TDFs in 401(k) plans gaining in popularity

Target-date funds have become popular additions to 401(k) retirement plans because they offer convenience, portfolio choices based on a participant’s retirement age and a commitment device for future age-based equity balancing. The funds have made it easier for employees, who do not have the financial literacy to make their own portfolio decisions, to have access to a professionally managed retirement account, according to a new report by the Pension Research Council.

The report evaluates how the introduction of target-date funds influences patterns of both adoption and portfolio construction within 401(k) plans.

Employers have added target-date funds to default arrangements, including automatic enrollment, reenrollment and fund mapping frameworks. In these arrangements, participant contributions are directly invested in a fund designated by the employer. Many participants are choosing TDFs on their own because they don’t have to make decisions about their investments.

The PRC report found that demand is high for target-date funds among workers. New plan entrants adopted these funds voluntarily at an average rate of 31 percent from 2003 through 2010. Existing employees’ take-up rate was roughly half that level.

Demand was particularly strong among workers early in the lifecycle. Participants electing target-date funds on their own, rather than being defaulted or mapped into them, were equally likely to be pure target-date versus mixed target-date fund investors. In other words, preferences for the features of target-date funds among those making voluntary decisions were not simply a binary, all-or-nothing choice. Demand for such funds was also quite resilient to equity market conditions, since active adoption of target-date funds increased somewhat during the recent financial crisis.

As expected from prior research, automatic enrollment of new hires did raise target-date adoption: they were 81 percent more likely to elect these funds, compared to an “unguided” outcome. When employers reenrolled participants from a prior default to new target-date default funds, adoption rates also rose by a similar amount, up 71 percent among new entrants. When employers eliminated a fund from the menu and “mapped” participants into target-date funds, target-date adoption rose by 166 percent among new entrants, and more than doubled among existing employees.

The report’s authors concluded that “responsibility for portfolio decisions is gradually shifting away from workers to employers through the growth of target-date funds in 401(k) plans. In default arrangements, this effect is direct: account contributions are invested in target-date funds at the explicit direction of the employer. When participants actively choose the funds, this effect is indirect: many participants adopt quite different allocations in response to the introduction of the target-date equity glide paths into the plan menu. Regardless of the decision-making mechanism, many retirement plan investors appear to have malleable or ambiguous preferences for portfolio choice, because of lack of financial knowledge and experience, behavioral biases, or other reasons.”

The report concluded that, “Households seem particularly willing to rely on default or simplified advice arrangements when facing complex and consequential financial choices. Inertia, too, is a dominant heuristic, not only in saving behavior but in portfolio allocation decisions. Policy prescriptions in such instances might include not only default arrangements, but also programs or services that offer simplifying choices and/or embedded advice. An important question for future research is whether such design principles can also inform household decisions of consequence in other domains, including the choice of health insurance plans, taxable saving and investments, mortgage instruments, and insurance.”

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