researchers say more should be done to encourage automatic enrollment and using TDFs as the default investment. They also suggest plan sponsors consider re-enrollment, so older workers in a plan that suddenly adopts automatic enrollment are swept into the automatic default.
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