Target-Date Funds: A Temporary Solution to a Permanent Problem

Target-Date Funds: A Temporary Solution to a Permanent Problem

David M. Blanchett Unified Trust Company, NA 2353 Alexandria Drive, Suite 100

Lexington, KY 40504 [email protected]

(859) 296-4407 x 222

David M. Blanchett, MBA, CFP®, CLU, AIFA®, QPA, CFA, is the Director of Consulting and

Investment Research for the Retirement Plan Consulting Group at Unified Trust Company in Lexington, KY.

Abstract: The wide spread acceptance of target-date portfolios has improved participant investing.

More participants are deciding to let investment professionals manage their accounts and will likely achieve higher returns and less risk as a result. Unfortunately, date portfolios, in particular target-date funds, are widely misused and are not properly understood by 401(k) participants. Because of this, target-date funds are likely only a temporary solution to the permanent problem of 401(k) participant self-direction. This paper will introduce an “automatic” managed account solution designed to a permanent asset allocation solution for 401(k) participants. Initial evidence suggests professionally managed

portfolios designed in way to maximize participant utilization have advice acceptance rates over 90% and dramatically improve the probability of 401(k) participants being able to retire successfully.

Target-Date Funds: A Temporary Solution to a Permanent Problem Introduction

The age of target-date portfolios is well upon us. Target-date portfolios, especially target-date mutual funds, have exploded in popularity since the introduction of the Pension Protection Act in 2006. Defined contribution plan fiduciaries, whether they are members of the Plan Oversight Committee or are plan consultants, have likely either already addressed the suitability of target-date funds for their plan or are going to in the very near future. According to a Summary of Committee Research Report prepared by the Majority Staff of the Special Committee on Aging (prepared in October 2009), 96% of plans that offer the automatic enrollment feature are currently using target-date funds as the default plan investment.

Target-date investments are a great “theory” to improve participant investing. The notion that participants are poor investors (the permanent problem) has been well established; therefore, moving participants into an investment that is professionally managed holds great potential. Unfortunately, the realization of these benefits in the current target-date mutual fund environment has been questionable. For example, only 19% of participants in defined contribution plans at Vanguard that have target-date mutual funds available are “pure” target-date investors, who invest solely in a specific target-date fund [How America Saves 2010].

The true “target” of any participant level investment policy should be to maximize the likelihood of achieving the goal (retire successfully) with the least amount of risk, something that target-date investments by their very nature are unable to do. While the “one size fits all” approach in target-date investing is an improvement over participant directed investing, target-date investing is by no means the optimal participant asset allocation solution. This paper suggests that another asset allocation solution, professionally managed accounts, offer a better solution to the permanent problem of poor investing decisions commonly made by 401(k) participants when designed correctly. Initial evidence suggests professionally managed portfolios designed in way to maximize participate utilization have adoption rates

over 90% and dramatically improve the probability of 401(k) participants being able to retire successfully.

Introducing QDIAs

The Pension Protection Act (PPA), signed on August 17, 2006 by President Bush, introduced a variety of changes to defined benefit and defined contribution plans. One provision in PPA was the introduction of Qualified Default Investment Alternatives (QDIAs). QDIAs can be used as the default investment for participants who are automatically enrolled in a 401(k) plan but who did not affirmatively elect a particular investment. Before the introduction of PPA there was was no Safe Harbor for the default investment choice and therefore no §404(c) relief for plan sponsors1. This led to the widespread use of very conservative investment options, such as money market or stable value funds, as the default (in the absence of a participant election). While as money market and stable value funds offer capital conservation, they are not necessarily prudent long-term investment solutions for 401(k) participants, and therefore do not qualify as QDIAs for purposes of ERISA §404(c)(5).

