Vanguard: Target-Date Funds Balance Investment Behavior

A study from Vanguard indicated target-date funds could solve the issue of participant extremes.

The study, Target-Date Funds: Plan and Participant Adoption in 2007, by the Vanguard Center for Retirement Research, shows that participants who do not invest in target-date funds tend to exhibit greater extremes in their equity holdings. Fully 30% of participants in the Vanguard study held risky, all-equity portfolios, while 16% held highly conservative, zero-equity portfolios.

In contrast, the stock exposure of target-fund investors ranged generally from 40% to 90%, depending on their age and time to retirement. Vanguard said the effect of eliminating extreme allocations extended even to “mixed investors”—those who combined target-date funds with other plan investment options.

The study also found that target-date investors have a markedly different pattern of equity exposure by age compared with non-target-date investors. For non-target-date investors, allocations to stocks declined by less than 10% between the ages of 25 and 65, while the equity allocations of target-date investors declined more than 40% over the same age range.

“Target-date funds help participants adhere to the principles of prudent investing,” said Stephen P. Utkus, head of the Center for Retirement Research and co-author of the study. “On the one hand, these funds maintain a positive equity exposure in pursuit of higher long-term returns. On the other hand, they are broadly diversified and reduce equity exposure over time in order to mitigate the risks associated with equity markets.”

Many Participants Not “Pure” Target-Date Fund Investors

The Vanguard study found a little more than half of target-date participants are “pure” investors, holding only a single target-date fund, as measured by employee contributions. Pure investors tend to be participants with lower plan balances and shorter job tenure. Their investment in a target-date fund is strongly influenced by the sponsor’s default fund designation.

The remaining target-date investors are “mixed” investors, combining target-date funds with other investment options. They are more likely to be engaged decisionmakers and not rely on the plan’s default designation, Vanguard found. Like pure investors, they are more likely to be recent hires, but they are otherwise similar to non-target-date investors.

The typical mixed investor holds four options, with the target-date fund accounting for 30% of contributions to the portfolio, according to the study report. The study findings suggest that mixed investors most frequently combine target-date funds with domestic equity funds, and less frequently with international funds and other plan options.

According to the study, six in 10 Vanguard DC plans offered target-date funds as of year-end 2007. Assets invested in target-date funds totaled more than $183 billion as of September 30.

Target-date strategies have been chosen as a default investment by 81% of plans offering automatic enrollment and 84% of plans designating a qualified default investment alternative (QDIA). As of year-end 2007, three in 10 participants were contributing to target-date funds when they were offered in their plan.

Vanguard attributes the growing popularity to the merits of target-date funds—broad diversification, transparency, automatic rebalancing, and professional management.

The study is based on data from more than 1,300 defined contribution plans that offered target-date funds as of year-end 2007. The study looked at the behavior of more than 1.24 million participants in those plans, including 357,000 who were actively contributing to target-date funds.

The report is available here.