401(k) plans in target date funds surge
Mutual fund giant Vanguard reported Tuesday that just over half of participants in the 401(k) plans it administers are invested in a single target date fund.
These funds — pitched as a sort of Rip van Winkle investment that you can set and forget until you wake up retired — now account for one-third of the assets in all 401(k) and other defined contribution plans run by Vanguard.
The popularity of target date funds has surged since 2006, when the U.S. Department of Labor made it clear that employers could automatically enroll employees in 401(k) plans and automatically increase their savings rate each year, unless the employee opts out. They also gave employers some legal protection if they invest contributions into one of three options, unless the employee chooses something else. One of the three options was target date funds, which have become by far the biggest default investment in 401(k) plans.
These funds invest in a diversified mix of stock and bond funds. Some add other asset classes ranging from real estate to commodities.
Employees are typically advised to choose a fund with a target date nearest their 65th birthday. The mix gradually grows more conservative — meaning more bonds and less stock and other risky assets — as the target date approaches.
The funds rebalance periodically. For example, in a year when stocks outperform bonds, the fund will sell some stocks and invest the proceeds in bonds to maintain the desired asset mix for that year. This imposes a level of discipline that individual investors often lack.
Target date funds accounted for 20.4 percent of the assets in large 401(k) and other defined contribution plans last year, according to Pensions & Investments. That’s up from 18.4 percent in 2016 and 16.8 percent in 2015, according to Pensions & Investments.
Fidelity Investments said that 49.1 percent of workers in the plans it administers were invested in a single targetdate fund in the first quarter. For Millennials, that number was 67.5 percent. Overall, 30.2 percent of its plan assets were in these funds.
It’s no coincidence that the three largest managers of target date funds — Vanguard, Fidelity Investments and T. Rowe Price — are also among the 10 largest administrators of 401(k) plans.
Typically, if the company that administers your 401(k) plan also sells target date funds, your only target date fund options will be that company’s funds. That’s starting to change, as the largest plans push for other companies’ funds, said Brooks Herman, head of data and research at BrightScope, which rates 401(k) plans. Herman said he has his entire 401(k) invested in a target date fund.
Target date funds are a far better option than money market or stable value funds, the default options in most plans before 2006. The downside is that not all employees of a certain age belong in the same fund, said Dan Wiener, chairman of Adviser Investments.
“You can have two individuals: same age, same job title. One is married and has two children. The other is single, has no plans to marry and stands to inherit $3 million. How is it that these two people should be invested in the exact same allocation?” said Wiener, who also publishes an independent newsletter for Vanguard investors.
I asked Jean Young, a senior research analyst with Vanguard, whether two 25-year-olds could put the same target date fund on autopilot for 40 years and have a successful retirement.
“For defined contribution plans to work, people only need to get two things right,” she said. The most important is to “save enough ... probably 10 percent (of salary) or more.” The second is to invest appropriately. If the only thing you know about a person is his or her age, they have the same human capital and that is the only thing you can base an asset allocation on, she said.
“Ideally, what you really want is a custom target date fund for everybody. That’s what a managed account is, but that requires engagement” on the employee’s part to personalize an investment mix. That’s something the 401(k) industry has “struggled with for decades,” mostly to no avail, Young said.
Although one could invest in a single target date fund over a lifetime, “at some point the accumulation gets big enough” that the person should “seek out unconflicted advice,” Young said. If everyone started saving 10 percent of salary at age 25 in a target date fund and retired at age 67, “we wouldn’t have an issue with retirement savings in America,” she said.
Leo Acheson, an associate director with fundrating firm Morningstar, sees nothing wrong with putting your entire 401(k) in a target date fund as long as you “do your due diligence and select a good series.”
The problem is, not all target date funds are created equal. Some are made up of low-cost index funds, some contain actively managed funds. Some take more risk than others. “Some have turned in sub-par results relative to peers and have folded,” Acheson said.
Some fund companies sell more than one line of target date funds. Morningstar has bestowed its highest “gold” rating on the Vanguard Target Retirement, BlackRock LifePath and JPMorgan SmartRetirement series of target date funds.
“There are also a number of silver-rated funds we think highly of,” Acheson said. They are the T. Rowe Price Retirement, Fidelity Freedom and American Funds Target Date Retirement series.