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How Target Date Defaults Affect Equity Allocation Exposure

Target Date Funds

The economic consequence of different defaults in defined contribution plans is significant, according to a new report by the TIAA Institute.

In “The effect of default target date funds on retirement savings allocations,” TIAA finds that participants who joined plans post target date defaults tend to have a greater percentage allocation to equity. And because so many allocate to the same type of fund, there is less cross-sectional variation in equity percentage for this group, according to the report. By contrast, those who joined under a money market default tended to customize their portfolios and there is a substantial cross-sectional variation in the equity percentage of their allocations.

Using data from more than 600,000 TIAA participants working at one of 98 large employers, TIAA examined how these changes affect participant contribution decisions, including the number of funds chosen and individual equity exposure.

Prior to the adoption of TD defaults, money market defaults were common for participants in TIAA’s samples. By 2012, participants who had joined a plan with a money market default mostly invested in funds other than the default investment and had widely varying equity exposures in their contributions.

Number of Funds

The report notes that a TD default is associated with a dramatic shift in the number of funds chosen by participants. Participants who joined before any of their plans had TD defaults had median holdings of three funds, with 19% allocating to more than five funds.

In contrast, for participants who joined after all their plans had TD defaults, 68% invested in one fund, with only 10% investing in more than five funds. And with more than two-thirds of new participants contributing only to a single fund, they therefore allocate contributions in accordance with the equity percentage of that fund, TIAA observes.   

As such, relative to using a money market default, participants using the default TDF would increase their equity exposure because the investment fund was composed of an underlying mix of equity and bond funds, with the portfolio weights dictated by the particular TDF.

TIAA’s report further observes that there are noteworthy gender effects, with women contributing significantly more to equity after TD defaults than before and male-female disparities in equity percentage vanishing after TD defaults.

TIAA emphasizes that the widespread acceptance of the default does not occur for participants who joined their plan before the adoption of TD defaults, when a money market fund was the typical default. More than 75% of these participants allocated nothing to the money market fund. The rest have customized their allocations, suggesting that these participants viewed investing solely in the money market default as suboptimal for their portfolio allocation, the report observes.

The availability of TDFs within a plan also seems less important than whether these funds are the default investment, the report observes. This is evident in the relatively limited use of TDFs in 2012 by participants who joined plans before they were a default, TIAA notes.

The report further suggests that the “welfare effects” of TDFs are unclear. TIAA explains that, while TDFs offer a simple solution, they typically only use a single factor – age – in setting the equity allocation. “They do not account for differences in income, wealth, risk aversion, and life expectancy. In particular, the higher equity exposure associated with target date fund defaults leads to higher expected returns, but also to greater portfolio volatility,” the report warns.

Vanguard’s Year-End 2018 Assessment

By comparison, How America Saves, Vanguard’s annual bellwether report on corporate retirement plans, finds that 9 out of 10 plan sponsors offered TDFs at year-end 2018 and 77% of all participants use TDFs, while two-thirds of participants owning TDFs have their entire account invested in a single TDF.

For Vanguard participants, 52% at year-end 2018 were invested in a single target-date fund, either by voluntary choice or by default, while 3% held one other balanced fund and 4% used a managed account program.

The firm anticipates that by 2023, 8 in 10 participants in plans managed by the firm will be solely invested in an automatic investment program. At year-end 2018, 6 in 10 Vanguard participants were solely invested in an automatic investment program, but that compares to just 1 in 10 at the end of 2004 and just 2 in 10 at the end of 2007. Among new plan entrants, nearly 9 out of 10 were invested solely in a professional managed allocation.

Vanguard emphasizes that these “diversified, professionally managed investment portfolios dramatically improve portfolio diversification compared to participants making choices on their own.” The firm notes that voluntary choice is still important, however, with nearly half of single target-date investors choosing the funds on their own, not through default. 

The report further suggests that extreme allocations have fallen as a result of the rise of TDFs and other professionally managed allocations. It shows that only 1 in 10 participants have taken an extreme position, holding either 100% in equities (6% of participants) or no equities (3% of participants).