The Inconvenient Truth About Target Date Funds

July 31, 2009

The popularity of target date funds in 401(k) plans has soared in recent years. Unfortunately, the current recession has given a rude shock to anyone who thought target date funds were a panacea. As the markets headed south in 2008, most target date funds — even those aimed at employees nearing retirement — suffered heavy losses. The popular Fidelity Freedom 2010 Fund, for example, lost 30 percent of its value in 2008.

These losses, and the understandable anxiety they are provoking among 401(k) plan participants, have already drawn the attention of the federal government. On June 18, 2009, the Securities Exchange Commission and the Department of Labor held a joint hearing on target date funds. Experts testified on a variety of topics related to target date funds, including plan sponsor considerations, “glide paths,” selection, monitoring, disclosures and alternatives.

Boiled down to its essentials, the expert testimony provided a hard lesson for employers: prudently selecting a target date fund is actually more complicated for employers than selecting most other types of 401(k) investment options. Plan fiduciaries face difficult issues in evaluating glide paths, benchmarking performance, controlling fees, and, ultimately, judging the appropriateness for plan participants of a target date fund’s overall strategy.

The Basics

Target date funds are designed to give participants a complete retirement investment solution in a single fund. Participants choose a target date fund with a target date closest to their desired retirement age. The target date fund maintains a broadly diversified portfolio of stocks, bonds, cash and other investments that is intended to offer an appropriate level of risk and return relative to the participant’s goal of retiring at the target date. The target date fund automatically rebalances as asset values change, and, as time passes, it gradually shifts to a more conservative asset allocation to reduce risk as the retirement date nears.

Target date funds offer a powerful combination of risk management, rebalancing and diversification without requiring any participant involvement. The Department of Labor (DOL) has recognized the strengths of target date funds by designating them as potential Qualified Default Investment Alternatives (QDIAs). A 401(k) plan that invests the account of a participant who has given no investment directions into a QDIA receives protection under Section 404(c) of the Employee Retirement Income Security Act (ERISA).

Hidden Issues

The many advantages of target date funds, however, should not lull plan fiduciaries into complacency. Although target date funds can be QDIAs, the DOL has repeatedly stated that choosing any plan investment option, including a target date fund, is a fiduciary act. Plan fiduciaries must evaluate whether a target date fund is a prudent and appropriate investment option for plan participants. Conducting this analysis requires fiduciaries to grapple with a number of complex issues.

Perhaps the most troublesome issue is the selection of a target date fund with an appropriate “glide path.” A fund’s glide path is its predetermined strategy for reducing risk by adjusting asset allocations as the target date moves closer to the present. Some funds have glide paths that end at retirement age, meaning that the portfolio has minimal risk at the target date. The majority of funds, however, extend the glide path out to the predicted life expectancy of a typical participant. This means that there are substantial equity holdings, and the associated risk, in the portfolio even at retirement.

Which glide path is most appropriate is not an academic matter. In 2008, the performance of target date funds with a retirement date of 2010 varied from losses of less than 10 percent to more than 40 percent. Almost all of this variation seems to be due to the proportion of equity in the funds. Many fund managers continue to believe that an extended glide path is appropriate given the typical individual’s inadequate retirement savings and lengthy lifespan after retirement.

Benchmarking target date funds poses extreme difficulties. Comparing two target date funds with different glide paths is like comparing apples to oranges. The superior performance of one target date fund may simply be due to a longer glide path that has increased potential return at the expense of increased risk.

Evaluating the fees of target date funds can also pose challenges. Some target date funds charge a management fee in addition to the fees of underlying mutual funds that comprise the target date fund’s investments. Other target date funds include mutual funds that may be underperforming or expensive.

Recommended Actions for Plan Fiduciaries

Fiduciaries should face the challenges posed in selecting and monitoring target date funds head- on. Fiduciaries should ensure that they understand a target date fund’s glide path and its implications for risk and return. The difference between target date funds with glide paths that end at retirement and those with glide paths that end later is ultimately philosophical. ERISA does not mandate either approach, but it does mandate that fiduciaries choose a fund with an approach that is prudent for plan participants.

The most important criterion may be to select a target date fund with a strategy that matches the expectations and needs of participants. If participants expect their accounts to be virtually risk-free at retirement, it may be best to choose a target date fund with a glide path that ends at retirement. On the other hand, if participants require a greater rate of return to achieve a reasonable account balance, a target date fund with more risk may be best.

Either way, fiduciaries should carefully study a prospective target date fund’s prospectus. Fiduciaries should be wary of vague statements about asset allocation and risk, and look for signs that the target date fund considers the need for asset preservation and inflation protection. Plan fiduciaries may want to consider adding more than one target date fund family to a plan’s investment options to allow participants to choose between different glide paths. Fiduciaries for very large plans may even want to consider having a fiduciary investment manager create a custom set of target date funds to meet the unique needs of plan participants.

Benchmarking a target date fund should be done by separately considering a target date fund’s asset allocation and mutual fund selection. Portfolio funds within an asset class can be evaluated in relation to an index appropriate for their respective asset classes. The target date fund as a whole may be best evaluated using a custom index based on the target date fund’s actual asset class allocation.

Fiduciaries should ensure that target date fund fees are reasonable. This requires a careful evaluation of a target date fund’s approach. Some funds rely heavily on passively managed index funds that should carry low fees. Other funds are more actively managed, or use alternative asset classes — such as real estate, emerging markets, and even commodities — that may carry much higher fees.

Ultimately, the key to successfully dealing with the fiduciary issues posed by target date funds is to treat them like any other investment option, while taking into account the complexities involved. Target date funds should be prudently evaluated according to criteria set forth in the plan’s investment policy statement. If a plan’s investment policy statement does not provide specific guidelines for selecting and monitoring target date funds, it should be updated to include such guidelines.

Despite the complex issues surrounding them, high-quality target date funds are still a powerful way to provide 401(k) plan participants with a “one-stop” investment solution. Participants who invest in a target date fund enjoy the benefits of an investment option that provides automatic asset allocation, rebalancing and diversification. As long as plan fiduciaries engage in a prudent selection and monitoring process, they can take advantage of the strengths of target date funds with minimal fiduciary risk.

For further information on evaluating target date funds or other employee benefit issues, please contact the authors or any member of the McGuireWoods Labor & Employment  or Employee Benefits teams.