March 28, 2011

Target Date Funds: Don't Set Them and Forget Them

Holland & Knight Alert
Robert J. Friedman

Growth of Target Date Funds

Target Date Funds (TDFs) were introduced in 1994 and marketed as a "set it and forget it" investment option for investors who may not have the expertise or time to monitor, balance and rebalance their portfolios. Investors responded positively to such funds: TDFs currently hold an estimated $270 billion in assets. Analysts estimate that by 2020, TDFs will hold more than $2 trillion in assets and one-third of all 401(k) plan assets. In addition, TDFs are popular with 401(k) plan sponsors: the Department of Labor (DOL) believes that nearly 60 percent of all 401(k)s use TDFs as the plan's qualified default investment alternative (QDIA), and that nearly 60 percent of all 401(k) plans offer TDFs as investment options.

Target Date Funds as Qualified Default Investment Alternatives

In addition to their popularity with investors and plan sponsors, at least part of the success of TDFs in the past few years can be attributed to passing of the Pension Protection Act of 2006 (PPA). The PPA authorized employers to select default investment options for participants and beneficiaries who failed to give the plan investment directions (whether due to automatic enrollment or otherwise) for their accounts. In connection with these provisions, the PPA directed the DOL to adopt more detailed regulations providing guidance on default investment options for participants or beneficiaries who fail to give investment direction with respect to their accounts.

In October 2007, the DOL issued final regulations which provided a safe harbor for plan sponsors to invest participant contributions in a QDIA in situations when participants or beneficiaries failed to give the plan sponsor investment instructions. The final regulations officially sanctioned the use of TDFs (as well as lifecycle funds, balanced funds or other professionally managed accounts) as QDIAs.

Effect of the 2008 Downturn – and the Response

Critics of TDFs argue that the result of the successful marketing of TDFs, in connection with the DOL's blessing of TDFs for use as QDIAs within 401(k) plans, caused individual investors to invest in TDFs despite lacking a clear understanding of how such funds actually work. When the market crashed in 2008, many investors were surprised at the huge decreases in the value of their TDF accounts, wrongly believing amounts invested in such funds to be more stable than they actually were.

In fact, asset allocation within TDFs can vary widely among investment managers. In 2010, one survey found that various TDFs with a 2010 target retirement held between 25 percent and 65 percent in equity investments, depending on the investment company offering the fund. This demonstrates the variation in asset allocation between funds (even those with the same target retirement date), which can vary dramatically depending on the assumption the fund utilizes as to investor needs and behavior. For example, a fund which assumes that investors will hold the fund past the maturity date and therefore need income-generating investments for an additional 20 or 30 years will have a considerably different asset allocation than a fund which assumes that investors will pull all of their funds out at retirement to purchase an annuity.

The recession (and the corresponding unexpected volatility of TDFs) created a new focus on TDFs. The result was a number of additional troubling allegations beyond suggestions that such funds simply invested aggressively. Critics argued that TDFs charged much higher fees than traditional mutual funds despite performing similarly or more poorly, purchased new or underperforming funds maintained by the TDF's investment manager to boost sales of such funds, didn't rebalance frequently enough to actually accomplish the asset allocation described and failed to adequately disclose asset allocation and investor assumptions to investors. Additionally, critics have noted that many investment managers of TDFs have the ability to deviate significantly from the target asset allocation described in fund prospectuses and the ability to invest in alternative investments beyond traditional stocks and bonds (both of which may result in a riskier investment).

Although TDFs eventually rebounded to pre-2008 performance levels, the incredible growth in such funds and their volatility and other issues alerted the U.S. government that intervention was necessary. In May 2009, the Securities Exchange Commission (SEC) and the DOL issued a joint investor bulletin designed to educate investors as to how TDFs work; it also included issues to consider prior to investing in a TDF. In addition, the SEC and DOL subsequently held a joint hearing regarding TDFs. Also, in October 2009, the Senate Committee on Aging held a hearing entitled "Default Nation: Are 401(k) Target Funds Missing the Mark?"

SEC Response

In June 2010, the SEC published proposed rules designed to regulate TDFs. They require investment companies offering such funds to make each of the following disclosures:

  • with respect to a fund which has a target date in its name, the fund must disclose the asset allocation among types of investments at the target date immediately adjacent to the first use of the fund's name in marketing materials
  • a prominent table, chart or graph that depicts asset allocation over the entire life of the fund and highlights the final asset allocation
  • a description as to when the asset allocation becomes final and stops changing
  • a statement that an investor should consider his or her risk tolerance, personal circumstances and complete financial situation before investing in such a fund
  • a statement that the investment is not guaranteed and it is possible to lose money in the fund (including after the target date)
  • disclosures as to whether and to what extent the disclosed asset allocation may be modified without a shareholder vote

DOL Response

In November 2010, the DOL published proposed rules designed to regulate TDFs used as investment options in 401(k) plans, including TDFs selected as a plan's QDIA. Additionally, the proposed rules were designed to harmonize QDIA disclosures with the DOL's participant fee disclosure final rules published in October 2010. The proposed rules require plan administrators of plans offering TDFs as investment options under the plan to make each of the following disclosures to plan participants and beneficiaries:

  • a description of the asset allocation, how the asset allocation will change over time and the point at which the investment will reach its most conservative asset allocation (including a chart, table or other graphical representation illustrating such issues)
  • with respect to an investment which has a target date in its name, a description of the age group for whom the investment is designed, the relevance of such target date and any assumptions about participant or beneficiary contribution and withdrawal intentions after such date
  • a statement that a participant may lose money by investing in the TDF and that there is no guarantee investment in the TDF will provide adequate retirement income

Additional disclosures would also need to be made if the TDF is the plan's QDIA.

Plan Sponsors Need to Monitor TDFs

Although marketed as a "set it and forget it" investment option for 401(k) plans, plan sponsors need to be aware of the potential risks and volatility of TDFs, as well as keep abreast of new legislative and regulatory developments in this area. They should continue to monitor TDFs in their plans and remember that plan fiduciaries are not relieved of liability for the prudent selection and monitoring of investment options in their 401(k) plans, including TDFs and QDIAs.

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