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Target Date Funds: DOA or Just a False Start?

September 16
00:16 2010

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

Roger Wohlner says, “When they were introduced, Target Date Funds (TDFs) were touted as a no brainer investment. Much of the education presented by fund companies to 401k participants portrayed these funds as a place where 214091_2029_buffalo_bills_warming_up_stock_xchng_royalty_free_300participants can ‘set it and forget it.’ In my opinion, no such investment exists… It is incumbent upon plan sponsors to ‘look under the hood’ of these funds… Plan sponsors need to perform the same level of due diligence with the selection of TDFs as they would with any other investment choice.” (“Target Date Funds-A No Brainer?Chicago Financial Planner, August 10, 2010)

As the chart below shows, there’s no question the use of TDFs in 401k plans has exploded since the Department of Labor (DOL) endorsed them as a safe harbor for automatic enrollment plans. But, given all the controversy surrounding TDFs, was that endorsement premature?

Use_of_TDFs_in_Vanguard_DC_Plans

The Investment Company Institute, the mutual fund industry’s association, states one of the primary features of TDFs is “avoiding extreme asset allocations: Research shows that some young workers invest very conservatively, by allocating all or almost all of their accounts to fixed income investments, while some participants nearing retirement invest very aggressively, allocating all or almost all of their accounts to equity. Target date funds follow professionally designed asset allocation models to eliminate such extremes.” (“Frequently Asked Questions About Target Date Funds,” ICI, June 2009). Yet, the debacle of 2008 exposed major flaws in TDFs, many of which committed the same mistake of investing “very aggressively” near retirement the ICI claims they were designed specifically to avoid. (“Many Target-Date Funds Miss Their Mark,” U.S. News, November 14, 2008).

Clearly, TDFs still had a few bugs to work out when the DOL blessed them following the Pension Protection Act of 2006. In general, government, and the DOL in particular, has a fairly poor record when it comes to investment guidance. (e.g., just earlier this year the DOL was caught unintentionally advocating index funds – just when evidence was beginning to show these products didn’t necessarily perform as advertised. See “3 Terrible Problems the New DOL Investment Advice Rule Poses to the 401k Fiduciary,” Fiduciary News, April 6, 2010). Fiduciary News asked industry leaders if they felt the DOL too quick to embrace these untested products.

“Many participants were shocked by their 2010 fund’s performance in 2008/2009, as they expected it to be much less aggressive than it was,” says Chad Griffeth, Co-Founder of BeManaged. He adds, “A participant’s expectation and these funds’ goal are often quite different in our experience.” Laura Lutton, Editorial Director, Fund Research Group at Morningstar, Inc., admits “There’s room for improvement with many target-date series, but overall, I’d much rather see a DC plan participant default into a target-date fund rather than other traditional defaults, like a stable value fund or a money market fund.”

And therein lies the dilemma. As the ICI note indicates, TDFs primary function serves to take long-term investors out of short-term investments and place them into more appropriate long-term investments.

Alas, we all know that old adage about good intentions.

Ryan Alfred, Co-Founder and President of BrightScope Inc., is upfront about the issues confronting TDFs but offers a ray of hope when he says, “I think the fast early adoption of the product is due in part to the regulatory ‘safe harbor’ offered by the DOL, but also because investors do want simple solutions.” Alfred prefers to think of this as a “false start.” “We jumped off the line before the snap, but I think the industry is iterating rapidly. It is a competitive marketplace and better solutions will come quickly.”

And maybe the marketplace is the only place we can count on. This summer, after a series of congressional hearings in the spring, the SEC asked the public to comment on TDFs. During the 60-day comment period, the SEC received only 44 comments – and this includes comments from lawmakers apparently miffed nobody heard them in their hearings. Industry professionals believe the concept of TDFs remains sound, but acknowledge problems exist. The race is on, then, between finding an adequate solution for TDFs and one sudden market cataclysm that spurs a slew of fiduciary liability lawsuits.

For the time being, Griffeth spells out the reality for today’s 401k fiduciary. He says “Clarifying the goal, fees and risk levels of these funds to participants is a great step, but we cannot expect investment behavior to change overnight. TDFs are a great tool, but definitely not an end-all, be-all for plan sponsors to ‘fix’ participant asset allocation.”

Do have your own thoughts on the long-term viability of 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.

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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