Introduction

The use of target-date funds has grown rapidly as a retirement investing strategy over the past decade. In a target-date fund, an investor receives a portfolio based solely on an expected year of retirement. All portfolio allocation decisions are delegated to the fund manager. Assets in target-date funds expanded from $2 billion in 1997 to $183 billion in 2007—a compound growth rate of more than 50% per year. The number of investment firms offering such funds grew from 4 to 37 over the same period.[1]

Target-date funds have radically simplified portfolio management decisions for retirement investors. The funds provide wide diversification among a large range of asset classes in a single investment option. They also gradually reduce equity exposure as the investor approaches the target retirement date of the fund—the so-called "equity glide path." As such, target-date funds are thought to be particularly valuable for less sophisticated investors who struggle with the task of portfolio construction. They are also appealing for investors who don't wish to reassess portfolio risk levels as they grow older.

Driving the growth rate of target-date funds has been their increased use in defined contribution (DC) retirement plans. Their use in DC plans is likely to expand given their designation by the U.S. Department of Labor as one of three qualified default investment alternatives (QDIAs)—along with balanced funds and managed accounts—under the Pension Protection Act of 2006.

In this report, we assess the impact of target-date funds on DC plans using recordkeeping data drawn from more than 2,200 DC plans and nearly 3.2 million participant accounts record kept by Vanguard. Within this universe, more than 1,300 plans, or nearly 60% of the total, offered target-date funds as of year-end 2007, and more than 350,000 participants were actively contributing to the strategy.[2] This analysis builds upon our earlier work on life-cycle funds—both our initial study of static-allocation or risk-based funds, as well as our more recent work on the early introduction of life-cycle funds in DC plans, jointly authored with researchers at the Wharton School of the University of Pennsylvania.[3]

We begin by examining plan and participant adoption. We then turn to the two types of target-date investors—pure and mixed investors—and their characteristics. We also discuss the impact of target-date holdings on the age-based pattern of equity exposure, and in an appendix, compare target-date and static-allocation funds.

Plan Adoption

As of year-end 2007, nearly six in ten DC plans using Vanguard recordkeeping services offered participants a series of target-date funds (Figure 1). Over the past five years, there has been a gradual substitution of target-date funds for static-allocation or risk-based life-cycle funds.[4] A little more than half of Vanguard-administered plans offered risk-based funds in 2004, and that level has now declined to 37%.

Among the important drivers of target-date fund adoption has been the growing use of automatic enrollment, as well as their increased designation as QDIAs.[5]  Of the Vanguard DC plans allowing employee-elective deferrals, 15% have adopted automatic enrollment, principally for new hires. Of that 15%, more than 80% have designated a target-date fund as the default investment (Figure 2).

As of December 2007, 27% of all Vanguard DC plans had designated a QDIA, and more than 80% of these plans employed a target-date option. By September 2008, the number of plans adopting a QDIA had risen to 40%, and again, more than 80% of these plans used a target-date fund as the default investment.

By comparison, money market and stable value funds remained the dominant default fund strategies among those plans that had not introduced automatic enrollment nor designated a QDIA as of year-end 2007. These types of default options are expected to decline as sponsors continue to designate QDIAs for their plans.

Participant Adoption

In DC plans offering target-date funds, about three in ten participants were invested in the strategy as of year-end 2007 (Figure 3). Participants' adoption of target-date funds lagged risk-based funds somewhat—27% versus 32%—probably because target-date funds were introduced several years later than risk-based funds in Vanguard-administered plans.

