Target-Date Funds Gain Larger Share of 401(k) Dollars

By Stephen Miller, CEBS Jun 18, 2013

Use of target-date funds in 401(k) and other defined contribution plans continues to grow. At the end of 2012, 84 percent of retirement plans that Vanguard managed offered target-date funds as an investment option, up 45 percent since 2007. Moreover, more than half of all participants (51 percent) put at least some of their 401(k) savings into these funds, and more than a quarter of all Vanguard participants (27 percent) were wholly invested in a single target-date fund, either voluntarily or by default.

Vanguard, which provides services to 3.6 million investors in more than 3,200 defined contribution plans, estimates, in its How America Saves 2013 report on U.S. retirement-planning trends, that 55 percent of all participants will be entirely invested in target-date funds or another professionally managed investment option by 2017.

In target-date funds, the year in the fund name refers to the approximate year (the target date) when an investor in the fund will retire from the workforce. Based on the target date, the fund will gradually shift its holdings from more aggressive stock (equity) investments to more conservative cash and fixed-income (bond) investments.

An important factor driving the use of target-date funds is their role as an automatic or default investment strategy. The qualified default investment alternative (QDIA) regulations put into effect under the 2006 Pension Protection Act continue to influence the adoption of these funds, although many target-date-fund investors choose the funds on their own, said Jean Young, the study's author and a senior research analyst at the Vanguard Center for Retirement Research, in an online video.

"Participants need to get two things right,” she said: “They need to save enough, and they need to construct good portfolios."

Constructing Balanced Portfolios

"One criticism of defined contribution plans is that many individuals don't have the skills needed to manage their retirement plan assets," Young noted. "And many participants do appear to make portfolio-construction errors, holding either too little or too much in equities. But the rising use of professionally managed allocations is reshaping this picture. In 2004 only 37 percent of participants had balanced investment strategies, holding portfolios with equity allocations in the 40 to 90 percent range. Now, 63 percent of Vanguard participants hold balanced strategies. And we expect that this picture will continue to improve as more participants adopt professionally managed allocations in the future."

Continued growth in the use of target-date funds could impact how plan sponsors design their 401(k) fund investment menus, leading more to offer, for example, a simplified plan with a target-date fund tier as the automatic enrollment default, plus an index fund tier, a small actively managed fund tier, and in some cases a brokerage window for participants who want more options (see the SHRM Online article "Tiers Recommended for 401(k) Investment Menus.")

Improving Savings Rates

"Going forward, we need to reach for high contribution rates for more individuals," Young said, adding that automatic annual escalation of participants’ salary deferral rates, with the opportunity to opt out, is becoming more common to ensure that most people set aside enough for a secure retirement. For instance, Vanguard found that:

  • 32 percent of plans had adopted automatic enrollment, up 3 percentage points from 2011. More than half of all contributing participants in 2012 were in plans with automatic enrollment. And 97 percent of automatic enrollment plans put their participants into a balanced investment strategy by default, with nine in 10 choosing a target-date fund as the default.

  • Seven in 10 auto enrollment plans also had implemented automatic annual deferral-rate increases.

However, one-third of participants contributed less than 4 percent themselves, according to the report, and the average participant deferral rate was 7 percent in 2012, down slightly from the peak of 7.3 percent in 2007. "The decline is largely due to the default contribution rates set by many automatic enrollment plans," said Young. "Although automatic enrollment raises plan participation rates and thus helps to ensure that more people overall save for retirement, the default rates are often set too low—3 percent or less—and thus pull down the overall average savings rate."

Retirement specialists recommend an annual savings rate of 12 percent to15 percent, depending on income level, Yound said. “While we are seeing good news overall in the retirement planning habits of participants, many Americans are still not saving enough for the future. Simply put, people need to save more—and save more now.”

Stephen Miller, CEBS, is an online editor/manager for SHRM.

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