April 30, 2015
TDFs Appeal to the Most Inexperienced
New research finds that the people most likely to benefit from target date funds are also the people inclined to invest their 401(k)s in them – unsophisticated investors.
Retirement and financial literacy researchers long ago established the pitfalls of our nation’s do-it-yourself system of retirement saving (i.e., people don’t save at all or don’t save enough, and investing is too complex for most people). Target date funds (TDFs) have become an increasingly popular solution to the investment piece of the problem in the wake of the Pension Protection Act of 2006, which allowed employers to use them as the default investment option in defined contribution savings plans.
TDFs place a 401(k) participant’s accumulated savings into a broadly diversified portfolio of stocks and bonds that shifts the asset mix as they age. When employees are young and retirement is a distant concept, TDFs invest heavily – as much as 90 percent – in stocks. As employees age, a growing share goes into more conservative bonds.
TDFs are now the primary default investment among employers that automatically enroll new employees into their savings plans. TDFs are a good option not only for inexperienced investors but also for more experienced investors who prefer to delegate the task of portfolio rebalancing to their fund manager. However, employees typically have the option of transferring out of the TDF and selecting other investments offered in their plan.
A study assessed the financial sophistication of 7,500 active contributors to 401(k)s, based on their answers to four standard questions in a financial literacy test. The researchers found that employees lacking financial sophistication – those who scored lowest on the test – were 22 percent more likely to invest some or all of their retirement savings in TDFs than participants who got all four questions right. The study controlled for factors known to influence investment behavior, such as education and wealth.
This study seems to confirm that the TDF default is doing precisely what it was designed to do – improving the asset allocations of inexperienced investors.