Clearly the Department of Labor (DOL) might have benefited from a longer engagement before rushing into marriage with Target Date Funds (“TDFs”) when the regulator ordained them in 2006 as one of three acceptable default options 
for 401k plans. The market crash of 2008-2009 proved, at least in the minds of many 401k investors, these heavily marketed mutual funds weren’t up to the task. While Congress held hearings, the SEC stepped into the fray with its own review. As they did with the term “Fiduciary,” the DOL has again jumped the gun on the SEC (whose report we’re still waiting for). In anticipation of the implementation of the finalized Fee Disclosure Rules issued earlier this year, the Department has now proposed a new set of disclosure rules pertaining to TDFs.
The inventory of allegations against target date funds has been well documented. Plan sponsors, their advisers, as well as all 401k participants and fiduciaries have only one question: How do the DOL’s proposed rules stack up against this checklist of charges?
Let’s review the litany of complaints against TDFs and see how the DOL addressed them and whether the proposed DOL rules actually create more worrisome fiduciary troubles. A few months ago, we outlined the five biggest concerns with TDFs (“A Hidden Fiduciary Liability for Plan Sponsors: The Five Most Critical Problems with Target Date Funds,” Fiduciary News, September 14, 2010). How do the proposed regulations by the DOL address these challenges?
Issue #1 – What’s inside your TDF? Roger Wohlner, CFP® summarized the issue earlier this year when he told Fiduciary News “The fact that there is such disparity between the holdings of various target funds with the same target year (say 2010 for instance) is a problem.” (“Readers Select Top Fiduciary Stories of 2009: #8 The Fall of Target Date Funds,” Fiduciary News, January 14, 2010)
DOL Response: The DOL’s proposed regs do try to address this issue by requiring the asset allocation description “must satisfy three requirements. The first is an explanation of the asset allocation, how the asset allocation will change over time, and the point in time when the investment will reach its most conservative asset allocation, including a chart, table, or other graphical representation that illustrates such change in asset allocation over time and that does not obscure or impede a participant’s or beneficiary’s understanding of the information explained pursuant to this requirement.” (“EBSA Proposed Rules: Target Date Disclosure,” Department of Labor, November 30, 2010)
Potential Fiduciary SNAFU: One cannot predict an appropriate asset allocation over time, even based on the age of the investor. The interest rate and investment environments all impact the exact nature of one’s asset allocation. The correct asset allocation is just as much a function of the economic cycle (a.k.a. “time”) as it is a function of a beneficiary’s age. The DOL’s proposed rule may be opening up a huge fiduciary liability. For example, once a TDF shows how the asset allocation will change over time, who will assume the liability for failing to change the projected asset allocation to one more appropriate given changing market conditions? Will the fund be bound to this “promised” asset allocation knowing it might not be in the best interests of the investors? Will the plan sponsor be held liable for failing to properly warn employees the “promised” asset allocation may be inappropriate at some unknown future time? Finally, if the DOL allows the TDF to change its “promised” asset allocation, what’s the point of the requirement?
Issue #2 – What’s the meaning of “glide path”? Compounding the issue was the interpretive meaning of the TDF’s glide path. Does the “2030” of a 2030 TDF mean the investor is retiring in 2030 or intends to exhaust their savings in 2030? Many actuaries might suggest the difference between retiring and exhausting your savings might be 30 years.
DOL Response: Buried deep within their proposal lie only two references to the term “glide path.” The first as a citation of an Investment Company Institute report issues in 2009 (and therefore not part of the proposed rules). The second appears in this sentence: “The TDF disclosures would foster a better understanding of how TDFs operate and the glide path that is associated with each fund.” The reader (and the fiduciary and the employee investor) is left to interpret the tea leaves of the rules. Sorry, folks. That’s all there is.
Potential Fiduciary SNAFU: Ignoring the fact the typical employee doesn’t know a glide path from a slide rule, there’s too much left unsaid in the new rules to offer any reasonable protection regarding the glide path issue. For example, does “the point in time when the investment will reach its most conservative asset allocation” mean when the employee retires, when he exhausts his savings or when he dies (all three may happen in different years)? Who’s left holding the fiduciary liability when the employee misinterprets this?
Issue #3 – What does my age have to do with the amount of money I need to have before I retire? The issue of glide path rises because TDFs themselves have a year as part of their name. Most financial advisers already know a person’s age is only one factor in determine an appropriate investment strategy. It’s often the least relevant number. There is one number, though, that stands at as most important: the Goal-Oriented Target (“GOT”). The CFA Institute calls this the “return requirement” and, in fact, the GOT represents the specific return requirement for a particular goal. In this case, the goal is retirement, and the GOT is based on a number of factors including existing assets, annual contributions, years to retirement and expected retirement expenses. Notice how only one of these factors includes the term “year” and it does not necessarily mean the investor’s “age.”
DOL Response: Alas, the DOL punted the ball on this perhaps most critical issue.
Potential Fiduciary SNAFU: Failing to address this issue leaves the fiduciary liability in limbo. TDFs remain a default option, so one would presume plan sponsors continue to fall under a safe harbor umbrella until a change in political winds say they can’t. This doesn’t help the investors, but at least it apparently doesn’t hurt the fiduciary.
