Are target-date funds (TDFs) serving the needs of their participants? To answer this question, JP Morgan Asset Management carried out research comparing participants' behaviour with the common industry assumptions that inform TDF design. The conclusion is that the latter should be more conservative than experts might think.

"Target date funds have changed during the last five years," says Anne Lester, JP Morgan Asset Management's senior portfolio manager responsible for defined contribution (DC) asset allocation products, including the SmartRetirement target-date funds. The firm's DC business has $50.6bn (€39.2bn) in assets.

TDFs become popular after the US Department of Labor endorsed them in the Pension Protection Act of 2006 as ‘qualified default investment alternatives' for all 401(k) plans. Now they have over $270bn in assets.

"We did our first examination of TDFs in 2008 and told our clients to think about what they want, to understand how participants behave with their savings, how often and how much they contribute to their DC plan and how much they withdraw after retiring," says Lester.

Many TDFs have an aggressive asset allocation when the retirement date is reached, because the managers believe that the assets will be kept in the funds as long as the participants live, or until they are 90 years old, and so they need more equities to get extra returns. "In theory this is true; but if individuals withdraw their savings, that strategy only gets extra volatility," says Lester.

"In an update of our research we focused on individuals that defaulted in TDFs in order to see if they behaved differently from the average." The default group generally has lower salaries ($35,000 per year compared with the average $38,000); their contribution rates start too low (5% versus the average 5.8%) and remain below industry expectations during working life; they have less borrowing outstanding in any given year (13% of them have loans versus 17% of all participants); and after they reach age 59.5 they withdraw less money from their accounts. But like all 401(k) members, the majority (80%) of defaulted participants withdraw their entire account balances within just three years of entering retirement. "They usually roll them over to individual retirement accounts but, anyway, that makes it inappropriate to have high volatility in a TDF close to the retirement date," Lester points out. "If a participant suffers serious losses in a stock market downturn, as in 2008-09, he won't be able to recover them."

A US Congress and regulators investigation into TDFs said that many participants could not understand how they work. The US Department of Labor has issued new rules on transparency and disclosure about TDF design, and has attempted to create more common disclosure language to make comparing products easier.

"We ensure that plan sponsors clarify the level of risk they want to have when the funds reach the retirement age, paying attention to the behaviour of their participants, which varies according to the specific demography and culture of each company," says Lester. "Key factors are how much participants save and how quickly they withdraw money after retiring. Besides, some plan sponsors try to retain 401(k) assets, because they feel it's part of their ‘paternal' obligation to keep taking care of their employees' savings or because a larger pool of assets means lower fees. Other sponsors require their employees to withdraw all the money when they retire."

JP Morgan uses its Target Date Compass to help sponsors articulate their strategy for maximising return and minimising risk, as well as to match their goals with the appropriate type of TDF. The tool, created by Lipper, analyses the TDF according to two variables: the level of the stocks in the glide path at age 65, which is a proxy for volatility, and the number of individual asset classes used, which is a proxy for efficiency. "We update our research every two years and it's possible that the TDF design will change the behaviour of participants," adds Lester.