Automatic Diversification

Target date funds are one option plan sponsors can use to provide age-targeted asset allocations and ongoing rebalancing to the respective target. In fact, this option is being adopted at the fastest pace by the broadest set of sponsors. Higher education institutions would do well to consider how a target date option can help employees prepare for their retirement, but institution leaders must also be prepared to communicate the benefits and choices of these options.

What We Know
Three factors are dominant in defined contribution plans with regard to determining how much a participant will accumulate over time:

0. How much is contributed to the plan. We know from years of data that 8 percent is about the average amount flowing into private defined contribution plans from participants. At the median, another 3 percent is contributed by the employer, for a total of 11 percent. Higher education institutions have generally done better, with a total contribution closer to 16 percent at TIAA-CREF, for instance.
0. The real rate of return. We know that real rate of return affects the amount that must be contributed to achieve a goal. The average worker is paid about $40,000. To keep things simple, let's assume the individual is 25 years old this year and will retire after a full career with that amount in final income in today's dollars. They will have "wage growth," but not "real wage growth"—something that has happened in recent decades for many workers. Social Security will provide a benefit of about $16,000, or 40 percent. Assume the individual will have health costs in retirement and wants to engage in expense-related leisure activities, so he or she seeks a 100-percent replacement of income. Finally, assume the individual plans to live to age 95, which would account for 28 years spent in retirement.
   
   Using a TIAA-CREF calculator one can obtain rough guidance on the impact of rate of return. To get to that $24,000 in today's dollars (the amount not covered by Social Security), at a steady 2 percent real return would require annual savings of 33 percent of salary to get to the required age 67 balance of $1,815,546. At a steady 3 percent real return would require a constant 22 percent contribution to get to the required age 67 balance of $1,621,148. At a steady 5 percent real return would require a 10 percent contribution to get to the required age 67 balance of $1,318,245. (One can double-check these numbers, add in a precise Social Security benefit, and add any expected pension income or income from earnings into the equation with the Ballpark® Estimate.)
0. The asset allocation, which determines the real rate of return. We know from the data that asset allocation varies widely, and that participants have a strong tendency to leave their accounts alone once opened. Most do not change contribution rates, and most do not rebalance. As a result, the Pension Protection Act of 2006 provided clear guidance on automatic enrollment, automatic diversification and rebalancing, and automatic contribution escalation. Maintaining a set balance in the portfolio manages risk and makes achieving target returns most likely. As a result, the Department of Labor Qualified Default Investment Alternative regulations provide alternative options that all seek to manage diversification. The target date option is being adopted at the fastest pace by the broadest set of sponsors.

Charting Return Trends
Chart 1 below provides a picture of how diversification can help achieve higher rates of return and larger accumulations. With higher risk, movements up and down (volatility) of higher expected return assets like stocks will also be much greater. That volatility will also lead to very different results, depending on the market trends, for individuals hitting retirement age at different points in time. The result is more than 80 percent replacement for the 1999 retiree, but 47 percent replacement in 2001, and a mere 27 percent replacement in 2009. Conversely, an allocation of 100 percent bonds may allow one to sleep better at night, but it will require a higher annual contribution rate to get to the same level of retirement income. The balanced portfolio of stocks and bonds leads to variation over time, but far less variation than with 100 percent stocks. That balance provided 47 percent replacement in 1999, and the same 27 percent replacement in 2009 as did a 100 percent allocation to stocks.

As Chart 1 shows, a major decline in the value of stocks and bonds right before retirement can dramatically reduce total assets and achievable retirement income. While those who choose a path of 100 percent bonds must save a lot, have few life extras, and live on a budget, they also typically have little debt and experience few roller-coaster rides. On the other hand, those who choose something closer to the 100-percent equity investment path will undoubtedly have periods when they feel rich and giddy and other times when they are looking for a bridge and wondering how they will ever retire. These folks typically save less and borrow and spend more. As a result, their retirement years may feel like a cutback from how they once lived. In sum, account performance is one measure, but the true measure is what you have at the end of the day and how have you reacted to the ride along the way.