Issue #4 – Do the fees add up? One of the most nagging problems dealt with how to uniformly compare fees among TDFs. Since most TDFs invest in other funds, they are “funds of funds” and therefore have two expense ratios: 1) the standard mutual fund expense ratio; and 2) the expense ratios of all the underlying assets.
DOL Response: The DOL tries to be exhaustive when it stipulates “the description must include the investment’s attendant fees and expenses, including: Any fees charged directly against the amount invested in connection with acquisition, sale, transfer of, or withdrawal (e.g., sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees, and purchase fees); any annual operating expenses (e.g., expense ratio); and any ongoing expenses in addition to annual operating expenses (e.g., mortality and expense fees).” This is the only relevant reference to the term “expense ratio.”
Potential Fiduciary SNAFU: The proposed regs do not address the expense ratios of the underlying assets. In many cases – and one of the reasons funds of funds were outlawed for such a long time – the inclusion of other mutual funds within a mutual fund can cause an extra layer of regulatory fees that can easily be avoided by direct investment into equity and fixed income securities.
Issue #5 – How’s that performance workin’ out for ya? This remains the million dollar question – no pun intended! With so much emphasis on the “theory” of target date funds, fund companies have conveniently avoided the big issue coming out of 2008 – these funds have a very dispersed performance record (see “401k Plan Sponsor Lament: Are Target Date Funds the Edsel of the Mutual Fund Industry?” Fiduciary News, September 13, 2010).
DOL Response: The only mention of investment performance is in the requirement that “the description must include the investment’s historical performance data (e.g., 1-, 5-, and 10-year returns).”
Potential Fiduciary SNAFU: The proposed rule makes the same “snapshot-in-time” error as the final fee disclosure rule. We can’t fault the DOL for this because the SEC memorialized the trend started by (rather astute) financial marketers decades ago who discovered a way to hide poor performance periods. Unfortunately, a body of academic evidence exists which dates back at least two decades suggesting the “snapshot-in-time” framing of investment performance can cause investors to make inappropriate decisions. It is not known if the DOL consulted with these researchers prior to drafting these rules.
Plans sponsors and fiduciaries haven’t had much time to absorb these proposed rules. Advisers, who have to work with these guidelines during the normal course of their business, have been more quick to comment on them.
“I think the DOL proposals are non-events, since they call for disclosures that should already be in all prospectuses and factsheets,” says Ronald J. Surz, President & CEO, PPCA, Inc, who perhaps best sums up the increasingly cynical attitude of financial professionals (and even some academics) who’ve all too often seen regulators and large financial institutions (or their industry association proxies) work in league to produce meaningless regulations. Surz elaborates his specific concern when he says “Where are the investment policy statements for target date funds, which are after all employer directed because the participant is either defaulted into them or limited to the choice made by the employer. Even more importantly, who is driving this bus when it comes to establishing objectives? So far fund companies have set objectives that bear no relationship to a one-size-fits-all vehicle, namely pay replacement and longevity risk.”
That said, Surz holds out hope the forthcoming SEC proposals may help the situation, “I think these have the potential to improve target date funds.”
So, why doesn’t the DOL just admit the marriage was a mistake and scrap the whole mess?
Fiduciary News asked BrightScope, Inc. Co-Founder Mike Alfred this same question last year and his answer remains as true today as it did then: “I don’t see the DOL taking it off its approved list because there’s too much money involved. Target Date Funds are the fastest growing product within the 401k market and it will only get bigger. There is too much vested interest in Target Date Funds for the DOL to remove them without seriously disrupting things.” (“Exclusive Interview with BrightScope, Inc. Co-Founder Mike Alfred on Rating Target Date Funds,” Fiduciary News, November 10, 2009)
Good article. I used to work for DOL. What can I say???? It reminds me of a joke about regulators. A man was in a hot air balloon and he was lost. He yelled down to two regulators that he saw beneath him, “where am I?” They answered, “You are in a balloon.” That is a typical regulatory answer–it is factual, states the obvious but it is absolutely useless.
It’s hard to believe that we’re almost two years down the road from when I wrote “Way Off Target.” (http://researchpuzzle.com/files/view/way-off-target.pdf) How far have we come?
The regulators messed up, sure, but how did fiduciaries and advisors bless the marriage and advocate the widespread use of target-date funds, not seeing past the marketing of the fund families to the realities of the structures?
Lynne & Tom, thanks for the quick comments.
Lynne: What do you think it would take for the DOL to actually do something substantial and meaningful?
Tom: I’m not sure fiduciaries and advisers “blessed” the marriage as much as just sit on their hands when the priest asked if anyone knew of any reason why this marriage should not occur.
Upon reflecting on your piece, it almost seems like the simple elegance of the traditional Conservative, Moderate, and Aggressive asset allocation fund approach might provide for a better solution. While not perfect, it would seem to alleviate issues #2-4 above.
The new DOL TDF proposed rule is irrelevant because participants dont have a choice between TDF fund families. The more significant proposal will come when EBSA advises employers on how to pick a TDF. EBSA is likely to fall down here too, but the real issue is requiring employers to compare TDFs (and all other investment options) — and not let them go along with the recordkeeper’s proprietary TDF.