When target date mutual funds first came on the scene, companies sponsoring 401(k) plans generally viewed these funds as a way to help make investment decisions easier for plan participants. However, even though these funds have become more popular and regulators have introduced new disclosure rules for these funds, the 401(k) plan participants investing in target date funds still do not fully understand how these funds work, according to a survey commissioned by the U.S. Securities and Exchange Commission (SEC).
Target date funds invest assets based on a specific timeframe or target date and, as such, automatically reallocate the asset mix in their portfolios accordingly. As a fund moves closer to its target date, its asset allocation generally becomes more conservative.
First, let's go over the background. Over the past several years, target date funds have become more and more popular as a 401(k) plan investment. Part of this is tied to the growing use of automatic 401(k) plan enrollment and the choice among plan sponsors to use target date funds as the default investment for newly enrolled participants who do not choose their own investments. For many plan sponsors, target date funds seemed to be a logical choice as a default investment choice that offered the chance of better returns than a money fund or a guaranteed investment contract with an acceptable level of risk.
Data compiled by the Employee Benefits Research Institute and the Investment Companies Institute finds that the percentage of new hires investing in target date funds when they enroll in a 401(k) plan has increased significantly since 2006. Interestingly, it is the younger participants in their 20s who are most likely to invest in target date funds, with 52% doing so in 2010 compared to 29.4% in 2006. There are similarly growing percentages of new hires in their 30s (47.8% in 2010 compared to 28.5% in 2006) and 40s (45.3% in 2010 compared to 27.4% in 2006).
When the financial markets plunged in 2008 and 2009, the growing number of participants who were invested in target date funds, particularly older participants within a few years of retirement, were in for an unpleasant surprise. Target date funds did not insulate these individuals from significant losses, and many older participants did not realize how much risk they were taking by investing in these funds.
In response, the SEC implemented disclosure rules that requires target date funds to disclose the glide path the fund uses to guide investment risk as the fund moves closer to its target date. The SEC also requires clearer, more prominent disclosure of each target date fund's asset allocation at different points in time.
Now, let's look at the SEC study, which is designed to gauge the impact of these disclosures on investor understanding of target date funds and how they work. Overall, the results show that more work needs to be done for individuals to fully understand target date funds and how they work as a retirement investment. Perhaps the most serious finding is that less than half of the respondents who own a target date fund understand that a target date fund does not provide guaranteed income in retirement.
In addition, only one-third of respondents who invest in target date funds correctly identified what the target date in the fund's name means from an investing perspective, i.e., the year in which an investor will retire or stop purchasing shares of the fund. Another third erroneously stated that the target date represents the year in which the fund reaches its most conservative asset mix. Three quarters of the individuals responding to the survey held target date funds in an employer-sponsored retirement plan.
CFOs should keep these findings in mind as they consider 401(k) plan communication and investment education programs for employees.