Who adopts target-date funds? And how are adopters different from other participants who are offered the funds, but don't use them? Compared with non-target-date investors, target-date investors are somewhat younger and have substantially shorter job tenure (Figure 4, two left columns). Indeed, more than one-third are recent hires with two years or less of job tenure. They also have somewhat lower incomes and are somewhat more likely to be female, although these differences are modest. The most substantial difference between the two groups—not surprising given their lower income and shorter job tenure—s their DC account balance. Target-date investors had a mean balance of around $11,500 as of year-end 2007, compared with $42,000 for non-target-date users. They also had somewhat lower levels of nonretirement financial wealth.[6]

Another factor influencing participant adoption of target-date funds is whether these funds are designated as the plan's default. In our data set, we do not know whether a specific individual was defaulted into a target-date fund. But we do know whether the target-date fund was selected as the plan's default. Nearly eight in ten target-date investors are in plans that designate target-date funds as the QDIA.

Mixed Vs. Pure Investors

Target-date funds were initially conceived as a single portfolio solution. Yet in DC plans, where participants are able to make investment choices on their own, two patterns of target-date usage have emerged. Participants may use target-date funds as "pure" investors, holding only a single target-date fund and no other investments. Alternatively, they may be "mixed" investors, combining one or more target-date funds with other types of funds offered by the plan.

Pure and mixed investors are distinctly different (Figure 4, prior page, two right columns). Pure investors are somewhat younger and significantly shorter-tenured compared with non-target-date participants, and 46% are recent hires. They have lower incomes and are somewhat more likely to be female. They have dramatically lower balances-a mean balance of just more than $4,700—and are less engaged investors; fewer than half have registered for Internet access to their plan accounts. We interpret Internet registration as a measure of a participant's engagement as well as of their technological sophistication because participants must actively choose to sign up for Internet access.

Also, 80% of the pure target-date investors were in plans that used target-date funds as the designated default, suggesting a link between the default fund designation and pure target-date investing. The target-date fund also may be influencing the equity exposure of pure investors, who have 81% allocated to equities, compared with only 69% among non­target-date investors.

By contrast, mixed investors are somewhat older, better-paid, longer-tenured, and more likely to be male than pure investors. In fact, they appear more like non-target-date participants, although they have shorter job tenure and lower balances compared with non-target-date investors. They also differ from non­target-date investors in their equity allocation, which is ten percentage points higher than that of non­target-date participants—again the possible influence of the target-date holding.

How many mixed and pure investors are there? It depends on the measure. When 2007 year-end account balances are used as a measure, 34% of target-date investors are pure users and 66% are mixed users (Figure 5). When total contributions during the 2007 calendar year are used as the measure, 45% of target-date participants are pure users and 55% are mixed users.[7] Finally, when we examine participants' first contribution (their first elective deferral) in 2008, which is perhaps the best indication of their forward-looking investment intentions, the percentage of pure investors climbs to 53% and the percentage of mixed investors falls to 47%.

Because of the confounding effects of employer contributions (which may be directed to other investments, such as company stock) and prior employee holdings, we use employee-elective deferrals as our preferred measure for analyzing investor behavior in the remainder of this report.

Factors Influencing Behavior

We conducted a formal statistical analysis of the factors driving pure versus mixed target-date investor status in DC plans, using the first 2008 employee contribution as our preferred measure of behavior.[8]  This analysis suggests that different factors drive target-date adoption, depending on the investor type.

Pure investors are more likely to have lower balances and shorter tenures than other participants and be strongly influenced by a plan's default fund designation (Figure 6, top panel). Mixed investors also are more likely than other participants to be recently hired, but are more active decision-makers than other participants: They are more likely to be registered for Internet access to their accounts and their decision to invest in target-date funds is not linked to the default fund designation (Figure 6, bottom panel). Aside from these characteristics, both pure and mixed target-date investors are otherwise similar to non-target-date participants.

Mixed Investor Characteristics

One of the unanswered questions about mixed investors is why they choose to adopt a mixed strategy. On the one hand, their behavior may reflect naïve decision-making, including:

• Lack of knowledge/financial illiteracy. Participants may fail to understand the purpose of target-date funds as an "all-in-one" portfolio solution.
• Naive diversification. While they may understand that target-date funds are well-diversified, participants may combine them with other funds in a haphazard way, under the naïve assumption that "more is better."
• Inertia. Participants may intend to invest exclusively in target-date funds but fail to rebalance existing holdings to the new approach.

