Investing January 28, 2020

Research Shows Positive Effects of TDFs

Various beneficial changes to retirement savings portfolios made by investing in TDFs could enhance retirement wealth by as much as 50%, research suggests.

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In “Target Date Funds and Portfolio Choice in 401(k) Plans,” researchers from The Wharton School, University of Pennsylvania, studied the effect of using target-date funds (TDFs) as the default investment for a worker’s portfolio over a 30-year career.

The researchers concluded that “the adoption of low-cost target-date funds may enhance retirement wealth by as much as 50% over a 30-year horizon. Including these funds in retirement savings menus raised equity shares, boosted bond exposures, curtailed cash/company stock holdings and reduced idiosyncratic risk.” Idiosyncratic risk is a type of investment risk, uncertainty or potential problem native to an individual asset (such as a particular company’s stock), or group of assets (such as a particular sector’s stocks), or in some cases, a very specific asset class (such as collateralized mortgage obligations).

The paper notes that TDF assets in 401(k)s have grown exponentially, from $5 billion in 2000 to $734 billion in 2018. The Pension Protection Act of 2006, which permitted TDFs to be used as default investments in 401(k)s, was largely the cause of that growth, the paper says.

Citing Investment Company Institute (ICI) data, the researchers say in 2018, 80% of 401(k)s offered TDFs, and 66% of plans used automatic enrollment, with TDFs being the primary default investment.

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The researchers’ findings are based on an analysis of Vanguard indexed TDFs, with management fees under 20 basis points used in 880 defined contribution (DC) plans between January 2003 and June 2015, a 12-1/2-year period. One year after the first appearance of TDFs on the investment menu, 78.7% of new hires were invested in these funds because they were defaulted into them. The researchers say workers are more inclined to be comfortable with whatever default their employer chooses for them, hence, the reason so many workers remain invested in TDFs when they are the default.

Importantly, the paper says, “in terms of portfolio effects, adoption of target-date funds had sizeable effects on equity share and risk factor exposures. Participants’ equity share rose an average of 24 percentage points for pure investors [i.e., those invested only in one TDF] and by 13 percentage points for mixed investors [i.e., those invested in a TDF and other funds]. As a result of increased equity and bond market exposures, expected factor returns for pure investors rose by 2.3% per year and for mixed investors by 1.7% per year.

“Accordingly,” the paper continues, “the introduction of target-date funds produced an important shift away from participants’ 401(k) plan portfolio selections and toward the target-date managers selected by employers. This change will have sizeable benefits. We estimate that improved returns could raise retirement wealth by as much as 50% over a 30-year savings horizon for a pure investor in a low-cost target-date series. Employees who [were] moved into the target-date funds could have previously made the portfolio changes on their own and realize potential benefits—yet they did not.”

The researchers say that a 30-year-old earning $35,000 a year, who makes annual deferrals of 10% a year into a retirement plan, and assuming a mean excess return of 5.4% would amass nearly $300,000 in savings over a 30-year period. However, the result would be 50% higher for pure TDF investors and 33% higher for mixed investors, “given a low-cost, well- diversified target-date series.”

In conclusion, the researchers say more should be done to encourage automatic enrollment and using TDFs as the default investment. They also suggest plan sponsors consider re-enrollment, so older workers in a plan that suddenly adopts automatic enrollment are swept into the automatic default.
Compliance January 28, 2020

Post-SECURE Act, IRS Provides RMD Relief

The SECURE Act extended the age at which RMDs take effect from 70 1/2 to 72, but financial institutions may not have had time to change their notice systems.

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The Internal Revenue Service (IRS) has provided regulatory relief to financial institutions that were expected to provide required minimum distribution (RMD) statements to individual retirement account (IRA) owners by January 31.

The relief is tied to the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which extended the age at which RMDs take effect by 18 months, or from age 70 1/2 to age 72.

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The regulatory relief is detailed in IRS Notice 2020-6, which acknowledges “the short amount of time after the enactment of the SECURE Act that financial institutions have had to change their systems for furnishing the RMD statement.” Technically, Notice 2020-6 clarifies that if an RMD statement is (errantly) provided for 2020 to an IRA owner who will turn age 70 1/2 during the year, the IRS will not consider the statement to be incorrect. Importantly, the IRS explains, this is only the case if the financial institution notifies the IRA owner no later than April 15 that no RMD is due for 2020.

By way of background, the SECURE Act was enacted on December 20, 2019, after being folded into a bigger federal appropriations bill. It established that the new required beginning date for an IRA owner or retirement plan participants to begin making withdrawals is April 1 of the calendar year following the calendar year in which the individual attains age 72, rather than April 1 of the calendar year following the calendar year in which the individual attains age 70 1/2.

Under the SECURE Act, this amendment became effective for distributions required to be made after December 31, 2019, with respect to individuals who will age 70 1/2 after that date. As a result of this change, IRA owners who will attain age 70 1/2 in 2020 will not have a required beginning date of April 1, 2021. In turn, this means that these IRA owners (who, prior to enactment of the SECURE Act, would have been required to take minimum distributions from their IRAs for 2020) will have no required minimum distribution for 2020.

The IRS encourages all financial institutions, in communicating these RMD changes, to remind IRA owners who reached age 70 1/2 in 2019, and have not yet taken their 2019 RMDs, that they are still required to take those distributions by April 1, 2020. 

When it comes to compliance with the broader SECURE Act in 2020, sources say, the increase in the age for RMDs, the elimination of the ability of certain beneficiaries to stretch IRA payments over their lifetime, and the exception to the 10% early distribution penalty for distributions for birth or adoption of a child are the most urgent for plan sponsors to address.

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