For the past decade, the conventional wisdom in the defined contribution industry was that investors in target date funds (TDFs) typically do not respond to market volatility by trading into or out of their TDFs. Because of this investor “inertia,” to use the term of art favored by those in the DC space, any losses suffered by TDF investors during challenging markets usually were “paper” losses, which could be recouped as the markets recovered.
As it turns out, plan participants in TDF funds (the default investments for many defined contribution investors) are not as passive when market volatility spikes as they are believed to be. Research I conducted with my PGIM colleague, Ashley DiMayorca, reveals that when stock prices plummeted during the Global Financial Crisis and at the beginning of the COVID-19 recession, older TDF investors did, indeed, sell out of their funds. In doing so they suffered actual losses, impairing their chances of recovery and threatening a successful retirement outcome.
Dispelling the Myth of Investor Inertia
The market sell-offs during the Global Financial Crisis and the COVID-19 pandemic provided windows into the behavior of TDF investors. In 2008, the vintage closest to its target retirement date was the 2010 Fund. According to Morningstar data, net flows in 2000-2010 funds averaged a positive $1.4 billion per quarter in the eight quarters prior to the market sell-off in October 2008. However, when the market dropped by 29% in the fourth quarter of 2008, outflows spiked. Net flows plummeted $785 million in the fourth quarter and $414 million in the first quarter 2009 before turning positive once again.1
More than a decade later, TDF investors ran to the exits again when the COVID-19 pandemic led the S&P 500 to drop by 34% in less than six weeks. As participants in 2020 funds were beginning to retire, net flows had been modestly negative in the eight quarters prior to the COVID-19-led market decline, averaging $1.6 billion in net outflows per quarter. However, when pandemic fears led the market to sell off in late February, TDF net outflows intensified, more than quadrupling to $6.6 billion in the first quarter of 2020.
Even more surprising was that many TDF investors who were still up to 10 years away from their target retirement date also pulled the plug on their TDFs in the market correction. Net flows for vintages five to 10 years before their target date are generally positive. But in the first quarter of 2020, net outflows were recorded in the 2025 and 2030 vintages (which likely encompasses investors around 53 years old and up). For example, 2025 Fund net flows had been consistently positive, but in the first quarter of 2020, they turned steeply negative with net outflows of $2.1 billion. (a turnaround of $5 billion from the previous quarter)
Trading Out of Fear and Necessity
While no one can say for sure why TDF investors traded out of their funds during the GFC and the COVID-19 pandemic, it is likely many of them exited their investments for the same reasons other investors trade out of theirs when markets are volatile. One of them is anxiety. Fearing further losses, investors often swap equity-heavy investments for those that historically are less vulnerable to market volatility. This appears to have been the case with TDF investors at the start of the COVID-19 pandemic. According to Alight Solutions, in February and March of 2020, 401(k) plan participants sold out of TDFs and traded into bond, stable value, and money market funds, with 64% of total inflows going into stable value funds in March.
Another reason plan participants may trade out of their TDF investments is that the economy leaves them little choice. Unemployment spiked during the recessions precipitated by the GFC and the COVID-19 pandemic. Unfortunately, financial hardship often prompts many plan participants to tap their 401(k) plans to augment unemployment benefits. Older participants may find it particularly difficult to find jobs during periods of high unemployment, prompting them to leave the labor force and draw upon their retirement plans.
Whatever the reason for selling out of their target date funds, participants tend to pay a high price for doing so. Data shows these individuals not only “abandoned ship” when returns waned, many did not move back into TDFs as the markets recovered. This reduced the value of their retirement holdings which results in even gloomier retirement scenarios. The reduction in their retirement funds means some investors will see a precipitous drop in their income during their retirement years. Others might deplete their retirement funds altogether.
The myth of TDF investor inertia has had a profound impact on the managers of target date funds. Operating under the assumption that losses suffered by TDF investors were paper losses that could be recovered during benign markets, many fund managers upped their allocations to equities to a level that may not be prudent, particularly for older participants. A higher allocation to equities has the potential to deliver better returns (with all that entails for the growth of retirement assets), but it also may generate large losses that prompt TDF investors to trade out of their funds at inopportune times. Contrary to popular belief, these losses may not be easily recouped, potentially leaving investors without the funds they need to enjoy a fulfilling retirement.
Given the role TDFs play in realizing the goals of retirement investors (TDFs had $2 trillion in assets and accounted for 65% of DC participant-directed contributions in 2019),2 it behooves retirement plan fiduciaries to carefully consider the behavior of TDF participants when structuring their defined contribution plans. TDF investors make the same mistakes as investors in general. They trade out of higher-risk investments when asset values plunge, generating real losses that may not be fully recouped. As such, meeting the needs of plan participants may begin by recognizing that they are not stoic in the face of market dislocations and that less aggressive TDF series that offer more downside protection may be in the best interests of plan participants, especially those who are approaching retirement.
All mentions of defined contribution (DC) plans and DC plan participants refer to qualified US retirement plans and account holders in US defined contribution plans, respectively. Target date funds (TDFs) are predominantly a US investment vehicle and are not readily available outside of the United States.
1 Source: Morningstar Direct as of Mar 31, 2020.
2 Source: Morningstar Direct and Cerulli Associates.