There are also several rational explanations for mixed investor behavior, including:

• Incremental approach. Participants may find target funds appealing but may want to learn more about a fund by investing only part of their portfolio in it.
• Core/satellite approach. Participants may want to "dial up" or "dial down" the risk of their portfolio by adding other fund options to a core holding in the target-date portfolio. These participants might also include actively managed funds in the mix.[9]
• Employer effects. Employer matching or other nonelective contributions may be directed by the employer into a different investment option, such as company stock or a non-target-date default, and so result in a mixed portfolio. Participants may fail to diversify these assets either by choice or inattention.

Without surveying participants, it is impossible to know with certainty which of these motivations plays a role in their decision-making. Indeed, in a large participant population, it is possible to imagine that different combinations of all these factors come into play for different groups of participants.[10] Without survey data, however, we can still attempt to understand the patterns of mixed investor behavior by examining portfolio holdings. Among mixed adopters, we find that:

• The median mixed investor holds four funds, including the target-date fund, and nearly half of mixed investors hold five or more funds (Figure 7).
• The median mixed investor contributes 30% of elective deferrals to the target-date fund. Only 15% of mixed investors are using the target-date fund for more than half of their contributions (Figure 8).
• Mixed investors typically combine the target-date fund with other domestic and international equity options (Figure 9). At the same time, some mixed usage arises because employers are directing money into company stock. Nearly four in ten mixed investors hold company stock, but that is more likely to be caused by employer rather than employee contributions.

In addition, among all mixed investors, 88% hold only one target-date fund. But 12% hold two or more target-date funds, often in addition to other funds.

These results seem to rule out core/satellite as a dominant explanation for mixed investing. The strongest explanations appear to be that participants may be taking an incremental approach or may be naïvely diversifying (holding too many options in addition to the target-date fund or holding multiple target-date funds). Another factor is the role of employer contributions, especially in company stock. Again, additional research will be needed to determine whether mixed investors are employing rational or naive strategies, or both.

Equity Allocations By Age

One of the objectives of target-date funds is to provide a declining rate of equity exposure by age across participant accounts. Target-date investors do have a markedly different pattern of equity exposure by age compared with non-target-date investors (Figure 10, top panel).

Among non-target-date investors, equity exposure tends to rise with age, peak around age 35 to 44, and then decline in an inverse U-shaped pattern. The change in participants' equity allocations from age 25 to 65 and older is less than 10 percentage points.[11] By contrast, target-date investors have a consistent decline in equity holdings by age, reflecting the funds' "equity glide path." For target-date investors, equity exposure declines by more than 30 points across the age spectrum.

The decline in equity exposure over time occurs for both mixed and pure target-date adopters, although it is more pronounced among the latter (Figure 10, bottom panel). Among pure investors, equity allocations decline by more than 40 percentage points from age 25 to 65 and older. Even among mixed adopters, who typically hold only a small allocation in a target-date fund, the decline over the age spectrum is 20 points.

Equity Allocation Extremes

One of the benefits of target-date funds is that they eliminate extreme equity allocations. Non-target-date investors tend to hold greater extremes in equity exposure (Figure 11). Sixteen percent hold no equities, while 30% hold only equities. Target-date investors cannot hold extreme positions because target-date options include both equity and fixed income assets.

Among pure target-date adopters, 95% have equity allocations ranging from 60% to 95% of their account balances, reflecting the underlying equity allocations of the target-date funds. Mixed investors tend to have a wider dispersion of equity allocations, but still have no extreme allocations because of their partial investment in a target-date strategy.

Implications

Target-date funds have emerged as a strategy to simplify the construction of participant retirement portfolios. Rather than engaging in the complex task of selecting and monitoring a portfolio of retirement assets, investors simply choose an expected retirement date. The fund advisor is responsible for making all critical asset allocation and rebalancing decisions, including reducing equity exposure as the investor grows older.

