The TIAA Institute has released a report discussing the effects of changes in participant contribution decisions following the adoption of target-date funds (TDFs) after the Pension Protection Act of 2006 (PPA) was introduced.
Prior to TDFs, money market funds were the most common default investment option. With this in mind, the study asks three questions: “First, how do the changes in default investments and available numbers of funds in the plan menu affect the number of funds used by participants? Second, what determines whether participants use target-date funds? Finally, how do these regulatory and plan changes affect the percentages of equity in allocations?”
The study finds that participants who join plans with a TDF default contribute to fewer funds and are significantly more likely to choose only TDFs for their allocations. Additionally, participants will, on average, contribute to funds with greater equity exposure, and the study found there is “less cross-sectional variation in contribution equity exposure across participants.” Instead, both equity exposure effects are high in different age groups and genders.
The study was conducted with a cross-section of 600,000 TIAA participants, with each added into three distinct groups of participants: (1) participants who joined plans in their current combination before any of the plans had target date fund defaults; (2) those who joined after some, but not all, combination plans had target-date fund defaults; and (3) those who joined after all combination plans had target-date fund defaults.
In the first group, participants who allocate contributions to a larger number of funds were found less likely to utilize TDFs when available, and they also hold significantly less equity than participants in the third group, the study says. These participants’ allocations were also more varied and prone to positive plan investment menu effects. For those joining after TDFs were made the default, these effects were mitigated.
Participants who joined after target-date defaults were made the default were significantly more likely to invest only in a single TDF, and as a result, target-date only participants tend to hold substantially more types of mutual funds because TDFs are composed of a number of underlying mutual funds, the study reports.
The study concludes by noting that TDFs offer an effective solution for plan sponsors and participants, but they do not account for differences in income, wealth, risk aversion, and life expectancy. Additionally, while the higher equity exposure linked to TDF defaults can lead to higher expected returns, it is also associated with greater portfolio volatility.
More information on the TIAA Institute’s study can be found here.