The Hidden Dangers of Target Date Funds
ERISA experts warn that Target Date Funds are ticking time bombs of potential losses and liabilities. In fact, they expect the funds to be the next big thing in ERISA litigation, possibly eclipsing fee and expense litigation.
TDFs have grown 1,200% over the past decade and are now estimated to hold $2.8 trillion of American’s retirement assets. They are effectively packaged as simple alternatives to standard 401(k) investment options. One fund, one investment, one transaction to glide plan participants to a secure retirement; an attractive turnkey decision that any retirement committee might make.
For the retirement industry however, these funds are the Holy Grail of 401(k) offerings. Regulations allow plan sponsors to set Target Date Funds as default investment options for a plan. Employee’s then pour their assets into “set it and forget it” products, paying more in fees then the old stable value alternatives. Research shows that most plan participants don’t change these investments very often. So in industry parlance, these are “sticky assets” and they can generate a decades long revenue stream for the fund companies. Everyone seems to be happy, plan sponsors, fund companies, and plan participants.
However, while glossy marketing materials present an illusion of simplicity, Target Date Funds consist of an extraordinarily complicated infrastructure of financial and operational tasks and functions. A Target Date Fund portfolio requires sophisticated investment assumptions and determinations about markets, interest rates, portfolio construction, asset allocations, and more. Much of it happens beyond the vision and understanding of most fiduciary retirement committees.
This matters now more than ever because the fine print of Target Date Funds shifts ultimate fiduciary liability to the plan fiduciaries (often senior management of the plan sponsor), and that liability is potentially personal to these fiduciaries. Soliciting advice from consultants and advisors likely does little to mitigate this ultimate potential liability.
For plan sponsors, the best defense is a good offense. Get underneath the investment jargon to understand the rationale for the investment strategy and the execution of the strategy. The list of factors that need to be reviewed for each component fund within the strategy is extensive and includes: investment performance and risk analytics; expenses; plan demographics; and the investment management teams directing the investment portfolios. Examining the fiduciary processes of each component fund is also equally critical. The details can make all the difference.
Most importantly, fiduciaries must understand, and sign off on, the Target Date Fund’s “glide path” – a formula that over time, shifts the asset allocation of the portfolio consistent with the projected termination date of the Target Date Fund.
Glide paths are unique to Target Date Funds and have never been deployed on a mass scale before. In theory, the formula works, but track records are limited and are based upon assumptions that may or may not apply to a particular plan. For instance, does the glide path match the demographics of the plan? In addition, Target Date Funds often delegate broad discretion to the fund managers. But what happens if a fund shifts an allocation into an alternative asset class, such as private equity? Do the plan fiduciaries understand (and approve) this shift in allocation?
Bottom line, retirement plan fiduciaries need to be attuned to the potential trouble spots – both those that are obvious today, and those that may be lurking down the road. Remember, the lifetime of a Target Date Fund can span anywhere from 20 years to even 50 years and beyond. Investing in one is a marathon, not a sprint.
Target Date Funds are a prime example of the rising complexity and cost of retirement plan options. Plan participants are investing their nest eggs with a single provider, for decades. Ultimately, plan sponsors are on the hook for potential liabilities based on intricate details that their retirement committees may not be equipped to evaluate. The most prudent course is to delegate these decisions to qualified experts who are willing accept the fiduciary responsibility of managing them.
As fiduciaries, we know there are no single decisions when constructing a retirement plan investment strategy. Essentially, we approach Target Date Funds the way GM constructs and assembles a Cadillac. Because the company incorporates hundreds of components from different manufacturers, specialists check the quality of every component, and another team assembles them into the cars you see on the road. It’s GM’s responsibility to apply expertise to every facet of its product and to assume liability for the vehicle’s performance. That’s important – after all, you’re not just buying a car that looks nice in your driveway, you need to have confidence in the safety and integrity of your car as you and your family hit the open road.
Saving for retirement is similar – you need to be confident that the investment vehicle you have selected will deliver you safely to your destination.