Nearly a quarter of all 401(k) participants invest solely in target-date funds—a six-fold increase over the previous five years, according to research of plans managed by financial services firm Vanguard. Adoption among new participants is considerably higher, with 64 percent of employees entering a plan for the first time investing in a single target-date fund (TDF).
Target-Date Funds: The Basics
A target-date fund is an investment that automatically resets the asset mix (stocks, bonds, cash equivalents) in its portfolio according to a predetermined "glide path," becoming more conservative (lowering portfolio risk) as it nears the year in which the participant expects to retire. The indicated year is usually reflected in the investment's name. A TDF for an older worker about to retire (such as a "2015 Fund") would have a lower percentage of stocks in its asset mix and more bonds and cash equivalents, while a TDF for a younger worker (such as a "2060 Fund") would have a higher percentage of stocks and fewer bonds or cash equivalents. Stocks are far more volatile than bonds and can be subject to steep short-term selloffs that can last several years, but provide long-term opportunities for substantial capital growth.
Some TDFs are designed to maintain a higher percentage of assets in stocks through the retirement date, so that the portfolio retains the potential to grow during the participants' retirement years. That's why it's important to compare the glide paths of TDFs offered by different brokerage and mutual fund companies when selecting a TDF series that best meets the needs of a particular employee population.
Vanguard provides recordkeeping and investment services to more than 3.4 million participants in nearly 2,400 plans. According to the firm's Target-Date Fund Adoption in 2011 report:
• 82 percent of 401(k) and other defined contribution plans at Vanguard offered a TDF in 2011.
• 47 percent of participants in Vanguard defined contribution plans had a position in TDFs, with 24 percent of participants invested in a single TDF.
• TDFs accounted for 27 percent of plan contributions.
A major factor influencing the rise of TDFs is the automatic enrollment of participants into their plan and the plan sponsors’ decision to choose TDFs as the default investment option, although about half of participants investing in them make that decision voluntarily.
Avoiding Extreme Allocations
“We view this trend as extremely positive because TDFs are providing an increasing number of participants who are neither engaged nor sophisticated investors with balanced, well-diversified portfolios, as well as reducing the risks associated with extreme equity allocations,” said Jean Young, the study’s author and an analyst in Vanguard’s Center for Retirement Research.
In 2011, 18 percent of Vanguard participants held extreme allocations—10 percent with only equities (stock funds) and 8 percent with no equities. In contrast, when TDFs first became available in Vanguard plans in 2004, 35 percent of participants held extreme allocations—22 percent invested only in equities and 13 percent did not invest in equities.
Target-date investors cannot hold extreme positions because TDFs include equity and fixed income (bond fund) asset classes.
The rapid growth of TDF adoption has led to increasing use overall of professionally managed account options, in which a fund manager or third-party advisor makes portfolio allocation and rebalancing decisions on behalf of participants. The entire account balances of one-third of Vanguard participants were invested in a professionally managed option in 2011—in a single TDF, a single traditional balanced fund or a managed account advisory service.
Continued Growth Foreseen
Vanguard expects continued growth in professionally managed options. “In five years, Vanguard estimates that 55 percent of all participants and 80 percent of new participants will be invested in a professionally managed option,” Young said.
Continued growth in the use of TDFs could impact how plan sponsors design their 401(k) fund menus, leading more to offer, for example, a simplified plan with a TDF tier, an indexed fund tier, a small actively managed, non-TDF tier, and in some cases a brokerage window for participants who want more options (see "Tiers Recommended for 401(k) Investment Menus.")
Plan sponsors should ensure that participants understand that investments in TDFs 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, and the fund will shift its emphasis gradually from aggressive investments to more conservative ones (generally, from equities to fixed income) based on its target date. However, an investment in a TDF is not guaranteed at any time.
Stephen Miller, CEBS, is an online editor/manager for SHRM.
Reduce 401(k) Risk
Best practice is emerging toward a suite of target-date funds as the default with a limited core menu of funds representing other asset class choices and perhaps a brokerage window for the few with a strong desire for more, says benefits attorney James Delaplane.
Target-Date Investors Are More Confident About Retirement Goals, SHRM Online Benefits Discipline, January 2012
Younger 401(k) Participants Prefer Target-Date Funds, SHRM Online Benefits Discipline, February 2012
401(k) Participants Who Use Target-Date Funds Tend to Stick with Them, SHRM Online Benefits Discipline, September 2011
Plan Sponsors Pick and Choose Funds in Target-Date Series, SHRM Online Benefits Discipline, August 2011
Tiers Recommended for 401(k) Investment Menus, SHRM Online Benefits Discipline, October 2010
SHRM Online Benefits Discipline
SHRM Online Retirement Plans Resource Page