Participants October 18, 2019

Participants Invested in TDFs Contribute Less to Retirement Accounts

Surprising actions from retirement plan TDF investors offer lessons for plan sponsors and indicate a need for more innovation in TDF design.

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Retirement plan participants who invest in target-date funds (TDFs) contribute less to their plans than participants who don’t use them, an analysis from Alight Solutions finds.

And what Alight thought were reasons this is true, turned out not to be. Alight studied behavior for approximately 2.5 million target-date fund investors as of January 1, 2019 who are in its book of business, and found that even when accounting for factors like age and automatic enrollment, participants who fully invest in TDFs tend to save less than others.

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According to the data, full TDF users who were automatically enrolled contributed an average of 5.3% of salary to their plans. This compares to 7% for partial TDF investors and 7.6% for non-TDF investors. Among those self-enrolled, full TDF users contributed 7.4%, while partial users contributed 8.5% and non-users contributed 8.7%.

Full TDF users younger than 30 contribute on average 5.6% of salary to their retirement plans compared to non-TDF users, who contribute 7.7%. For those ages 40 to 49, full TDF users contribute 6.4% and non-TDF users contribute 8.7%. The differences are even higher for those age 50 and older.

The study found when people changed from full TDF use, approximately half (47%) actively changed their contribution rate, 14% changed their contribution rate via automatic escalation and the rest kept their contribution rate the same. Among those who remained full TDF investors, only 24% actively made a contribution rate change, while another 24% increased their rate via automatic escalation.

“The prevailing wisdom is that younger investors save less than older investors or participants who are automatically enrolled save less because they stick with the initial default rate, but we isolated for those things and still find people investing in TDFs are saving less,” says Rob Austin, head of research at Alight Solutions.

Another possible idea is that those who remain full TDF investors feel that TDF returns will boost their savings accumulation more so than other investments. However, other findings from Alight seem to contradict this as well. Even though many plans label TDFs with descriptions like “lifecycle funds,” participants are not staying invested in them throughout their working lives. In fact, half of participants (49%) who were fully invested in them ended up moving out of them within ten years.

In addition, when participants stop using TDFs, many make extreme changes to their asset allocation, the study suggests. Among those who stopped using TDFs altogether, 46% invested their entire portfolio in equities, while 14% went all-in on fixed income.

Austin calls this finding “pretty interesting.” He notes, “Some TDFs for the youngest participants have high balance in equities already—up to 90%—so the move to 100% equities is a bit alarming. It is less surprising for older participants to take on more equities; they may need a greater return. But maybe all those moving out of TDFs are chasing returns, especially with the fixed income market as it is today.”

Austin says knowing what the reasons for these actions aren’t is a lesson in itself. “We have debunked some of the myths about savings behavior.” He also says the findings indicate there is something unique to TDFs that lead participants to take these actions. It’s an area ripe for future research. Employers could target participants making these decisions to ask why—maybe even use focus group conversations.

The research found investing in multiple TDFs is common. One out of every 10 TDF investors uses more than one vintage. Among partial TDF users—those who invest in TDFs as well as other core investment menu options—the percentage more than doubles.

“I think this is a combination of people following the market and misunderstanding TDFs. In previous research we found only 11% of people know a TDF is designed to invest in only that fund,” Austin says. “People have been told not to put all their eggs in one basket, and that’s what a TDF looks like to them. They don’t understand that there’s diversification in underlying funds.”

Aside from indicating the need for better education and communication about TDFs, another lesson for plan sponsors is to perhaps slim down the core investment menu. “We looked at the number of investments offered other than TDFs, and found the more funds available to participants, the less likely they are to fully invest in TDFs. It’s counterintuitive because TDFs are an easier choice,” Austin says. “We also found if fewer funds are available, the less likely participants are to create their own portfolios.”

Austin concludes that there needs to be more personalization in TDFs. “I think what we’re seeing here is TDFs are good, but not all they promised to be. They are not lifecycle funds because people are not staying in them. Maybe they are oversimplified—they only consider the age of participants and there are other considerations for people planning for retirement.”

Some may argue that managed accounts are the solution to more personalization for participant investment choices. And, Austin admits Alight’s study on managed accounts showed they provided better outcomes than if participants chose their own investments.