In reality, less than 20 percent of workers choose asset allocations at the low-risk end of the spectrum, and they do not typically save as high a percentage of pay as they should. Based on what individuals are known to choose on their own, target date funds accept that most participants want a higher risk, higher return, lower-required-savings-rate approach. But, target date funds do seek to "rationalize" the asset allocation over time tied to age and regularly rebalance assets as the markets move to maintain the target allocation.

In contrast to individually chosen asset allocations, Chart 2 shows how participants would have fared if they had been invested in target date funds. In this chart, the "excess" shows to what extent the average target date allocation outperformed most individual choices. While some would have fared worse in a target date fund, most would have been better off.

Chart 3 illustrates two things about target date funds. First, the longer away retirement is, the higher the allocation is to stocks; the closer the date of expected retirement, the smaller the stock allocation. Second, the decisions of individual target date fund managers about what the stock allocation should be at any given age vary widely. For 2010 funds, the stock allocation low is at about 25 percent and the high at about 65 percent. For the 2050 funds, the stock allocation range is between 85 percent and 95 percent. These alternative "glide paths" of dropping asset allocation are particularly important during the years right before or immediately after retirement.

Choosing an Appropriate Glide Path
For employers that choose to use target date funds, the single biggest factor to consider is what type of glide path you believe best fits the demographics of your workforce and what manager will provide that glide path. Very large institutions can create their own, with the aid of consultants, while most smaller institutions will want to purchase a set of funds off the shelf. Charts 4 and 5 show the difference in plan assets in target date funds depending upon whether it was the default into which persons were placed at the time of enrollment. Furthermore, these show that across the plan size and account balance spectrum, participants remain in the target date funds at very high rates, compared to self selection of the target date funds from among all available options.

A new study from EBRI, "Use of Target-Date Funds in 401(k) Plans, 2007" (March 2009 EBRI Issue Brief #327), highlights the success rates of conservative and aggressive equity glide paths for meeting target replacement income based on when participants start to contribute. For instance, those who begin to contribute at age 25 for 40 years using a conservative equity glide path enjoy a retirement success rate of more than 92 percent—about 2 percentage points higher than the probability of success of the participant who takes an aggressive equity glide path to meet the target replacement income. However, if participants start to contribute later in their working career (e.g., at age 45), the aggressive equity glide path has a higher probability of success over the conservative glide path in order to meet the target replacement income. The takeaway here is that the best equity glide paths for participants by plan demographics differ based on when participants start to contribute as well as on the target replacement income.

The Effects of Age and Tenure
Chart 6 presents findings on defined contribution plan participants account losses from Jan. 1, 2008, to May 5, 2009. The results indicate how important age and tenure are to account accumulation, and thus to investment gains and losses. Short tenure participants have contributed enough during this period to cover account losses so that the statements they review appear to present good news: I have more than I did before. The oldest and longest tenure participants have large accumulations, such that new contributions are small compared to the total account. Investment losses overwhelmed new contributions. The data show how misleading a simple average can be, and how important it is to look at the participant population by age, income, tenure, and other demographics, to determine the long-term implications of what is happening in the markets for individuals.

Finally, Chart 7 presents a picture of how long it may take participants to return to pre-decline balances using alternative investment return assumptions. Should equity returns even be modest in the years immediately ahead, most participants will be back to where they were within three or fewer years. Viewed another way, those who had to postpone retirement will not have to postpone it that long if the markets begin to recover and stay on that path.

Communicating Benefits and Choices
Participation, contribution rates, asset allocation, and investment returns matter. More than 80 percent of plan participants in most defined contribution plans choose some allocation to stocks and do not focus on rebalance. Target date funds are one option plan sponsors can use to provide age-targeted asset allocations and ongoing rebalancing to the respective target. However, because target date funds also come in many glide paths, careful selection and communication are essential. Employers must be prepared not only to communicate the benefit of these options, but also to help employees understand the selection choices they still face in determining which is right for them.

Dallas Salisbury is president and chief executive officer, Employee Benefit Research Institute, Washington, D.C.; e-mail: salisbury@ebri.org.