PPA introduced three types of QDIAs: risk-based investments, target-date investments, and professionally managed portfolios. Among the three options, target-date investments (also referred to as lifecycle investments) have become the overwhelming favorite. According to a Summary of Committee Research Report prepared by the Majority Staff of the Special Committee on Aging in October 2009, 96% of plans that offer the automatic enrollment feature are using target-date funds as the default investment. In terms of overall adoption, as of 2009, 75% of plans with assets over $200 million were using target-date portfolios, 66% of plans with assets between $5 million and $200 million were using target-date portfolios, and 50% of plans with assets below $5 million were using target-date portfolios [The Burden…].

1

 §404(c) is a defense for an allegation of imprudent investing at the participant level, and in order to compliant a number of conditions must be satisfied, one of which is that the participant had to have affirmatively made the investment election, not the sponsor. 

Vanguard, the second largest retirement plan provider in the U.S. by assets, has seen a dramatic increase in its defined contribution plans offering target-date funds. In 2004 only 13% of its plans had target-date funds while 75% offered them by 2009. Vanguard’s experience with increasingly 401(k) utilization mirrors that of the 401(k) industry, with assets in target-date portfolios exploding as more plan sponsors introduce them to their 401(k) plans. Figure 1 includes information about the growth in total assets in target-date mutual funds in 401(k)s from 1999 to 2009 based on data obtained from the ICI 2010 Factbook.

Figure 1: Growth in Target-Date Mutual Fund Assets in Retirement Plans

Participant Investing: The Permanent Problem

In theory, the widespread usage of target-date funds (or really any professionally managed portfolio) holds great promise. This is because most people, 401(k) participants included, are notoriously bad investors. Studies have consistently documented this, see for example [Kasten 2005] or [Munnell 2006]. These poor decisions are limited not only to fund selection, but to asset allocation decisions as well. $0 $20 $40 $60 $80 $100 $120 $140 $160 $180 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 To ta l Assets in Billio ns Year

From a fund selection perspective, research by Frazzini and Lamont [2008] has noted that mutual fund flows tend to be “dumb money,” where by reallocating across different mutual funds, retail investors tend to experience lower returns and reduce their wealth in the long run (e.g., buying tech mutual funds in 1999). Fund investors tend to purchase funds that have outperformed their peers (chase returns), which subsequently underperform. In a separate analysis, Teo and Woo [2004] also find evidence in support of the dumb money effect.

From an asset allocation perspective, Mottola and Utkus [2007] provide one of the most robust studies about the asset allocation decisions of investors. They review the allocations of approximately 2.9 million participants at Vanguard and found that only 43% of participants had “green” portfolios with balanced exposure to diversified equities. They noted 26% of participants had “yellow” portfolios with possibly too-aggressive or too-conservative equity allocations and that 31% of participants had “red” portfolios with either no equities or too high a concentration to employer stock. The authors also noted that the “cost” associated with these poor asset allocation decisions is significant, reducing expected real returns by anywhere from roughly 60 to 350 basis points per year.

A white paper by Hewitt Associates and Financial Engines titled ”Help in Defined Contribution Plans: Is It Working and for Whom?” noted that the median annual return for investors who received employer-provided help or advice (e.g., use of a managed portfolio solution) was 186 basis points higher (after taking fees into account), on average, than those who did not receive any help from January 1, 2006 to December 31, 2008. While these findings are notable and consistent with past research on the benefits of professionally managed solutions, only 25.3% of the participants eligible to receive the advice in those plans choose to do so. Of the 25.3% who did use advice, 9.8% used Target-Date Funds, 9.7% used Managed Accounts and 5.8% used Online Advice. Therefore, while there clearly is/was a benefit to utilizing advice, most participants don’t actually enjoy the benefits of advice because they don’t use (or follow) the advice.

Educating participants, or really attempting to educate participants, to help them make better investing decisions has also yielded poor results. Most participants are simply not interested in learning about investing and financial markets (no more, for example, than is the author learning about his car operates). When confronted with too many options, 401(k) participants experience something known as “choice overload” and participation tends to decline. A commonly cited study regarding choice overload conducted by Iyengar and Jiang [2007] noted that participation in 401(k) plans dropped 2 percent for every 10 options offered among the plans surveyed.

