TDFs: Prevalent in plans, possibly game-changing

 
Vanguard | 04/27/2012

 Jean Young

There’s no question that target-date funds (TDFs) have become an increasingly popular option in defined contribution (DC) plans. In Vanguard-recordkept plans, since 2004 when only 13% of DC plans offered TDFs, the growth has been remarkable—reaching 82% of plans last year.

But the growing prevalence of TDFs—along with other types of professionally managed allocations, such as managed accounts and target-risk funds—is only part of the story. The professionally managed allocation approaches, driven in large part by TDFs, are “actually reshaping the investment landscape for participants,” said Jean Young, a senior research analyst at Vanguard Center for Retirement Research.

“It’s changed the investment decision for participants because of the portfolio construction that TDFs and similar options offer,” Ms. Young said. “With professionally managed allocations, you’re replacing the complex task of portfolio construction and replacing it with a simplified choice.” 

That’s not only appealing to participants, but it also resolves the huge challenge plan sponsors and providers have faced in trying to educate participants. “We have terrific participant educational programs,” she said. “But it’s unrealistic to think that, no matter how much education we deliver, every plan participant is going to have sufficient skills to construct their own portfolios.”

Note: Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a target-date fund is not guaranteed at any time, including on or after the target date.

Participant portfolios shifting—toward more balance

DC participants face two difficult decisions: how much to save and how to invest. “The savings decision is hard enough,” Ms. Young said. “At least there are general rules of thumb—save your raise, maximize your company match. One recommendation we have is to save between 9+% and 15+%, depending on income and including any company contributions. But the rules around how to invest are tougher.

“TDFs, especially positioned in a voluntary enrollment plan as an option that someone will manage for you, simplify investing,” she said. “We’re finding that these managed allocations seem to be constructing better portfolios for participants than they are likely to do on their own.”

TDFs and other managed allocations could indeed be having a positive impact on participant portfolios. The table below—with data from 2003, which was gathered shortly before TDFs began to proliferate throughout the industry, to 2011—shows a marked increase in the percentage of Vanguard plan participants using  balanced strategies by last year. The amount nearly doubled, with 35% of participants holding balanced strategies in 2003, and 61% of participants with balanced portfolios in 2011. The phenomenon had a converse effect on those holding concentrated amounts of company stock, widely viewed as very risky and nondiversified. In 2003, 20% of participants had concentrated company stock positions. By 2011, that figure dropped to 9%.

QDIA not the only driver

While the foothold that TDFs has gained in retirement plans seems indisputable, the cause of this growth may be misinterpreted. Most attribute the popularity of TDFs to the increased use of automatic enrollment plan design as sponsors seek an autoenrollment default investment, and also to the fact that TDFs are eligible as qualified default investment alternatives (QDIAs) under the Pension Protection Act of 2006. But Ms. Young said that this rationale doesn’t account for the many participants voluntarily choosing TDFs.

“Everyone says it’s because of QDIAs and autoenrollment. And, yes, that is helping to drive the growth,” she said. “On the other hand, there are many, many participants choosing TDFs on their own.”

Only 29% of Vanguard-recordkept plans have autoenrollment, she said. Most of those plans (more than 80%) implement the automatic system for new hires only, rather than try to “sweep in” current employees. “So a big majority of the default investors are going into TDFs,” Ms. Young said. “But if you look at the overall picture of who is investing in TDFs, you see an about equal proportion of voluntary enrollment and automatic enrollment investors.” (See graphic below.) 

Where do TDFs go from here?

The rising growth of TDFs and other professionally managed allocations is likely to continue.  In a recent Vanguard Center for Retirement Research paper, Target-date fund adoption in 2011, Ms. Young wrote:  “Because of the growing use of target-date options, we anticipate that 55% of all participants and 80% of new plan entrants will be invested in a professionally managed option by 2016.”

TDFs and similar options can help resolve many challenges, Ms. Young noted. “One of the big criticisms lodged against DC plans is that you transfer the investment responsibility to the participant, and therefore you lose the professional investment management you have in DB (defined benefit) plans,” she said. “But the industry has responded with solutions that enable participants to easily access professional investment management through these professionally managed allocations.”

Note:

  • All investments, including a portfolio’s current and future holdings, are subject to risk.

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“Vanguard Research and Commentary”
“Vanguard Retirement Insights”