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Target Date Funds: Democratizing DC plan asset allocation

Target Date Funds: Democratizing DC plan asset allocation

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In the most recent update to their quarterly installment of “Building Financial Futures,” Fidelity stated that 98% of employers are offering target date funds to their Defined Contribution (DC) plan participants and 92% use them as the default investment option. With 69% of millennials 100% invested in a target date fund, it’s not hard to see why they are now the dominant investment election for all future contributions, and on their way to becoming the single largest asset class in all DC plans.

Since their propagation promoted by the 2006 Pension Protection Act (PPA), target date funds have brought a thoughtful asset allocation approach to millions of DC plan participants, better enabling them to focus more on how much they should save for retirement and less on the investment of that savings.

In fact, these funds have been hugely successful in moving millions of investors to an asset allocation that will give them a better shot at achieving a steady retirement income. They “unencumber” DC plan participants from emotional reactions that can damage their savings in the long run. And recent history proves they have been enormously successful: After the huge market sell-off about a year ago at this time, DC plan participants in target date funds stayed the course.

Benefits to plan sponsors

For plan sponsors, including target date funds in plan menus with investment decisions delegated to managers, has helped to raise equity shares, boost bond exposures, curtail cash/company stock holdings, and better align participant investment risk. In fact, adopting lower cost, institutionally priced target date funds may have enhanced future retirement wealth by as much as 50% over a 30-year horizon.

More recently, the SECURE Act in December 2019 eases liabilities that plan sponsors could face when offering annuities to participants, and opens the door for annuities within target date “glidepaths” (the course that guides a participant’s asset allocation from their early working years to, and often through, retirement).

What has fueled this success?

The first target date funds were designed in response to one of the most persistent problems plaguing DC plan sponsors—that the investment decisions now in the hands of participants were tougher to make than their average skills were up to. The consultants, recordkeepers and investment managers that arose to service those plan sponsors acknowledged that education efforts were unlikely to turn the rapidly-growing participant population into expert investors. To make the process more straightforward, participants were categorized along a spectrum of “do-it-for-me” to “do‐it‐myself” savers. Target date funds were specifically designed for the former, those who preferred someone do it for them.

In 1994, Wells Fargo and Barclays Global Investors (NKA BlackRock®), working together at the time, rolled out the first target date funds. Their strategy was to move the participant investor safely to a targeted retirement date and at that point fold the dated fund into a static “income” or “retirement” fund, where the fund reached its terminal asset allocation.

Over the next decade, Fidelity, T. Rowe Price, and Vanguard created proprietary target date products and began promoting them more heavily through their proprietary recordkeeping platforms, with the endorsement of retirement plan consultants. After the passage of the 2006 Pension Protection Act (PPA), the number of managers steadily grew to the more than 40 strategies available in the market today, with a group of five to seven managers as the dominant gatherers in the asset class. The dollars flowing into target date funds simultaneously swelled as the ranks of former do‐it‐myself investors, overwhelmed by the number of options available for selection, poured their account balances into these funds. As a result, target date funds in corporate retirement plans have grown from $5B in 2000 to $2.8T in 2020, further powered by their offering within collective investment trusts for the exclusive investment by ERISA qualified plans (https://www.morningstar.com/lp/tdf-landscape).

Bewildered and unprepared

A variety of studies have been conducted on the value of an appropriately diversified portfolio, starting with the seminal 1986 study, Determinants of Portfolio Performance, published by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower. While subject to subsequent vigorous debate, and sometime misquotation of the study’s application, there is little doubt that a chief determinant of investment outcomes is asset allocation. High-net-worth investors have long had access to financial advisors to help them implement appropriate allocations among stocks, bonds, and cash. However, DC plans allowing participants to self-select from a host of variations in those asset classes created a whole new population of investors completely unprepared to implement an allocation based on retirement time horizon and risk.

Into the perfect storm of the ascendancy of DC plans and burgeoning investment menus came a group of funds that offered one choice that aligned a participant’s asset allocation with their retirement time horizon, implemented on a professionally managed basis.

Professionally managed asset allocation for “the people”

Millions of DC plan participants now have access to an investment option that, at its base, allows them to have the benefit of a skillfully managed asset allocation with the same starting point as many individuals with investible assets far exceeding the average 401(k) participant’s portfolio.

This widespread adoption and endorsement by the institutional retirement community has democratized access for legions of novice DC plan investors, liberating them from the focus on how to invest their retirement nest egg, and instead build a nest egg on which they could retire.

Sources: 2021 Target-Date Fund Landscape, Morningstar®; 4th Quarter 2020, Building Financial Futures, Fidelity Investments®; Target Date Funds and Portfolio Choice in 401(k) Plans, Wharton Pension Research Council; How America Saves 2020, Vanguard; 2019 Defined Contribution Benchmarking Survey Report, Deloitte.

This article is for informational purposes only and is not a recommendation for any specific investment product, strategy, plan feature or other purposes. The opinions and information contained herein should not be construed as Legal or Tax advice.

All information that is obtained from external sources cannot be guaranteed but is provided by those who have been proven to be credible, reliable, and recognizable.