recent

Forging a path from PhD to MD to Amazon Web Services advisor

How the Russia-Ukraine war is upending global supply chains

The promise of edge computing comes down to data

Credit: iStockphoto

Ideas Made to Matter

Finance

Study: How target date funds impact investment behavior

By

Today’s average American invests significantly more of their money in the stock market than they did in the last few decades, a trend accelerated by the popularity of target date funds, new research from MIT Sloan shows.

Target date funds — which have been growing in use as the default investment option in workplace retirement plans since the mid 2000s — start out as stock-heavy and gradually adjust to a more conservative investment mix as an individual ages, relieving people from having to actively rebalance their investments between stocks and bonds.

Many Americans who aren’t sure how to allocate their retirement savings end up taking the default investment option provided in their employer-sponsored retirement plan. Nowadays, this default is often a target date fund or TDF. This “set and forget” model has been well received by American workers, with the total amount of assets invested in TDFs rising to more than $2 trillion from only $8 billion in 2000.

“They’ve had a lot of efficacy,” saida professor of finance and co-director of the MIT Golub Center for Finance and Policy

Given that stocks are riskier than bonds but offer higher expected growth rates, “a target date fund might start with 80% or 90% of your money in equities when you are less than 35 years old,” Parker said. After age 45, that percentage declines gradually so that “older households who aren’t working anymore are not too exposed to stock market fluctuations,” said Parker, co-author of a new working paper,  “Household Portfolios and Retirement Saving Over the Life Cycle.”

Stocks on the rise

7 0 %

Investors today hold about 70% of their wealth in the stock market. Prior to 2000, that number was 58%.

On average, investors today hold about 70% of their wealth in the stock market, a figure that is higher than in previous decades. One prior study that looked at retirement savings before 2000 showed an average equity share of 58% and no rebalancing out of equities as people aged, the authors noted in their research.

Part of the reason for this shift can be attributed to the 2006 Pension Protection Act, which allowed the use of TDFs as a default option in an employer’s retirement savings plan.

The authors were curious about whether TDFs had accelerated a worker’s increased allocation to equity and whether there was actually a subsequent rebalancing into safer assets over time.

To find out, they used anonymized portfolio data covering millions of investors and trillions in financial wealth from a large U.S. financial institution. The researchers compared data from the two years before the Pension Protection Act was established (when the default fund was not a TDF) to the two years that followed the act, when the TDF option was adopted. By controlling for the company and the age of the individual, “we can infer what the causal effect is of having a target date fund as the default fund on their investment behavior,” Parker said.

The authors found that the adoption of a TDF as a qualified default investment alternative led younger new enrollees to invest more of their financial wealth in the stock market compared to those who did not have the TDF option.

“What we find is that the young households with a target date fund as the default tend to have a higher share of equity on average” whereas the equity shares of people who are older when they are hired by the business “tend not to move much, consistent with the fact that those are the equity shares they might have chosen anyway” because they wanted to be in safer assets.

Parker said that the causal effect of a having a TDF as a default when starting to save is short-lived.

“A lot of the effects that we find are quite mitigated by about five years after the people initially enrolled,” he said.

Parker suspects that investors who enrolled in a retirement plan before the default option changed have adopted TDFs or TDF-like strategies over time like their peers who enrolled after the option changed, perhaps in response to conversations they had with financial advisors or with co-workers.

Going forward, Parker expects TDFs to continue growing in popularity because they make life easier for typical Americans who are busy, don’t know how to allocate their portfolios, or don’t have an interest in actively managing their portfolios. It’s also good to keep in mind that TDFs have quantitatively large effects on stock prices, and if they continue to grow in popularity, they could decrease volatility in the stock market.

“While people ultimately have the choice, sometimes they’re not sure what to do, so if we can get good economic advice into the regulatory framework and have financial institutions design products that deliver good outcomes, then we end up in a better place,” Parker said. Giving people the option to save for retirement automatically, simply, and cheaply “is a great boon to the ability of people to have sufficient funds when they retire.”

The research was co-authored by Duncan Simester and Allison T. Cole, all of MIT Sloan.

Read next: Target date funds have ‘quantitatively large effects’ on stock prices

For more info Tracy Mayor Senior Associate Director, Editorial (617) 253-0065