Target date funds to capture 63% of 401(k) contributions by 2018

Risk management, asset allocation features appeal to younger investors, study finds

Mar 26, 2014 @ 1:36 pm

By Carl O'Donnell

The popularity of target date funds continues to gain momentum and will soon absorb the majority of 401(k) contribution, according to a study released Wednesday.

By the year 2018, target date funds will attract 63.4% of 401(k) contributions, and will constitute 35% of total 401(k) assets, the Cerulli Associates Inc. study predicts.

"Asset managers must have a strategy in place to grow target-date assets; otherwise they risk irrelevance in the defined-contribution market," the report said.

(See also: Advisers' role in target date funds grows more complex.)

Target date funds' most appealing characteristic by far is risk management and asset allocation expertise, according to Cerulli.

This feature was cited as a very important quality by 84% of more than asset managers surveyed by Cerulli in the fourth quarter as part of the report. Meanwhile, 42% mentioned the funds' diversity of asset classes.

“The funds let you choose a portfolio that matches your retirement date, and adjusts the portfolio allocation over time so that you always have the appropriate level of risk,” said Wyatt Lee, a vice president at T. Rowe Price Group Inc. “This solves some of the constant mistakes that investors often make on their own.”

These funds, which automatically re-balance to maintain a risk profile that is consistent with a particular target date for withdrawals, such as retirement age, have been growing at a remarkable clip in recent years. In 2005, target date funds held less than $100 billion in total assets. After several years of double-digit growth — in some cases as high as nearly 50% annually — target date funds reached more than $500 billion in assets as of 2013, according to a report by Morningstar Inc.

“The bulk of [inflows] are attributable to [the] Pension Protection Act of 2006, which allows employers to automatically enroll eligible employees in their 401(k) plans and direct the participants' contributions to target date funds,” said Scott B. Smith, a director at Cerulli Associates, in an email.

Target date funds that track indexes are increasingly becoming the norm. Assets in such funds grew to 32% of all target date fund assets last year, from less than 4% in 2003, according to the Cerulli report.

“Passively managed funds often offer lower expense ratios than actively managed funds,” Mr. Lee said. “Many plan sponsors are choosing passive funds to minimize plan costs for participants.”

STAND-ALONE FUNDS SUFFER

The biggest purveyors of target date funds include Fidelity Investments, T. Rowe Price, The Vanguard Group Inc. and BlackRock Inc.

(See how BlackRock is getting into the retirement business.)

The growth of these funds is coming at the expense of other investment options. For example, stand-alone funds, which offer investment options tailored to employer's preferences, are expected to see declining market share in the future.

Stand-alone funds are most popular among an older demographic. As these investors make withdrawals for retirement, total assets in stand-alone funds will shrink.

“Stand-alone funds will remain popular among investors who want more control over their portfolios,” Mr. Lee said. “We still see about 20-25% of assets from new 401(k) business going into stand-alone funds.”

Target date funds, meanwhile, are the preferred choice among younger workers. The average allocation to target date funds of those in their 20s is 34.2%, compared with 12.5% for those in their 60s, the report said.

Asset managers would do well to heed these trends. Gaining a share of the defined-contribution market means commanding a reliable source of assets that actually grows faster during economic downturns. This is because people are less likely to withdraw from 401(k) plans when assets are undervalued. Meanwhile, contributions, which are based on income, tend to remain flat, the study said.

"Asset managers with a DC business based solely on stand-alone options are less likely to experience this benefit as much in the future, as contributions continue to shift from stand-alone investments to target date funds," the report said.

(An earlier version of this story misstated the amount of assets in target date funds in 2005 and as of 2013. It should be $100 billion, not $100 million, in 2005 and more than $500 billion, not more than $500 million, as of 2013.)

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