What does appear to work is simplicity. A study by Citistreet (now part of ING) in 2007 found that the fewer decisions employees need to make, the more likely they are to enroll in a 401(k) plan. The study noted that enrollment rates can be improved significantly by removing the investment decision-making up-front and by defaulting employees into an appropriate fund or portfolio. Once enrolled, a second tier of communication can be used to to help participants, if desired, to choose other investments that are the most appropriate and effective for their savings goals. They key is to make the enrollment process as simple as possible.

Target-Date Funds: The Temporary Solution

The investment strategy of a target-date portfolio is relatively straightforward, as the portfolio approaches its target retirement date the asset allocation becomes more conservative by reducing the equity exposure of the portfolio over time. For example, a target-date portfolio with 40 years until retirement may have an 80% allocation to equities that decreases to 40% as the portfolio approaches its retirement date. The lifetime equity exposure of a target-date portfolio is commonly referred to as its

“glidepath”. Glidepaths can vary significantly across target-date providers. Figure 2 includes the range of equity allocations across target retirement years for target-date mutual funds2.

Figure 2: Equity Allocation Glidepaths Across Target-Date Mutual Funds

Selecting a target-date fund is generally intuitive for 401(k) participants, since participants simply select the portfolio with the target retirement date that most closely matches his or her expected retirement date. Target-date funds also work well as default investment, since all you need to know about a

participant to default them into the appropriate target-date fund is the the participant’s birthdate and an assumed retirement age. The default procedure is generally outlined in the plan’s Investment Policy Statement.

Target-date funds aren’t without their faults, though, as many plan sponsors, participants, and plan consultants have come to realize. Three key problems with target-date portfolios (in particular target-date mutual funds) are that they are a “one size fits all” approach to risk (where all participants have the same equity allocation based on expected retirement date), that they tend to be constructed

2

 Data was obtained from Morningstar as December 31, 2009. For data integrity purposes all funds with equity allocations less than 20% were removed from the test population.  

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 2050 2045 2040 2035 2030 2025 2020 2015 2010 Equity Allocation Target-Retirement Date Source: Morningstar

entirely from investments from the sponsoring mutual fund company, and that they are combined with other plan investments.

Can you imagine walking into a doctor’s office and after providing no other information than your birthday the doctor prescribing you a medication? A single glidepath approach to target-date investing ignores the possibility of investors with varying risk preferences. There is such a thing as a conservative 30 year old and an aggressive 60 year old; yet in a single glidepath environment, everyone with same age has the same equity allocation regardless of risk tolerance.

While it is unlikely each participant will provide detailed information about their risk tolerance and risk capacity, it is possible to determine whether or not a participant is “on track” to retire

successfully using a few data points that should be available from the plan sponsor, such as the participant’s age, savings rate, compensation, and current total plan savings. The true “target” of any participant level investment policy should be to maximize the likelihood of achieving the goal (i.e., retire successfully) with the least amount of risk, something that target-date investments by their very nature are unable to do (since there is only one possible option for each age). Research by Blanchett and Kasten [2010] suggests that dynamically updating a participant’s asset allocation based on his or her funded status leads to not only a higher probability of achieving retirement success, but also less account dispersion at retirement.

Most target-date portfolios, especially target-date mutual funds, are constructed entirely from mutual funds from the sponsoring organization. For example, the Fidelity Freedom 2030 Fund consists of 23 different investments, each of which is a Fidelity mutual fund. Very few 401(k) core menus today feature investments menus from a single provider, so how can it be prudent that plan investments which are expected to receive a lion’s share of the money should be invested entirely with a single company? A study by BrightScope, Inc. found that target date funds have internal fees that are between 10 to 25 percent more expensive than other funds offered on the core menu. Also, conducting due diligence on

traditional equity and fixed income funds can be difficult enough, target-date funds are a nightmare (at least in the opinion of the author).