The introduction of such funds has led to the creation of two distinct classes of target-date investors: pure investors, who hold a single target-date fund; and mixed investors, who combine a target-date fund (or funds) with other options. Pure investors are more likely to be strongly influenced by the plan's default fund designation, while mixed investors are more likely to actively make their own portfolio choices.

By design, target-date options provide two important investment benefits to pure and mixed investors. The funds sharpen the age-based gradient of equity exposure. They also eliminate extreme equity allocations—both zero- and all-equity positions. In this sense, target-date funds encourage arguably better-diversified portfolios than those constructed by non-target-date investors.

The main concern with target-date funds appears to be whether mixed investors are naïvely diversifying their portfolios. The typical mixed investor uses the target-date fund as an incremental or supplemental holding in a portfolio with four funds in total, and typically combines the target-date fund with domestic or international equity funds. Further research is needed to disentangle to what extent rational or naive strategies (or both) drive this decision.

That said, the concern about naïve diversification is not unique to mixed target-date investors. There is evidence of inadequate diversification across a range of participant portfolios, whether or not target-date options are in the mix.

Sponsors concerned about the quality of participant portfolio decisions can consider several strategies. One is to expand educational efforts regarding target-date options and their "all in one" approach. Some participants may fail to realize that the funds are intended as a single portfolio solution and that they are already broadly and professionally diversified across the global capital markets. This education effort could also contrast rational approaches to portfolio diversification (e.g., core/satellite) with naive ones (e.g., holding multiple funds regardless of their objective).

A second strategy is to offer a managed account advisory service. With such a service, each participant's portfolio is constructed according to a disciplined investment methodology. The participant does not make investment choices, but delegates control to the advisor, who makes all portfolio construction and rebalancing decisions.[12]

Sponsors may also want to consider a new planwide strategy known as "reenrollment." Under reenrollment, all participants are transferred to a QDIA, such as the target-date fund strategy, with prior notice and with a right to opt out. Through inertia, it is likely that many participants will remain in the default investment option after reenrollment. This strategy is explained in more detail in a separate report from Vanguard.[13]

Appendix: Target-Date Vs. Risk-Based Funds[14]

How do the risk exposures from target-date funds compare with those from risk-based or static-allocation funds, the funds that target-date options are gradually replacing? Target-date funds appear to have a close alignment between the participant's age and the time horizon of the fund (Figure 12, top panel). By design, younger target-date participants tend overwhelmingly to choose (or are defaulted into) long-dated funds, while older target-date participants tend to choose (or are defaulted into) near-term funds.

Participants in risk-based funds are expected to complete an investor questionnaire that assesses their time horizon, risk tolerance, and other factors. If participants consistently used this questionnaire, the result would be that risk-based investors would shift over time from higher- to lower-risk portfolios. If participants are defaulted into a risk-based fund, it is typically to a single fund, regardless of age, for the entire plan.

Our results suggest that static-allocation participants are not assessing age and risk tolerance systematically (Figure 12, bottom panel). The most aggressive risk-based fund in our analysis, the growth fund (with 80% in equities), is more likely to be held by participants ages 35 to 44, not by younger participants. Younger participants are typically in the moderate growth fund (60% in equities), which may be because of this fund's popularity as a default fund. Overall, in plans using risk-based funds, there appears to be no pronounced age-based variation in equity exposure.

Target-date funds put the age-based pattern of equity exposure in the hands of the fund manager, not the participant. Risk-based funds require participants to take the initiative to alter their equity allocation over time. The results for risk-based funds suggest again that participants tend to procrastinate and be passive decision-makers, and so do not alter risk exposures in a disciplined way as they age.[15] Again, it is important to emphasize that the results for both types of funds reflect voluntary choices made by participants as well as default decisions made by employers.

