Target-Date Funds: The Default That Is Becoming the First Choice

About a year before the Great Recession, prompted by a large amount of pension defaults, the Pension Protection Act of 2006 was signed into law. Essentially it requires any company with a defined benefit (DB) plan that is underfunded to pay higher premiums to the Pension Benefit Guaranty Corporation (PBGC) and become fully funded over a set amount of time. Measurements and benchmarks were created to help identify “at risk” plans and help them regain funded status and stability.

The Act has also changed investment options for defined contribution (DC) plans and other private investment vehicles. For example, the Act gives investors the ability to rollover pre-tax or after-tax investments from one type of plan to another. Also, exemptions were added to allow companies offering a DC plan to their employees to provide investment advice to participants. Employers can now set up automatic enrollment for participants with an opt-out provision. This helps investors “help themselves” by putting them into a plan without prodding them to do so.

With employers automatically enrolling employees into DC plans, and with employees generally paying little attention to their investments, many plans (and the fund industry along with them) looked at ways to help plan participants reach their retirement goals and milestones. Rather than placing unaccounted for pension money into bond funds or funds with little future yield potential, DC plan administrators looked towards target-date funds (TDFs) as a best-case scenario.

TDFs adjust asset allocations over time. For example, a younger investor would select a TDF that puts an emphasis on an equity bias, and as they reach retirement age the fund rebalances and is invested in less risky investments in order to preserve capital. The rebalancing is continuous over the life span of the fund and the worker invested in it. These types of funds grew in popularity as default funds since they allow the participant to benefit from the market while at the same time “forgetting” about asset allocations and balancing the fund as their age warranted.

Such funds also became part of a volatility management strategy whereby plan sponsors were looking to de-risk their portfolios (or give plan sponsors the ability to do so) and increase exposure to low-risk or liability hedging-type investments. Diversification was also part of the equation that would supposedly help soften the blow of a volatile equity market.

There are, of course, differences amongst TDFs. Some are slower to rebalance while others act quickly, each kind affecting the risk profile for the investor. The financial crisis exposed some of the risks of these ever-popular default funds. Some TDFs, with a 2010 target date for example, might have lost upwards of 30% to 40% of their value due to overexposure to equities. Also, many fund families use funds from their own lineups, treating investors the same no matter what their risk tolerances may be.

Still, the industry and growth of products shows no signs of letting up, especially given how volatile the markets have been since the Great Recession. BrightScope, a research firm that ranks 401(k) plans, says that more than $1.1 trillion is invested in TDFs, and they predict $2 trillion will be invested in them by 2020.

With the endorsement of the U.S. government vis-a-vis the Pension Protection Act of 2006, and with more DC plans replacing DB plans to save costs, TDFs continue to grow in assets and numbers to satisfy the needs of plan sponsors looking to provide better-than-average or no-yield, fixed-income funds.

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