Austin says while TDFs lagged managed accounts, they also provide better outcomes than if participants choose their own investments. “I think there can be more innovation in TDFs going forward,” he says.
Data and Research October 18, 2019

Retirement Income Can Be About More Than Guaranteed Options

Given some negative views of annuities, plan sponsors could consider in-plan income options that are not guaranteed.

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BlackRock analysts tackle the timely and vexing issues of retirement income strategies and the potential greater use of in-plan annuity products in a new white paper, “Income reimagined: expanding DC from saving to spending.”

According to BlackRock, plan sponsors, providers and legislators are all showing growing interest in providing guaranteed or income annuity options within defined contribution (DC) retirement plans. But so far, BlackRock finds, no consensus approach has emerged.

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“Despite the rational case that can be made for lifetime income solutions, a number of participant biases and behavioral financial barriers need to be overcome to drive adoption,” the paper suggests.

The BlackRock analysis points to the contractions one discovers when surveying retirement plan investors about annuities and guaranteed income. On the one hand, survey data tends to show that participants are interested in “guaranteed income solutions,” but at the same time people commonly voice negative views of “annuities.” As such, even when progressive plan sponsors have made annuity products available in their plans, there has been quite modest uptake.

“Yet when they do choose guaranteed income, the surveys suggest that [investors] are more satisfied than those who try to manage retirement spending on their own,” the BlackRock white paper says. “A MetLife study found that nearly everyone who took monthly income instead of a lump sum payment were happy with their choice. The same study found nearly one-third who took a lump sum regretted their first year spending habits.”

According to the white paper, research suggests that how one frames income solutions greatly impacts participants’ perceptions and decisions. For example, when income solutions are framed as a way to protect their ability to spend over time, participants see it as a rational decision. If participants focus on the “risk” that they will not collect enough income payments in return for the purchase price, they may think of income as a bad “investment.”

“We believe that framing income as a smart decision to protect retirement spending can be the first step to overcoming a range of biases and behavioral barriers,” the BlackRock paper concludes. “And by embedding income into the default option, DC plans can take advantage of one of the most powerful plan design features to help nudge participants into appropriate retirement income decisions.”

The analysis then explains that target-date funds (TDFs), as highly trusted and popular default investment options used by many plan sponsors, may be a great pathway for introducing guaranteed income in the plan context.

“Target-date funds are already in place on most plans and capture the majority of contributions,” the paper explains. “They are widely understood by participants and already frame their planning around the target date. They have a structure that naturally lends itself to building up income over time, leading to partial annuitization at the target date. They may offer a growing stream of retirement income that feels like a natural extension of the lifecycle management they provide.”

An Alternative Take

Toni Brown, senior defined contribution specialist at Capital Group, home of American Funds, agrees that retirement income is the next frontier of innovation in this space.

“There is a broad and important discussion going on about the potential of bringing annuities closer to DC plans,” Brown says. “First of all, I am so excited about the energy in the marketplace and among plan sponsors about the 401(k) becoming a true retirement vehicle, rather than a supplemental savings plan as it was originally designed.”

However, as Brown sees it, so much of the discussion has been around guaranteed income and annuities, and while that makes sense to some extent, guaranteed income products are not the only important part of this conversation. In fact, given the various challenges associated with bringing annuities into DC plans, Capital Group’s perspective is actually that annuities are better sitting outside of plan.

“Many plan sponsors offer an annuity bidding platform that is linked to their plan, but it technically sits outside of the plan for a number of important reasons,” Brown explains. “Under this approach, in the plan, you then select the TDF be very effective to and through retirement. Sponsors should also then consider adding an option specifically built for those people who will be taking money out regularly.”

As an example, Capital Group/American Funds offers a retirement income solution that is basically a series of three risk-based funds. In a sense, they are similar to the risk-based portfolios that were quite popular before the Pension Protection Act cleared the way for target-date funds’ dominance.

“The difference between these funds and other funds is that these are built specifically for retirees, so they are sufficiently liquid and portable to serve retirees’ needs,” Brown says. “They are, generally speaking, more conservative in their equity holdings, to make it possible for the funds to pay income efficiently to retired investors. Within this more conservative framework, there are three different risk levels to meet the individual’s needs—conservative, moderate and enhanced.”

Other investment managers have similar solutions. They aren’t guaranteed and they don’t need to be guaranteed, Brown says.

“In sum, we think the future of retirement income in-plan is really this non-guaranteed approach,” Brown says. “It will be important for people to, out of plan, be able to access guaranteed income that is really tailored for and appropriate for the individual.”

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