Short Note USA Target Date Funds

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Short Note USA Target Date Funds
 				 Team 6: Alex, Afonso, Pirke
Description
In the US pension system target date funds (TDF) are a relatively recent addition to the 401(k) plans or more broadly to the private-sector defined contribution plans. A TDF consists of a multiple offerings with differing allocations across portfolios described by the expected year of retirement (if automatically enrolled this is generally at age 65) for the saver(i.e. investor/employee). TDFs thus aim to optimize asset growth for a specific time period. Furthermore a TDF offers savers two unique features; first its anticipated retirement year gives a recommendation to the investors as to what fund to choose, second risk levels are automatically rebalanced over time by fund managers. The latter signifies a gradual shift to a more conservative profile to minimize risk as the target date approaches.
Behavioural Economics
As mentioned previously TDFs are a relatively recent addition to the 401(k) plans yet have grown significantly over time. This is in part due to application of insights from behavioural economics to stimulate participation. Mitchell and Utkus find 3 distinct behavioural effects influencing adoption of TDFs (2020). First an active choice effect whereby new entrants in a voluntary plan have to make an active choice what to enrol in compared to the existing savers have to choose whether to switch. As one may expect taking into account procrastination the new entrants choose the TDF far more frequently then the existing savers switch. Furthermore there is a strong default effect, wherein new entrants in a auto-enrolment plan, thus being automatically enrolled for a TDF with the option to choose not to do so, have a far higher adoption, probably once again due to procrastination. Finally there is a default-related endorsement effect where the employers selection of the TDF as default influences existing employees willingness to switch funds. These effects signify the major impact of behavioural economics in the adoption of TDFs. As the funds are subsequently managed by professional funds managers other uses of behavioural economics are limited.
Strengths and Weaknesses
The shift toward TDFs does show some potential benefits. In no small part due to employers moving away form their own selection, which was the standard previously under 401(k) to an environment created by the target date fund manager and his employees. Potential benefits for the savers can be large as Mitchell and Utkus estimate the now improved returns could raise expected retirement wealth by up to 50 percent over a 30 year saving horizon. It is also great for savers who do not want to rethink their portfolio allocation as it serves as a one-off pick based on your retirement time. 
There are some significant drawbacks though. The TDF works based on expected retirement age, which can substantially differ from reality once you approach that age. There is also no guarantee of benefits received as it is not an annuity but a risk-bearing investment (although the amount of risk may vary depending on specific allocation of the funds).