Participants holding target-date funds in their 401(k) plans now have more reason to cling to the funds even as the market plummeted into bear territory.
A recent paper from the University of Pennsylvania's Wharton School and the Vanguard Group Inc. suggests that investors who remain faithful to their target-date funds — and stick with them exclusively over the long term — could reap sharply greater returns than those who don't.
The academic paper, which was released in January, studied target-date funds that were introduced into 401(k) plans from January 2003 to June 2015, and found that 12 months after the funds first appeared in a plan, target-date investors earned annualized returns as much as 2.3% higher than non-target-date investors. The findings covered periods of strong market growth as well as the 2007-08 market downturn.
Over 30 years, the improved returns could translate into 50% more retirement wealth for participants who invest solely in target-date funds than those who invest in other funds offered in their plans, according to the researchers' calculations. Even semi-faithful or "mixed TDF investors" investing in both target date and other funds have much to gain, conceivably realizing up to 30% greater returns, the researchers found.
"That's a big number," said Olivia Mitchell, the paper's co-author and a professor of business economics and public policy and executive director of the Pension Research Council at the University of Pennsylvania's Wharton School in Philadelphia. "I think it's a testament to the power of putting your money in low-cost funds and having a professional manage it for you."
The paper analyzed target-date funds in 880 defined contribution retirement plans covering 1.2 million participants. The target-date funds studied were almost exclusively low-cost Vanguard Group indexed portfolios, diversified across global equity and fixed income with management fees less than 20 basis points. Ms. Mitchell and her co-author — Stephen Utkus, principal and director of the Vanguard Center for Investor Research in Malvern, Pa. — compared participant portfolio exposures as well as target-date fund adoption rates one year after the introduction of the funds in plan investment menus. Once participants adopted target-date funds, their allocation to equities or "equity share" rose. For the faithful, or "pure TDF investors," the allocation to equities rose by an average of 24 percentage points relative to non-target-date fund investors. For mixed investors, the allocation climbed by 13 percentage points. Meanwhile, their holdings in cash and company stock fell.
"Equity share went up for both pure and mixed investors because they held relatively little equity before the TDFs were introduced," Ms. Mitchell said.
Target-date funds also increased participant returns. For pure target-date fund investors, returns were 19 basis points a month higher than non-target date investors, or 2.3% on an annualized basis. Mixed target-date fund investors, meanwhile, posted returns that were 14 basis points a month higher, or 1.7% on an annualized basis.
To determine the impact the greater returns would have on retirement balances over a 30-year period, the researchers did what they called a "static calculation." They took a stylized hypothetical investor and forecast outcomes assuming 1% real wage growth and no leakage from retirement accounts during that time.
The researchers, however, conditioned their findings on the fact that only low-cost Vanguard funds were studied. "We cannot necessarily conclude that people's wealth would be 50% higher if they were holding very high-cost target-date funds offered by some other fund family," Ms. Mitchell said.
Indeed, some observers found the potential 50% improvement in retirement balances aggressive. David Blanchett, head of retirement research for Morningstar Inc. in Chicago, felt that the estimate was aggressive due to the number of people opting out of the target-date fund default investment option over time. While roughly 80% of new hires are enrolled in target-date funds when selected by the provider as the default option, 2% to 5% will opt out every year after that, "mitigating its effect," he said.
"Say people opt out at 5% a year, you can have half of the people out of the TDF after 10 years," Mr. Blanchett said.
Mr. Blanchett and other observers also pointed out that target-date funds aren't perfect answers for participants as they essentially put everyone within a five-year age range into a one-size-fits-all portfolio. "I do believe that TDFs are in a much better place than we were before but it's hard for me to envision that the perfect solution is one where everyone within five years of age has the exact same portfolio," Mr. Blanchett said.
Jason Shapiro, director of investments at Willis Towers Watson PLC in New York, echoed similar views. "There seems to be a recognition that target-date funds may need to evolve further or possibly change drastically in order to meet the retirement readiness goals of a broad, diverse group of participants," he said.
Mr. Shapiro also noted that target-date funds often have a relatively high percentage of assets allocated to equities even as participants hit retirement, putting them at risk of losing a significant portion of their wealth.
Retirees having to withdraw money from their 401(k) accounts during a market downturn are especially hit hard because their balances are falling at the same time they're pulling assets out of their accounts, locking in their losses, Mr. Shapiro said.
At retirement, target-date funds hold an average of 48% in "return-seeking assets," which includes equities (40%), commodities, real estate investment trusts, and high-yield and emerging market debt, Mr. Shapiro said. The allocation to return-seeking assets ranged from 25% to as high as 64.3%, according to Willis Towers Watson's database of 22 target-date fund providers.
Still, most investors — whether in a target-date fund or a do-it-yourself core lineup — have been challenged by the coronavirus-driven market downturn "given typical broad market exposures of each," he said.
In fact, industry observers agreed that while target-date funds might need some fine-tuning, they're still a good way to go for investors ill-prepared to navigate the vagaries of the market. "I think any way you can keep investing simple and low cost the better," said John West, a partner at Research Affiliates LLC in Newport Beach, Calif., explaining that simplicity reduces the risk of investors doing harm to their portfolio by chasing returns or abandoning certain segments of their portfolio.
"If you combine headlines and recent returns for European and/or emerging markets stocks, you can readily envision large cohorts of 401(k) investors selling these asset classes, despite attractive forward-looking returns," Mr. West said.
People tend to make the classic investing mistake, selling when markets are down and buying when they're high, such as they did during the dot-com bubble in the late 1990s, he said.
"There's just no incentive to try to outperform when you're an individual investor," he said. "You just aren't frankly equipped. Pension funds have a hard enough time doing it."
