Behind the growing popularity of target-date funds

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Target-date funds have become a standard retirement vehicle offered by a majority of plan sponsors. Roughly seven in 10 plans offer a suite of TDFs, according to research conducted by BrightScope and the Investment Company Institute, which analyzed more than 35,000 defined contribution plans — mostly 401(k)s — that have between four and 100 investment options.

“There’s been a big upturn in both the availability and usage of target-date funds,” says Holly Verdeyen, Russell Investments’ director of defined contribution investments. There are five reasons for popularity among TDFs, she says. Those include:

1) Auto features. “There’s an increased adoption of automatic enrollment by plan sponsors and the vast majority of plan sponsors are selecting target-date funds as the default option,” Verdeyen says.

2) Improved DC plan design. “More plan sponsors are designing their plans with a tiered investment menu that highlights target-date funds as the first tier or menu option,” she says.

3) More participants are self-selecting TDFs. That’s because TDFs “offer meaningful benefits over other options,” Verdeyen says, adding that they are “a cost-effective, professionally managed, age-appropriate, and highly diversified asset allocation that is easy for them to use and that automatically adjusts their asset allocation over time as they get closer to retirement.”

4) Improved DC plan communications. “DC plan communications are effectively highlighting target-date funds as the proper choice for participants who desire a professionally managed asset allocation,” she says.

5) Participant inertia. “Participants auto-enrolled into the target-date funds are very unlikely to move out, so cash flows into target-date funds continue to accumulate,” Verdeyen says.

TDFs are attractive for several reasons — one of the top features includes the asset allocation. “The target-date fund’s ability to provide an appropriate asset allocation — based on the projected retirement date of the participant and designed to meet a participant’s retirement income goals — was one of the most important innovations in the DC industry in the past 20 years,” Verdeyen says. “Other attractive features of target-date funds include their ease of use for participants, cost-effectiveness, professional management and inherent diversification. Target-date funds also offer the plan sponsor the fiduciary protections granted in the Pension Protection Act.”

Furthermore, TDFs satisfy the needs for most participants, says Russ Shipman, senior vice president and managing director of retirement strategy at Janus Capital Group. But, TDFs don’t take individual factors into account.

“Target-date funds are built for the average participant, and no one participant is average,” Verdeyen says. “Differences in participants’ savings and market experiences can lead to different outcomes, and target-date funds are not able to account for these individual factors.

“Target-date funds are built for the average participant, and no one participant is average."

“Also, target-date funds automatically adjust their asset allocation based on only one variable — age,” Verdeyen adds. “Two participants of the same age may be on very different tracks to meeting their retirement income objectives, but target-date funds will treat them both identically.”

That’s why customization is the next step for TDFs. “The future of target-date investing is individualized glide paths for each participant, which incorporate factors beyond age and are periodically rebalanced, all without any direct participant involvement,” Verdeyen says.

TDFs must continue to evolve, says Shipman, in particular first and second-generation funds, which are outdated, and need to reinvent themselves.

Increased adoption of TDFs is unlikely, he says. “We’re at a point of saturation.” However, customization will continue, and TDFs need to provide a thoughtful way of engaging participants to meet the high and ever-changing demand of participants, he says.

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