The TIAA Institute has released a report discussing how participant contribution decisions have changed since the enactment of the Pension Protection Act of 2006 (PPA) enabled the use of target-date funds (TDFs) as a plan default investment.
Prior to TDFs, money market funds were the most common default investment option. With this in mind, the study asked three questions: “First, how do the changes in default investments and available numbers of funds in the plan menu affect the number of funds used by participants? Second, what determines whether participants use target-date funds? Finally, how do these regulatory and plan changes affect the percentages of equity in allocations?”
The study found that participants who join a plan with a TDF default contribute to fewer funds and are significantly more likely to choose only TDFs for their allocations. Additionally, it says, participants will, on average, contribute to funds with greater equity exposure, and there is “less cross-sectional variation in contribution equity exposure across participants; both equity exposure effects are significant across age groups and gender.”
“While it is not surprising that a target date default leads to more concentrated contributions with less variation across investors, it is not obvious that this should change equity exposure,” the study says. “Before the adoption of a target-date default, investors could have selected any amount of equity exposure. After target-date defaults, investors who selected the default could also have selected additional funds to alter the equity exposure of their overall allocations. The fact that the default altered average equity exposure suggests a strong behavioral effect associated with the design and default designation of target-date funds.”
The study was conducted with a cross-section of 600,000 TIAA participants, who were divided into three groups: 1) participants who joined their current combination of plans—i.e., their employer’s primary plan plus at least one supplementary plan—before any of those plans had a target-date fund default; 2) participants who joined after some, but not all, of their plans had a target-date fund default; and 3) participants who joined after all of their combination of plans had a target-date fund default.
Participants who joined their company plan after a target-date fund was made the default were significantly more apt to invest in the TDF only. As a result, TDF-only participants tend to hold substantially more types of mutual funds. This is because TDFs contain a number of underlying mutual funds, the study reports.
The study concludes by noting that TDFs offer an effective solution for plan sponsors and participants, but they do not account for differences in income, wealth, risk aversion and life expectancy. Additionally, while the higher equity exposure linked to TDF defaults can lead to higher expected returns, it is also associated with greater portfolio volatility.
More information on the TIAA Institute’s study can be found here.