Finally, target-date mutual fund investors commonly combine the funds with other investments, effectively destroying the intended benefit of the target-date portfolio. A study by Janus noted that 65% of 401(k) participants believe they need combine a target-date fund with other funds in the plan in order to achieve the desired amount of retirement income in retirement. Additionally, 63% of participants believe target-date funds need to be combined with other funds in order to achieve a diversified portfolio [The Burden…]. Participants often fail to realize the diversification benefits of target-date funds, and instead tend perceive them as “black boxes” which they then combine with other investment options in the plan.

Given the before mentioned information, it should not surprise the reader that target-date usage has not been overwhelmingly positive. Vanguard has noted that only 41% of their participants use target-date funds when they are offered. Of those participants that utilize target-target-date funds, 54% of target-target-date investors are mixed investors, combining a target-date fund or funds with other fund options3. Therefore, only 19% of participants who had access to target-date funds at Vanguard are using them correctly [How America Saves 2010], or are “pure” target-date investors. While the number of retirement plans adding target-date funds has increased at Vanguard, asset growth in target-date funds has not nearly followed suit, as noted in Figure 3. It can also be inferred from Figure 3 that only 9% of Vanguard’s total retirement plan assets are currently invested in target-date funds.

3 _{Of the 54% “mixed investors” using target-date funds and core menu investment, only 3% were using}

combinations of only target-date funds, the other 97% are combining target-date funds with other investments in the core menu.

Figure 3: Target-Date Fund Utilization at Vanguard

The Target-Date Experience

Most participants’ experience using a target-date fund has been mixed at best. During the enrollment process, a participant will typically see a list of target-date funds, along with a list of the other core menu investment options, similar to the sample Enrollment Form in Figure 4. Given this layout target-funds appear to be “black boxes”, not as distinct total portfolio solutions. Therefore, it’s not surprising that most participants don’t use them correctly, or at all. While target-date funds should serve as the entire investment solution to participants, they appear to be one of many potential options.

13% 28% 43% 58% 68% 75% 3% 5% 6% 7% 9% 12% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 2004 2005 2006 2007 2008 2009

Percentage of Plans Offering Total Plan Assets of those Offering Source: Vanguard

Figure 4: Sample Enrollment Form with Target-Date Funds

Additional participant confusion about target-date funds stems from how they operate. A study conducted by Janus and Brightwork Partners titled "The Burden of Good Intentions: Opportunities and Challenges for Target-Date Funds" (available through Janus’s website) concluded that many participants do not sufficiently understand target-date funds or how to use them and that investor education about target-date funds has been inadequate and ineffective. The study notes that despite target-date fund holders’ general understanding of the target-date concept, they are prone to misuse and often harbor misperceptions about the specific objectives and attributes of the target-date portfolios.

Plan sponsors appear to be as equally unsure when it comes to selecting target-date funds. The preamble to the QDIA regulation says “a fiduciary must engage in an objective, thorough, and analytical process that involves consideration of the quality of competing providers and (QDIA) investment

products, as appropriate”. Despite this guidance, the most important overall consideration when selecting a QDIA by sponsors was best overall performance, not more relevant attributes like the equity glidepath or fees [The Burden…]. Plan sponsors are also not applying the same level of due diligence on

target-date funds or holding them to the same standards as other funds in their investment menu, despite the fact they are significantly more complex from a selection and monitoring perspective.

Plan sponsors are becoming increasingly weary of target-date funds, likely due to poor participant utilization and the additional difficulties associated with selection and monitoring. A study by Janus and PLANSPONSOR noted a significant decrease in the percent of plans that believe target-date funds are the best QDIA for their participant, with balanced and target-risk funds gaining attention. In 2009 56% of plan sponsors believed target-date portfolio options were the best QDIA option for their plan, but in 2010 only 34% did. Only 51.7% of plan sponsors believe participants are using target-date funds correctly, and over one-third of plans are unsure if their recordkeeper is offering the most appropriate target-date funds available [Trends in Target-Date Funds].

