Advisers' role in target date funds grows more complex

Recommending and monitoring target date funds requires sophisticated analysis and oversight

Mar 2, 2014 @ 12:01 am

By Richard F. Stolz

From their humble beginnings more than two decades ago with the 1993 launch of Barclays Global Investors' LifePath Portfolios, target date funds are rapidly taking over the defined-contribution world.

Cerulli Associates Inc. estimates that TDFs make up about 20% of 401(k) assets today and capture 42% of 401(k) contributions. Those numbers will grow to 35% and 63%, respectively, by 2018, the research firm projects.

Advisers, particularly those serving in a fiduciary capacity for retirement plan sponsors, need to ensure that the sophistication of their analysis and oversight keeps pace with that growth. If simply honoring one's professional responsibilities alone were not a sufficient motivator, the Labor Department's focus on the matter and employee litigation are added incentives.

Ronald Surz, president of Target Date Solutions, predicts an explosion of litigation against plan sponsors and fiduciary advisers after the next substantial equity market downturn. Employees approaching retirement with 401(k) accounts bulging with TDFs that have a far greater equity allocation than they realize, staring at what may prove to be a lean retirement, will join class actions and ultimately win, Mr. Surz predicts.

“Nothing is going to change until there are lawsuits,” he said.

It will be worse than 2008, Mr. Surz fears, because a far higher proportion of fund assets will be in TDFs. His premise is that most employees are oblivious to their TDF's glide path — the pace at which the fund's allocation shifts over time from high equity exposure for investors farther away from retirement to a more conservative, short-term asset mix as investors reach or pass their expected retirement date. Employees typically plan to liquidate their 401(k) holdings at retirement and roll them into an individual retirement account, and have specific spending plans for the money they assume will be there, Mr. Surz said.


Others don't share his dire assessment but nonetheless are gaining a greater appreciation for the need to choose and monitor TDFs more carefully.

Some may have been lulled into a false sense of security by the Pension Protection Act of 2006, which established qualified default investment alternatives. Target date funds, along with managed accounts and money market funds, form the universe of QDIAs. Target date funds are by far the most popular QDIA.

The Pension Protection Act added a new section to the Employee Retirement Income Security Act of 1974's 404(c) rule absolving fiduciaries from responsibility for the consequences of investment selections made by plan participants from a specified set of safe-harbor investment choices.

That new section, 404(c)5, expanded fiduciary protection to include the QDIAs created by the act. In other words, even when participants wind up in a particular investment by default, some 404(c) protection may yet exist. (A rule making to amend this regulation and enhance the disclosure of information concerning target date funds, as well as fees and expenses, is expected to be issued this month.)

This protection appears to fly in the face of the practical effect of the QDIA rules: that the employer (with whatever degree of guidance from an adviser), not the employee, is making the investment decision on employees' behalf by picking which category of QDIA to use, the investment managers for those funds and, in the case of TDFs, the glide path formula.

Looked at from that perspective, ERISA attorneys and others emphasize that advisers should not count on the narrow implications of 404(c)5 to bail them out if things go awry.

“An employee can't say, "I am going to sue you because you put my money into a target date fund designated as a QDIA, and the fund only earned 10%,'” said Robert C. Lawton, president of Lawton Retirement Plan Consultants. “But the participant could say, "I am going to sue you because you selected a target date fund that eventually went belly up because your brother-in-law worked for that firm and you believed everything he said.'”

Among many other TDF due-diligence criteria Mr. Lawton uses are how long a TDF series has been in the market and its total assets. He generally avoids funds that have been around less than three years and have under $1 billion in assets.


In any case, Labor Department guidance has made it clear that TDFs, even in a QDIA context, entail more due diligence than static funds, given the critical role of a TDF's glide path in determining ultimate investment outcomes.

“The glide path adds significantly to the analytical burden,” said ERISA attorney Marcia Wagner of the Wagner Law Group. Beyond investment performance and cost, initial TDF selection criteria must take plan demographics into account, she said. Those include age distribution, risk tolerance, income levels and anticipated participant investment decisions upon reaching the retirement date.

Gregg Andonian, principal of Baystate Fiduciary Advisors Inc., advises many colleges and universities, and offers one example.

“A lot of professors tend to keep working after 65,” he said. They also tend to be more sophisticated about their personal finances. For those clients, Mr. Andonian often recommends TDFs with relatively high equity allocations in the later years.

But even at the opposite end of the demographic spectrum, recommending a TDF that glides heavily toward cash at retirement may not always be the best choice, Ms. Wagner said. “Advisers need to understand that some level of equities will always be needed to fight inflation and reduce longevity risk.”

Mr. Surz disagrees. He thinks a pure “to” TDF glide path that places 100% of plan assets in cash at the targeted retirement date is the safest bet.

What about the possibility of lawsuits against plan sponsors and advisers by participants who feel burned by having their TDF too conservatively invested leading up to their target age, missing out on a bull market? Mr. Surz is not concerned.

“I think it's silly to think anyone could sue for the opportunity cost of being safe,” he said.

But just as there is no consensus on the optimum glide path for any demographic segment or plan profile, there also are no standard definitions of “to” and “through” retirement glide path formulas.

Research conducted by Mr. Andonian indicates that maximum equity exposure of “to” funds at 65 can vary widely — for example, between 28% for Wells Fargo & Co. to 65% for AllianceBernstein. (Mr. Surz's model, as noted, goes to 100% cash at the retirement target year.)

Also, the average equity exposure at the target date for “to” glide path models is 34%, versus 49% for “through” models. The lack of extreme variance between those numbers points to the increasingly blurred distinction of the two categories.


TDF fund providers, particularly those seeking to take market share away from the small handful of asset managers that dominate the TDF field (Fidelity Investments, The Vanguard Group Inc. and T. Rowe Price Group Inc.), are promoting TDFs that can be more easily customized by asset manager and glide path. But even the dominant players are offering such opportunities.

“The days of putting people into standard bundled proprietary mutual funds are gone,” said John Guido, an executive with Retirement Research Inc. That may be a double-edged sword for advisers: greater opportunities to help clients craft the optimum TDF but a virtually infinite set of choices to consider.

Richard F. Stolz is a freelance financial writer based in Rockville, Md.


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