It started on a cloudy Monday morning in Washington, D.C. With the temperature hovering just below freezing, the cold wintry mix would soon change to freezing rain. Perhaps the weather served as a metaphor for the quiet government report released 
that day. On January 31, 2011, the United States Government Accountability Office (GAO) release “Defined Contribution Plans: Key Information on Target Date Funds as Default Investments Should Be Provided to Plan Sponsors and Participants.” What began as a mixed reviews and three discreet recommendations led to a cavalcade of cold-hearted criticism.
What do the three recommendations tell us about the GAO’s overall confidence of Target Date Funds (TDFs)? According to its on-line summary, the GAO recommended:
- The Secretary of Labor should direct the Assistant Secretary of the Employee Benefits Security Administration to amend the qualified default investment alternatives (QDIA) regulations so that fiduciaries are required to document that they have considered, to the extent possible, whether other characteristics of plan participants, in addition to age or target retirement date, are relevant factors in choosing a QDIA.
- The Secretary of Labor should direct the Assistant Secretary of the Employee Benefits Security Administration to provide guidance to plan sponsors regarding the limitations of existing TDF benchmarks and the importance of considering the long-term TDF investment allocations and assumptions used in developing the TDF asset allocation strategy.
- The Secretary of Labor should direct the Assistant Secretary of the Employee Benefits Security Administration to, in its final regulation on target date disclosure, expand the requirement that plan sponsors provide information regarding key assumptions concerning contribution and withdrawal rates by requiring that participants receive a statement regarding the potential consequences of saving, withdrawing, or otherwise managing TDF assets in a way that differs from the assumptions on which the TDF is based.
If that doesn’t sound like a ringing endorsement for TDFs, then maybe now you understand the rather frozen response from financial writers. (For a Pre-GAO overview of how industry leaders feel about the DOL’s ideas on how to fix TDFs, see Fiduciary Checklist: Target Date Problems vs. DOL Proposed Rule, Fiduciary News, December 2, 2010.)
The GAO provides a litany of TDF problems but a study by a Georgia State doctoral student may have uncovered the answer to the cause of the problems. Karen Kroll writes (“What’s Mysterious about Target-Date Funds: Too Much,” CFOworld, March 4, 2011) of a 2010 research paper by Vallapuzha Sandhya of the J. Mack Robinson College of Business at the Georgia State University. “Agency Problems in Target-Date Funds” shows, while TDFs are while increasingly popular as a default option in 401k plans, they underperform balanced funds, a DOL sanctioned alternative default option. According to the paper’s abstract, “this under-performance is driven by TDFs having a fund-of-fund (FOF) structure that invests within the family, where the constituent funds have lower performance and higher expense ratios.” Furthermore, the paper questions the suitability of TDFs as a default option as “results suggest that under-performance of TDFs is driven by agency problems arising from lack of monitoring by participants, weaker incentives for fund managers to outperform peers, and private benefits to fund families – all structural matters too fundamental to the product to change without significantly changing the nature of the product.
Ironically, this little known paper may have uncovered the secret of the emperor’s new clothes far more effectively than the Wall Street Journal (“Targeting Fees in Target-Date Funds,” February 26, 2011), the New York Times (“Shifting Strategies for Target-Date Funds,” March 2, 2011) and even the GAO. The Wall Street Journal focuses on expense ratios, implying there’s a problem with higher fees. While it’s true, the paper fails to explain it’s true only because TDFs are primarily index funds (actively managed funds often more than justify higher expense ratios) and it fails to explain the compounding of fees caused in a fund of funds situation. The New York Times article, after correctly pointing out the TDFs’ performance problem of 2008, ironically suggests a shift towards less liquid assets may solve the problem of volatility (for those who don’t understand the irony, read “How the Harvard and Yale endowment models changed to avoid a repeat of 2009,” RIABiz, February 15, 2011).
Which leaves us with the dear old GAO. In its write up, the GAO was shocked, simply shocked to discover the broad variance in return among funds. According to the report, “between 2005 and 2009 annualized TDF returns for the largest funds with 5 years of returns ranged from +28 percent to -31 percent.” Gentleman, welcome to the world of mutual funds, where variations in investment performance come with the territory. Granted, had the GAO explained better, it might have suggested such a wide variation would not be expected between index funds (although, again, such variation does exist in the real world). Finally, while the GAO provides an expense ratio example showing the fund with the highest expense ratio (1.71%) is more than nine times more than the fund with the smallest expense ratio (0.19%), it fails to explain that lower expense ratios do not necessarily guarantee higher returns.
Alas, pundits can opine forever on the nature of the problems of TDFs. But, why speculate on what can be done to fix the too broke TDFs when there’s already a completely acceptable alternative like balanced funds? Proper due diligence suggests it’s wise not to look the other way when the naked emperor walks by. Or, like the Index Fund industry before it, is the TDF industry now, like James Dean’s character in Giant, too big to kill?
Good post Chris. As you and I have discussed in the past, TDFs are a good idea, the implementation has not been what it should be. My personal and professional bias says that participants need access to direct investment and retirement advice in the workplace delivered by unbiased, unconflicted fee-only advisors.
What has been the range of returns on balanced funds during the same 2005 – 2009 period? What are the ranges of expense ratios on balanced funds as well?
I will be presenting on this very subject at the World Series of ETF’s the 29th in Boston. The problem with TDF is they are premised on knowing what the low risk assets are and allocating more to them the closer to the date. However, how does anyone really know where the risks lie at any given time? We saw some money markets break the buck in 2008. That same year, some 2010 funds lost a third or more of their value. I personally prefer Asset Allocation funds, especially as a QDIA.
KISS is good. I’ve written a commentary on precisely this necessity, at http://www.targetdatesolutions.com/pdf-source/Primer.pdf. Target date funds are reasonably good ideas that have been contaminated by the greed of the providers. There is a better way, but fiduciaries need to take the time to look at it..