Time to focus on target date fund reform

Rather than focusing on past deficiencies in target date funds, the Senate Special Committee on Aging’s recent hearing on the funds focused on how they can be turned around quickly. However, the hearings should serve as notice to all fiduciaries involved — retirement plan sponsors, investment advisers to the plans, fund managers and mutual fund boards — that they are perceived by regulators as the sources of problems with target date funds and will be held accountable to fix them.

In her testimony, Assistant Labor Secretary Phyllis Borzi stressed the need for plan sponsors to become better educated about their fiduciary responsibilities, demand better information about key characteristics of the target date fund options they have to choose from, and put in place investment selection processes that protect investor participants. As regulators force product providers to make better disclosures and to initiate controls on fees and conflicts for target date funds, sponsors will be expected to use all the material information at their disposal to choose target date fund products according to a thorough and prudent process.

Managers of such funds also appear to be getting by without much finger-pointing. But they will be required to correct what are perceived to be major transparency problems in their products quickly. Most significantly, they will be called upon to make clear whether their funds are designed to “target through” or “target to” retirement. In other words, does the glide path of the fund presume the fund will be retained and used to support the retirement income needs of the investor, or does it presume that funds will be withdrawn and spent at or near retirement? Andrew “Buddy” Donohue, director of the Securities and Exchange Commission’s Division of Investment Management, testified that given the inconsistency in glide path construction, the fund industry may have to move away from the current practice of using the projected year of retirement in the name of virtually all target date funds, if the SEC concludes that this practice is misleading.

John Rekenthaler, vice president of research at Morningstar Inc., provided testimony based upon an excellent research paper published in September. The paper, “Target Date Series Research Paper: 2009 Industry Survey,” captures a wealth of data that can be used by plan sponsors, advisers and consultants to educate themselves on the issues that must be considered in the process of selecting target date funds. The variation across providers is startling and is indicative of an inefficient market for these products — a situation that is going to change quickly.

Increased transparency, whether forced by regulators or by the marketplace as a result of published research, is necessary but not sufficient to correct all that is wrong with target date funds. Competitive pressure should drive down the ridiculously large spread in fees. Ac–cording to the Morningstar report, the average asset-weighted expense ratio of target date fund series ranges from 0.19% for the lowest-cost provider (The Vanguard Group Inc.) to 1.82 % for the highest-cost provider (SunAmerica Inc.).

According to Mr. Donohue, the SEC intends to do more to hold boards of directors of fund pro-viders accountable for their fiduciary obligation to act in the best interests of shareholders. This includes the obligation to prevent fund managers from charging fees that are blatantly excessive.

Both the Department of Labor and the SEC could also step in to address the significant issue of conflicts of interest associated with the overwhelming use of proprietary funds in target date products. Michael Case Smith, head of institutional strategies at Avatar Associates, a manager of -target date products that are -constructed of non-proprietary exchange-traded funds, called the Labor Department to task for allowing mutual fund groups to skirt the prohibition in the Employee Retirement Income Security Act of 1974 against conflicts by not recognizing as plan assets the various funds that a target date fund comprises. This allows fund groups to populate their target date products with their own funds, even in asset classes for which they do not have truly competitive offerings. It is easier and much more lucrative for fund companies to go down this path — it is also an obvious conflict with investors’ best interests.

The bottom line is that fiduciaries at all levels of involvement with target date funds collectively hold the power and the responsibility to force positive changes in these products. Failure to exercise that power is a disservice to investors and will be a source of increasing regulatory risk.

Blaine F. Aikin is president and chief executive of Fiduciary360 LP.

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