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A Hidden Fiduciary Liability for Plan Sponsors: The Five Most Critical Problems with Target Date Funds

September 14
00:01 2010

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

Five vital signs have contributed to this disease currently infecting Target Date Funds (TDFs): an overall lack of sense on the part of plan participants, including the typical 401k fiduciary, of what these products really represent. Chad Griffeth, 1099993_29232371_medical_monitor_stock_xchng_royalty_free_300Co-Founder of BeManaged tells Fiduciary News “the biggest misunderstanding we see from a participant level is understanding the goal of the fund.” This vast unknown has perhaps created a new fiduciary liability where none previously existed. Worse, as Ryan Alfred, Co-Founder and President of BrightScope Inc., says, plan sponsors have little selection choice.  “Based on our research the vast majority of sponsors end up with the proprietary fund of their recordkeeper. Target date funds have many moving parts and are not a one size fits all solution. Without choice, all the other problems of target date funds are compounded.” This lack of comprehension and lack of choice can cause the 401k  plan fiduciary to fail to ask the right questions. And that lurking liability can spell trouble.

  1. Biggest problem – TDFs haven’t performed as advertised: On January 15, 2008, “PT” of wrote this in his blog: “I just moved my entire 401K balance (even the portion I had rolled over from my previous job) to one fund: the Schwab Managed Ret Trust 2040 Class III. Yes, I sold out to the ease of the target date fund. I’ll no longer need to bother with the investment mix inside my 401K (assuming the fund maintains a decent return)… Lastly, the fund’s performance over the past 1, 3, and 5 year periods are 13.74%, 14.21%, and 15.38%, respectively. All these are right up there or better than the benchmarks and category averages. I’d be happy with those returns for the next 30 years!” (“Target Date Funds: I Just Rebalanced My 401K For the Last Time! …maybe,” January 15, 2008) In the three years since PT bought this fund, its average annual LOSS through 8/31/10 has been 5.41%! (Source: Yahoo:Finance). To be fair, this 2040 fund is a long-term fund and Lipper still ranks it in the top quintile for its class. The real issue comes with the 2010 funds bought at the same time. These supposedly safe funds have lost an average of 0.91% annually over the last three years – and the worst ones have lost nearly 10%! (Source: Lipper). No wonder why there’s talk of requiring 401k plans offer annuities.
  2. Names that Confuse (by Emphasizing “Date”): Laura Lutton, Editorial Director, Fund Research Group at Morningstar, Inc., in her letter to the SEC on TDFs, writes that too much emphasis on the date perhaps gives a “mistaken impression to investors.” She further tells Fiduciary News, “It’s important that investors understand how a target-date fund’s assets shift over the entire life of the investment.” The CFA Institute says portfolio managers, among other things, need to assess a client’s time horizon and return requirement in determining an investment strategy. TDFs certainly have the “time” element down, but that leaves the return requirement hanging out there in limbo. Does the TDF’s date imply a certain return? Most definitely not – it simply can’t. Truth be told, the date can mislead. People with the same retirement date, but with different assets and/or different life expectancies, will almost assuredly have a different return requirement. Whose job is it to tell this to the plan participant?
  3. Inadequate Disclosure or Lack of Transparency: Rich Lynch, COO of fi360, says “the underlying make-up of the funds with similar names is different. This results in either inadequate disclosure or a lack of understanding on the part of investors.” As we saw from the table in the first article in this series (“401k Plan Sponsor Lament: Are Target Date Funds the Edsel of the Mutual Fund Industry?Fiduciary News, September 14, 2010), not all 2030 funds perform the same way. Why not? There could be two reasons. First, the underlying assets of the TDF (usually mutual funds) could have different performance attributes. Second, the allocation among the underlying classes of TDF assets may be (and probably is) different. Does one 2030 fund have more international exposure than another? How about technology exposure? It’s currently difficult to answer these kinds of questions because TDFs only report the breakdown of the underlying funds, not the individual securities within these funds. “Transparency is a big issue on two levels,” adds Morningstar’s Lutton. Because asset allocation shifts are such a new concept, she says investors “need the tools to clearly understand how a target-date fund works” while plan fiduciaries “need to be able to fairly and accurately compare a number of target-date series on behalf of their clients.” She feels current disclosure requirements make this very difficult.
  4. Unusual Fee Disclosures: Lynch says “I believe it’s true the underlying expense ratios are not including in the target date fund expense ratio. This is clearly an example of the improved disclosure that’s needed and should come out of the SEC’s review process.” Alfred, on the other hand, says “We have found that usually the TDF-level expense ratio does reflect the underlying expense ratios of underlying funds fairly well.” They’re both right. While TDFs report the expense ratio both in terms of the TDF itself and the underlying funds, aggregators like Morningstar, Yahoo, Lipper and the Wall Street Journal – sources the typical investor relies on – only report the TDFs expense ratio and do not include the expense ratios of the underlying funds. This is a common problem not just with TDFs, but with any fund of funds.
  5. Confusion over “To” or “Through” Glide Paths: We saved the best for last. This confusion stems from the previously mentioned emphasis on the date rather than the investor’s objective. For example, in using the 2030 date class, the date can imply two very different goals. Lynch describes the glide path problem – and the question of the date in particular – in this manner: “Is it the retirement date or the date with which distributions can begin?” In overly simplistic terms, here’s the glide path dilemma: If you retire on the date but don’t need the money until later, you’ll want a “through” glide path. If you need the money on the date advertised, you’ll want a “to” glide path. It’s often not clear which aspect of the glide path the TDF refers to. And how does one interpret different life expectancies into all this? Complicating matters, this theoretical problem compounds the more practical problems discussed earlier. Furthermore, Griffeth says there’s evidence investors don’t abide by their theoretical glide path anyway. Alfred just throws in the towel on this issue and says “the one big trend I am looking for is what I call ‘glide path agnosticism.’ Asset managers should focus on managing the investments and allow those investments to be plugged in to a glide path that fits the plan. I don’t know why they are in the ‘to’ vs. ‘through’ debate, they should leave that to the consultants and sponsors.”

