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Rekenthaler Report

Target-Date Funds: The Triumph of Academia

What the behavioral economists advocated 20 years ago is today’s 401(k) reality.

More or Less?
In the 1990s, 401(k) plans hit early adulthood and faced a life decision. They could continue to gain complexity, by giving employees additional investment options such as specialized funds and open brokerage platforms. Or, they could reverse their recent course and simplify. Perhaps less would be best.

I made my call. Late in the decade, I submitted a guest column for a 401(k) trade website, stating that expansion was inevitable. As 401(k) balances grew, and employees became more financially sophisticated, they would no longer be satisfied with the basics. Rather, they would demand full investment freedom: The ability to invest where they wished. The history of the mutual fund industry was the history of doing more. The 401(k) business would be no exception.

Boy, was I wrong. Worse, I was wrong while hearing the truth through a megaphone. At the time, I was conversing with several behavioral economists, all of whom insisted that 401(k) plans were failing participants by offering too many choices. Classic economic theory states that providing consumers with additional options is always good. The behaviorists said, nonsense. Restaurant diners prefer two-page menus to 20-page booklets. The same principle applies to 401(k) participants, only more so, because selecting funds isn't as enjoyable as thinking about food.

The Path Selected
The 401(k) industry has behaved accordingly. Rather than expand their investment lists in the following 20 years, most 401(k) plan sponsors have pruned. In addition to having smaller fund lineups, they also advocate that their workers hold smaller portfolios. No longer do 401(k) sponsors suggest that employees should create custom solutions, by combining several different funds in a fashion that particularly suits them. Keep it simple: Just own a target-date fund.

That such counsel has been eagerly accepted may be seen in the data presented by Vanguard's "How America Saves 2018" report, released yesterday.

Last decade, Vanguard opted for simplicity. The best plan structure, it informed its plan-sponsor customers, was to steer new participants toward a target-date fund. If, for whatever reason, employees failed to make any investment selection, then default them into a target date. The message required some repeating, but it ultimately was successful. The numbers are as Vanguard would have wished.

Specifically, 75% of Vanguard's 401(k) participants now hold at least one target-date fund. One third of that 75% owns multiple funds, which is not how target-date funds were designed to be used, but this is not necessarily harmful. (There's neither much damage done by "diversifying" among several target-date funds within the same family, nor much benefit.) The rest, representing 51% of Vanguard's total 401(k) population, owns but a single target-date fund.

Of that 51%, about half arrived at their target-date fund by choice, with the other half put into one by default. Thus, from the target-date perspective, the two paths are equally important. When selecting initial investment options, many (although not yet most) of Vanguard's 401(k) participants take the target-fund track. Their numbers are roughly matched by those who take no track at all and purchase a target-date fund by default.

The Big Picture
These numbers could not have been achieved without the support of the academics. The early argument against target-date funds--or any other version of one-stop shopping--was that they oversimplified the investment process. Financial advisors ask many questions of customers to ensure that their recommendations are appropriate. Target-date funds ask only about age. Surely, that is insufficient. What suits one 40-year old may be a poor fit for another.

The professors responded in a fashion that mutual fund companies could not, by replying, "It doesn't matter."

Fund managers make their living by emphasizing the importance of the investment decision. They attract and retain customers by emphasizing relatively small performance advantages. It is therefore difficult for them to argue that sometimes the forest cannot be seen because of the leaves. It may well be better for a 401(k) participant to own an imperfect fund than not possess any fund at all--but who are fund companies to make that claim? They, after all, are the people who sell perfection.

But the professors do not sell perfection. In addition, their reputations protect them from being shrugged off as naive. If others were to claim that the investment argument is overstated, and that what matters most to prospective 401(k) owners is not suitability, but instead the mere act of participation, they would be criticized for being amateurs. They underrate the importance of the investment decision because they do not fully understand investments. However, people do not say such things of Wharton or Stanford business-school faculty.

Academics, of course, were also the right party to promote automatic-default programs. It would be self-serving for fund companies to make that argument. They could avoid such criticism by hiring outside consultants to study the issue, and to make recommendations, but the suspicion would remain that the consultants arrived at the conclusion they were paid to reach. Once again, academics are protected by their brand. By and large, their research is regarded as being independent and trustworthy.

Wrapping Up
In summary, target-date funds would not have become behemoths without academic support. That target-date funds outdueled their competitors, target-risk funds (that is, funds that possess different percentages of stocks, and carry such labels as "Growth," "Moderate," and "Conservative"), is a money-management achievement. Rightly or not, target-date funds came to be viewed as the better investment. But the extraordinary sales growth of target-date funds, as outlined in Vanguard's 2018 report, came about because of the professors. Without their involvement, the 401(k) industry would look more like I had envisioned.

Which, I confess, would not be a good thing. That was one prediction where I am delighted to have been wrong.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.