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401(k) Challenges

What’s in Your 401k and Where Did It Come From?

Here's the history lesson all savers should read.

Articles by Katherine Buck

By Katherine Buck
  |  Published: July 16, 2013

In the 1980s, 401k plans gained popularity as an alternative workplace retirement benefit.

By 2008, 68 percent of 401k plans were offering target date funds as an option.

How did the target date fund in your 401k plan get there?  Your employer chose it for you.

Target date funds — a popular kind of investment vehicle — emerged almost 20 years ago in response to shifts that sought to satisfy the needs of employers.  Legislation encouraging adoption of target date funds was written with a view towards helping companies avoid complications and liabilities from offering workplace benefits.  For individuals, however, these funds may not always maximize the potential of their portfolios.

Here’s why: target date funds don’t tell you how much you need to save to have enough money to retire.  Rather, what they do is lock you into a step-down reduction of your risk as you approach retirement.  That means you are likely to be getting the lowest returns when you have the most money in the market.  Target date funds also use just one data point to put together an investment — the age at which an investor plans to retire.  The Center for Retirement Research at Boston College argues that more data could be used to make these “one-size-fits-all” funds a better option for retirement savers.  They leave you still needing a solution for other major expenses and financial goals, such as debt repayment or a grandchild’s education.

How did it all begin?

In the early 1980s, new legislation made traditional pension plans a potential liability for employers.  An underfunded pension plan would now look like “debt” on a company’s balance sheet.  As a result, newly created 401k plans — tax-deferred savings vehicles which place funding responsibility onto employees — gained popularity as an alternative workplace retirement benefit.

The shift quickly exposed a need for a new type of investment.  Employees were not only responsible for savings contributions, but now they also had the burden of choosing and managing the investments within their 401ks.  While some people enjoyed spending their free time researching and managing their investments, many Americans were unwilling and unqualified to do so.

Enter LifePath, the first widely-distributed target date fund, launched by Wells Fargo and Barclays in 1994.  LifePath funds were diversified portfolios made up of individual mutual funds, based on the notion of a “glidepath”, which gradually transitioned from risky assets to stable assets over time.  The glidepath ends at the “target date” — when an investor plans to retire, stop contributing, and start withdrawing funds.  It was an early, rudimentary implementation of “set it and forget it”, and a definite improvement over what had previously been available to retirement savers.

The other big retirement players, including Fidelity, T. Rowe, and Vanguard, soon followed suit with their own glidepath funds, and by 2008 68 percent of 401k plans were offering target date funds as an option.  Adoption benefited from the passage of the Pension Protection Act of 2006, which required employers to provide employees automatically enrolled in 401(k) plans with a default investment appropriate for long-term retirement savings (also called a Qualified Default Investment Alternative, or QDIA).  Target date funds met the QDIA requirements, and from 2006 to 2008 alone, the percentage of 401(k) plans offering target date funds increased by 25 percent.

Popular, but not the best option for everyone

By the end of the first quarter 2013, target date funds held more than $517 billion across all retirement accounts.  Target date funds are undeniably popular, and at one point, were a much-needed innovation.  They’ve helped a lot of people avoid improper asset allocation… or no asset allocation at all.  But much has changed since 1994, and the popularity of yesterday may no longer be the best we can do.

Betterment doesn’t offer target date funds.  We take the valuable innovations of those products and build upon them, using the latest technology and insights from behavioral finance.  “Set it and forget it” is still the mantra, but there’s more to consider that just a single planned retirement date.  Our technology takes a more personal approach.  Long-term savings goals come in a variety of shapes and sizes — a single umbrella term like “retirement” is too rigid and circumstances can always change.

A target date fund has no idea how much you need, so it can’t advise you on how to get there.  Unlike a target date fund, Betterment monitors your progress and if you’re off-track, our software can help you fix it.  This kind of sophisticated, personalized advice was recently only available from a pricey financial advisor, but in 2013, software can do what we never dreamed of in 1994.  Saving for a retirement is a huge, complex responsibility. Luckily, the tools available to investors are rapidly evolving, and, like Betterment’s technology, are accessible to everyone.

Now you know the history — what will you do with your future?

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