The target-date mutual fund industry came under increasing scrutiny given the performance of target-date funds during the recent recession, especially during 2008. In 2008, the average mutual fund with a 2010 target retirement date was down approximately -24%. The Oppenheimer Transition 2010 fund was down -41% alone, an incredible drop given participants in the fund would be expected to retire in two years. While the poor performance of target-date funds can likely be attributed to a number of different factors, the internal competition to generate the highest return in the peer group (i.e.,

Morningstar Category) led to increasing equity allocations which played a significant role in the poor performance.

In response these events the Department of Labor has proposed new rules to enhance target-date retirement fund disclosures about the design and operation of target date or similar investments, including an explanation of the investment's asset allocation, how that allocation will change over time, with a graphic illustration, and the significance of the investment's "target" date. While these updates should provide participants more information about target-date funds, it is unlikely these updates will

The Permanent Solution… Is Automatic

So why aren’t target-date portfolios working? The fundamental theory is actually quite sound: automatically enroll participants in a professionally managed portfolio. Automatic enrollment works because people, 401(k) participants included, are prone to inertia. The proper definition of inertia is “the resistance of any physical object to a change in its state of motion or rest.” Or, more simply, people tend to be lazy with matters they do not necessarily understand and too often just “go with the flow”. If the default (or easy) investment choice is a target-date portfolio, more participants are likely to use it than if they have to actively select it. Target-date usage will also increase when participants believe the plan sponsor (potentially in contention with the plan consultant) has vetted the default option through implicit endorsement.

A key problem with the current enrollment process, though, is that most people don’t “automatically” enroll in their 401(k) plan, they actively participate in the enrollment process. They receive enrollment packets, forms, and other information that demands their time and involvement when it comes to determining allocations or selecting funds. Instead of asking participants how they would like to allocate the monies, a better approach would be to get information about each participant’s funded status status (i.e., risk capacity) and their risk tolerance. This information can then be used to determine how to invest the participant monies.

Granted, most participants won’t provide much information (if any at all), but by enabling the participant to provide the 401(k) provider with additional information, it can ensure the asset allocation assigned to that participant is far more meaningful than a single glidepath. There will be some

participants who will always want to “opt out” of any managed account platform and direct the

investments themselves. Given the evolution of the 401(k), taking away the ability to self-direct would likely be poorly received among participants, even though it is well within the right of the plan sponsor to do so.

Given the attributes and behaviors of 401(k) participants, especially as it relates to evidence regarding the usage of target-date funds, the author contends there is a better approach to getting

participants in a professionally managed portfolio. The ideal strategy maximizes not only professionally managed portfolio adoption by participants, but also ensures the portfolio is suitable for each participant’s situation. This strategy would contain the following features:

1. Enrollment in the managed account solution is automatic. No checking a box, just fill in your basic personal identification and beneficiary information (at a minimum) and you’re done.

2. The portfolio assigned to the participant uses basic information available to the 401(k) provider, such as age, compensation, savings rates, and total savings to make general asset allocation decisions based on the funded status of the participant, but additional information can also be provided by the participant. This would allow participants the chance to be engaged in the portfolio selection process by providing data about their unique situation, and ensures the portfolio matches both their risk tolerance and risk capacity.

3. The optimal portfolio dynamically updates through time based on the funded status of the participant. This prevents the initial allocation from becoming “stale”.

4. The portfolio is built from the core menu funds and is presented as such. This would remove the “black box” nature of target-date mutual funds.

5. The solution is offered at no additional cost to the employee. Currently managed account platforms can cost anywhere between 10 bps and 75 bps. Additional cost is an obvious barrier to participant adoption. A lower fee assessed at the plan level also removes any prohibited transaction concerns with respect to using advice options as the default.

6. The solution needs to be an all-or-none. Either you’re in or you’re out. Some participants will always want to self-direct their accounts, and given the history of the 401(k) it is unlikely

self-direction will disappear anytime soon. Multiple advice options could be offered, though (e.g., a variety of target-date portfolios with varying risk tolerances along with risk-based portfolios).

