Study: How Target Date Funds Affect Investment Behavior

The average American today invests far more of their money in the stock market than they have in decades past, a trend accelerated by the popularity of target date funds, according to new research from MIT Sloan. .

Target date funds – which have been increasingly used as the default investment option in workplace retirement plans since the mid-2000s – start out being equity-heavy and gradually adapt to a more conservative investment strategy as the individual ages, thus saving people from having to actively rebalance their investments between stocks and bonds.

Many Americans who don’t know how to allocate their retirement savings end up choosing the default investment option provided in their employer-sponsored retirement plan. These days, that default is often a target date fund or TDF. This “set and forget” model has been well received by American workers, with total assets invested in TDFs rising to over $2 trillion, up from just $8 billion in 2000.

“They were very effective,” saidprofessor of finance and co-director of the MIT Golub Center for Finance and Policy.

Since stocks are riskier than bonds but offer higher expected growth rates, “a target date fund can start with 80% or 90% of your money in stocks when you’re under 35,” he said. Parker said. After age 45, that percentage gradually declines so that “older households that are no longer working aren’t 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 now hold around 70% of their assets on the stock market. Before 2000, this number was 58%.

On average, investors today hold about 70% of their wealth on the stock exchange, a figure higher than in previous decades. An earlier study looking at retirement savings before 2000 showed an average stock share of 58% and no stock rebalancing as people age, the authors noted in their research.

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

The authors were curious whether TDFs had accelerated the increase in a worker’s allocation to equity and whether there was in fact a subsequent rebalancing towards safer assets over time.

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

The authors found that adopting 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. the TDF option.

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

Parker said the causal effect of having a default TDF at the start of savings is short-lived.

“A lot of the effects that we see are quite muted around five years after people initially enroll,” he said.

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

Going forward, Parker expects TDFs to continue to grow in popularity because they make life easier for typical Americans who are busy, don’t know how to allocate their portfolios, or have no interest in actively managing their portfolios. It’s also worth keeping in mind that TDFs have significant quantitative effects on stock prices, and if they continue to gain popularity, they could reduce stock market volatility.

“Although people ultimately have a choice, sometimes they don’t know what to do, so if we can get good economic advice within the regulatory framework and financial institutions design products that work well, then we will end up in a better place,” Parker said. Giving people the ability to save for retirement automatically, simply, and affordably “is a boon to people’s ability to have sufficient funds when they retire.”

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

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