References

Mitchell, Olivia S., Gary R. Mottola, Stephen P. Utkus, and Takeshi Yamaguchi, 2007. "The Dynamics of Lifecycle Investing in 401(k) Plans." Working Paper 2007-08. Wharton Pension Research Council. Philadelphia, PA. http://www.pensionresearchcouncil.org/publications/ document.php?file=400.

Vanguard, 2005. Life-Cycle Funds Mature: Plan Sponsor and Participant Adoption. Vanguard Center for Retirement Research. Volume 20. Malvern, PA. https://institutional.vanguard.com/VGApp/iip/site/ institutional/researchcommentary/article?File= LifeCycleFundsMature.

Vanguard, 2008a. Evaluating and Implementing Target-Date Portfolios: Four Key Considerations. Vanguard Investment Counseling & Research. https://institutional.vanguard.com/VGApp/iip/site/ institutional/researchcommentary/article?File= EvalImplemTargetDatePortfolios.

Vanguard, 2008b. Improving Plan Diversification through Reenrollment in a QDIA. Vanguard Strategic Retirement Consulting. https://institutional.vanguard.com.

Endnotes

1. Source: Strategic Insight. These figures are a lower bound estimate of assets in target-date strategies, as they exclude target-date money held in nonfund vehicles, such as commingled funds.
2. In total, 67% of the 3.2 million participants had access to target-date strategies in their employer plan as of year-end 2007, and more than 570,000 participants held a position in one or more target-date funds.
3. See Vanguard (2005) for an analysis of static-allocation funds and Mitchell, Mottola, Utkus, and Yamaguchi (2007) for an assessment of the early adoption of life-cycle funds in DC plans. Vanguard (2008a) also describes the criteria for the selection of target-date funds in a DC plan.
4. These funds, sometimes known as lifestyle funds, require the investor to choose from a series of risk-based portfolios, such as low-, medium-, and high-risk, based either on the fund descriptions or a questionnaire that incorporates time, risk, and other variables.
5. Default funds are the designated investment when a participant is automatically enrolled. They are also used when the employer makes a nonelective contribution for all eligible participants, whether or not they are contributing to the plan, or when a participant has chosen to make elective deferrals but has failed to make an investment choice.
6. Our measures of participants' economic resources includes nonretirement financial wealth-the mean value of nonpension and non-IRA wealth held by households in the same ZIP+4 region, provided by the IXI company.
7. Employer and employee contributions, calculated separately, follow the same 45/55 split as total contributions.
8. The regression is a multinomial logistic regression, relating investor type (mixed, pure or non-target-date investor) to a variety of participant and plan variables, using plan clustering to control for heteroskedasticity. Complete regression results are available from the authors.
9. The target-date funds record kept at Vanguard are exclusively passive or index-based.
10. Another possible reason for a mixed target-date strategy is that the participant is using a managed account advisory service that uses a target-date fund and other options in its portfolio construction process. In our sample of mixed adopters, fewer than 3% used a managed account service.
11. The possible explanations for this U-shaped pattern include the prior use of conservative default investment options, which leads to lower equity exposure among younger, defaulted participants, as well as learning over the life cycle, with young investors first choosing familiar or safe investments in their early 20s, and then choosing riskier portfolios as they learn more about investing and equity markets.  
12. A managed account advice service will not necessarily reduce the number of mixed target-date investors if the advisory methodology also uses a target-date option.
13. See Vanguard, 2008b.
14. This analysis is based on contributions made by single-fund investors only (i.e., those who are not combining the target-date or risk-based funds with other fund holdings).
15. Another possible explanation is that participants and plans who wish to maintain a reasonably constant equity exposure over the life cycle choose risk-based rather than target-date funds. This is a plausible theory, but inconsistent with our prior research on early adoption of life-cycle funds, which suggested, using time series data, that introducing target-date funds led to a larger change in equity exposure by age than did static-allocation funds.

Contributors to this report prepared by the Vanguard Center for Retirement Research include Kathy Berardi, Meg Shearer, Vicky Hubert, Anita Smith and Diane LeBold.