If you’re a 401k Plan Sponsor or ERISA Fiduciary, you need to familiarize yourself with each of these problems. Each problem presents its own unique hidden fiduciary liability. Perhaps Alfred sums it up best when he says, “Plan sponsors who do their due diligence need to be able to select a target date fund that fits the needs of their participants.” Easy to say. Right now, without proper disclosure, without consistent definitions and with so many different expectations, it’s not so easy to accomplish.

Do have your own thoughts on the problems associated with TDFs? Please leave a comment below and share those ideas with others.

Like this article? You might be interested in reading other articles in this series.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


  1. Tim Wood
    Tim Wood September 14, 18:22


    Another great article. One other issue that I uncovered last fall is the density of junk bond holdings, especially in those funds marketed as “Retired” or Target 2010 where you would expect the funds to be the most conservative. I finally got Bloomberg to write a story about it in December last year.

    In some of the funds, the proportion of junk bonds as a percent of the overall bond portfolio was as high as 34% in the “Retired” funds. It is really reprehensible in my opinion.

  2. Roger Wohlner
    Roger Wohlner September 15, 07:51

    Great article/series. To expand on Tim’s comment, in some TDFs when you look under the hood you find a number of the underlying holdings are not top-flight funds. In fact in the case of one major player, I would contend that they use a number of both second-tier and newer funds in their TDFs in an effort to build assets in these funds.

  3. Brian E. Schaefer
    Brian E. Schaefer September 20, 10:45

    I think that much of this is simply the world of investing. A 2040 fund should have more stocks in it than a 2010 but what the optimal allocation is is subjective. There’s no formula to follow. As for an allocation to junk bonds in a 2010 fund, the prudent person rule long ago was modified to allow risky assets in a portfolio if there was proper diversification. And structuring a portfolio for retirement date or life expectancy? Ask any participant what their life expectancy is and what do you think you’ll get for an answer? Does anybody know their life expectancy? We’re in a bear market and both stocks and bonds will struggle for a while until the deleveraging abates. If we were in a bull market, we probably wouldn’t be having all this angst about TDFs.

  4. Aiden P. Hannan
    Aiden P. Hannan October 19, 11:39

    Great article – 1 clarification I’d like to make regarding the comment …” aggregators like Morningstar, Yahoo, Lipper and the Wall Street Journal – sources the typical investor relies on – only report the TDFs expense ratio and do not include the expense ratios of the underlying funds.” At least for financial professionals and those advising plans it is just a matter of knowing which of the Morningstar expense ratios to use to get the one that includes the underlying fund fees. Use the Prospectus Net Expense ratio for a target date fund to get the most accurate expense ratio.

  5. PaulKay
    PaulKay June 27, 14:06

    You’re absolutely correct about the hidden underlying expense ratios. My 401K offers target date funds. These funds all advertise an expense ratio of .1%. But provide no information on the expense ratios of the underlying funds. So the expense to rebalance the mix every year may be low, but who knows what they are charging to manage the underlying funds. My opinion is that this is intentional. There was pressure to provide expense disclosure, so the target date funds became a facade over the true expenses which remain hidden. Also, none of these funds have any reinvestment distributions, so you have to rely completely on share price growth. But there is no way to know what that share price growth is based on. It goes up and down with the market, but if the fund gets dividends from the underlying fund’s holdings, it isn’t passed along in the form of additional shares and there is no way to know if is reflected in share price growth.

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