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401k Plan Sponsor Lament: Are Target Date Funds the Edsel of the Mutual Fund Industry?

September 13
00:41 2010

(This is the first in a series of five articles on Target Date Funds)

How do you solve a problem like Target Date Funds? At a recent education seminar for ERISA plan sponsors, a 401k fiduciary lamented, “With the best interests of the beneficiaries in mind, I put Target Date Funds in our 401k plan in 138935_2978_Edsel_Ford_streetsign_stock_xchng_royalty_free_3002008. Now I’m finding out they’re not what they promised. I selected the Target Date Funds from a well known mutual fund company to reduce my fiduciary liability. Are you telling me this actually raises my fiduciary liability?”

This is a real, front-line concern among 401k plan sponsors. What’s more, it’s not a new concern. Shortly after the Department of Labor (DOL) declared Target Date Funds (TDFs) acceptable default options for 401k plans using automatic enrollment, a panel of industry experts convened at the September 2008 Art of Indexing conference in Washington D.C. to discuss the fiduciary implications of the new rule. When asked by an attendee if the DOL’s seal of approval meant a substantial reduction in personal fiduciary liability, the panel merely looked at each other and laughed. Their consensus: rather than decreasing personal fiduciary liability, given the lack of track record, TDFs may in fact increase fiduciary liability.

The promise of simplicity has driven millions of dollars in new assets to these untested products. According to Vanguard (“How America Saves 2010: A Report on Vanguard 2009 Defined Contribution Plan Data,” Vanguard, September 2010), the percentage of plans offering TDFs skyrocketed from 13% in 2004 to 75% in 2009. Increased use of TDFs has been spurred primarily by the Qualified Default Investment Alternative (QDIA) regulations promulgated under the Pension Protection Act of 2006. Vanguard reports half of their DC plans have designated a QDIA and, of those, 80% have selected a target-date fund as their default option (compared to only 20% having selected a balanced fund as their default investment. Furthermore, the percentage of contributions allocated to TDFs increased from 12% in 2004 to 42% in 2009.

But problems abound with TDFs. The market crash in 2008 exposed some of the most obvious issues surrounded this nescient product. As the table below shows, the variability of performance within similar TDFs, however, remains a sticking point. The acute variance in returns raises a question if the “Date” in TDF names means nothing more than “growth” or “value” in other mutual fund names.

YTD Return Dispersion of 2026-2030 TDFs_550

While the average Year-to-Date return of the 2026-2030 class is 1.64%, we see return extremes ranging from a gain of 7.65% to a loss of 0.66% (source: Morningstar). Compare this to the range of YTD returns for S&P 500 index funds: A gain of 1.08% to a loss of 0.56% with an average return of 0.50% (source: Lipper). The type of large dispersion seen in this popular class of TDF ought to give the typical plan fiduciary something to worry about. What causes it? Are there clues to identify poorer performers before it’s too late for the participants? Are these funds, although nominally all in the same class, really comparable? Or are we comparing apples to oranges? “A ‘to’ fund and a ‘through’ fund are as different as a “conservative fund” and an “aggressive fund”, so a straight up comparison is basically useless,” says Ryan Alfred, Co-Founder and President of BrightScope Inc.

This week, Fiduciary News will run a series of reports spotlighting the mystique, misery and mayhem wrought forth by a mutual fund product that may soon rival index funds in sizzle. We’ll break things down into four easy-to-swallow articles:

Fiduciary News sought the opinion of various industry leaders and we’ve included their thoughts in these reports. Feel free to add your own comments.

If these stories interest you, you might also be interested in “Readers Select Top Fiduciary Stories of 2009: #8 The Fall of Target Date Funds,” (Fiduciary News, January 14, 2010).

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

1 Comment

  1. Larry Beeferman
    Larry Beeferman September 13, 15:14

    Given what you have written you might have an interest in the following:

    http://www.law.harvard.edu/programs/lwp/pensions/publications/occpapers/occasionalpaper6.pdf

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