Empirical evidence suggests introducing a managed account platform as the default investment option, based on the above attributes can significantly improve retirement readiness for 401(k) participants. According to a white paper by Kasten [2010], utilizing a similar managed account solution led to advice acceptance of over 90%. Combining the automatic portfolio solution with other automatic features such as automatic enrollment and progressive savings can lead to a 50% increase in the percentage of participants on track to retire successfully (which is defined as replacing 70% of compensation during retirement including social security).

Conclusion

The wide spread acceptance of target-date portfolios has improved participant investing. More participants are deciding to let investment professionals manage their accounts and these participants will likely achieve higher returns and experience less risk as a result. Unfortunately, target-date portfolios, in particular target-date funds, are widely misused and are not properly understood by 401(k) participants. Because of this, target-date funds are likely only a temporary solution to the permanent problem of 401(k) participant self-direction.

The true “target” of any participant level investment policy should be to maximize the likelihood of achieving the goal (i.e., retire successfully) with the least amount of risk, something that target-date investments by their very nature are unable to do. This paper introduced an “automatic” managed account solution designed to a permanent asset allocation solution for 401(k) participants. Initial evidence suggests professionally managed portfolios designed in way to maximize participate utilization have advice acceptance rates over 90% and dramatically improve the probability of 401(k) participants being able to retire successfully.

References

Blanchett, David M. and Gregory W. Kasten. 2011. “Improving the “Target” in Target-Date Investing.” Journal of Pension Benefits, vol., 18, no. 2 (Winter): 11-18.

Brightscope Study. http://aging.senate.gov/events/hr217cr.pdf

Citistreet Study. 2007. http://benefitslink.com/pr/detail.php?id=40628

Frazzini, Andrea and Owen Lamont. 2008. “Dumb Money: Mutual Fund Flows and the Cross Section of Stock Returns.” Journal of Financial Economics, vol. 88, no. 2 (May): 299-322.

Help in Defined Contribution Plans: Is It Working and for Whom? 2010. http://corp.financialengines.com/employer/DCHelpReport_Jan2010.pdf How America Saves 2010.

https://institutional.vanguard.com/VGApp/iip/site/institutional/marketing/HowAmericaSaves ICI Factbook 2010. www.ici.org/pdf/2010_factbook.pdf

Iyengar, Sheena and Wei Jiang. 2007. How Much Choice is Too Much?: Contributions to 401(k) Retirement Plans: http://www.archetype

advisors.com/Images/Archetype/Participation/how%20much%20is%20too%20much.pdf

Kasten, Greg K. 2005. “Self-Directed Brokerage Accounts Tend to Reduce Retirement Success and May Not Decrease Plan Sponsor Liability.” Journal of Pension Benefits, vol. 12, no. 2 (Winter): 43-49. Kasten, Greg. 2010. Increasing Retirement Success with the UnifiedPlan.

https://www.unifiedtrust.com/documents/UnifiedPlanIncreasesRetirementSuccess.pdf

Mottola, Gary R. and Stephen P. Utkus. 2007. “Red, Yellow, and Green: A Taxonomy of 401(k) Portfolio Choices.” Working Paper: http://www.reish.com/publications/pdf/redyellowgreen.pdf

Munnell, Alicia H., Mauricio Soto, Jerilyn Libby, and John Prinzivalli. 2006. “Investment Returns: Defined Benefit vs. 401(K) Plans.” Center for Retirement Research, no. 52:

http://www.bc.edu/centers/crr/issues/ib_52.pdf

Summary of Committee Research Report prepared by the Majority Staff of the Special Committee on Aging. October 2009. http://aging.senate.gov/events/hr217cr.pdf

Teo, Melvyn and Sung-Jun Woo. 2004. “Style Effects in the Cross-Section of Stock Returns” Journal of Financial Economics, vol. 7: 367-398.

The Burden of Good Intentions: Opportunities and Challenges for Target-Date Funds. 2009. Janus White Paper: https://ww3.janus.com/advisor/research-white-papers/white-papers

Trends in Target-Date Funds. 2010. Janus White Paper. https://ww3.janus.com/advisor/research-white-papers/white-papers