by Chris Tobe, CFA, CAIA
Target Date Funds now are above 50% of all 401(k) assets.[i] They are the most non-transparent plan investment option and the easiest to hide fees and play performance games. They are also the dominant default option or QDIA (Qualified Default Investment Alternatives) resulting in the highest level of fiduciary responsibility. Despite the high level of fiduciary risk, they are specifically designed to avoid accountability and thus need the most scrutiny.
A 2021 study shows that in general Target Date funds cause participants to “lose 21%” over career to primarily excessive fees from proprietary funds.[ii] A 2020 study finds that asset managers exploit reduced investor attention (i.e. lack of transparency) to deliver lower performance.[iii]
The history of the Target Date Fund, I believe, is mainly a story about Fidelity. I think around 2002 they saw Vanguard and indexing as their biggest threat. Fidelity needed a new vehicle to hide the fees for active mutual funds and created the Target Date Fund.
With heavy lobbying by Fidelity, in 2006 the Pension Protection Act was passed. This act allowed for auto-enrollment of target-date funds into defined contribution plans and set the stage for QDIAs (Qualified Default Investment Alternatives), which strongly supported the growth of these funds.[iv]
Fidelity had Target Date Funds ready to go before the legislation was passed and dominated in market share immediately, and still keep the highest levels today. This gave them basically a 10-year ride from 2006-16 in which they could load-up their higher fee active funds in target date funds with little or no pushback. Starting around 6 years ago there has been a shifting inside Fidelity’s target date funds toward greater indexing.
USING THE RECORDKEEPER
After choosing a record keeper or administrator, most plans automatically default to the Target Date Funds of that company. A prudent process would be to have a competitive bid, but most 401(k) committees make selections based on informal processes and relationships.
Many times, the target date and administrative fees are commingled in the Target Date funds using revenue sharing to create a total lack of transparency.[v]
This record keeping default fuels the 2021 study showing that Target Date funds cause participants to “lose 21%” of their end-returns over their career due primarily to excessive fees from proprietary funds [vi]
A 2020 study found that the average higher-cost actively managed target date funds failed to perform as well as the cheaper indexed competition in the 2015-2019 period.[vii] Some of the actively managed funds did very well in relative terms, but most did not. We found that past performance is only weakly predictive of future performance. The implication is that even an active fund with a superior record has an expected future return below the passive alternative TDFs.
However, even within a record keeper’s Target Date Fund selections, there can be a wide variety of fee levels (especially with market leader Fidelity) in which 401(k) committees can make better fiduciary decisions. The burden is on the plan fiduciary to show why they are not selecting an index fund for the Target Date Fund the QDIA.
HIDING HIGH RISKS & FEES IN TARGET DATE FUNDS
The least transparent Target Date Funds are those that are not SEC registered mutual funds. Many are in poorly state regulated annuities either in whole or in part. Many are in poorly state regulated Collective Investment Trusts (CIT)s. [viii] There are a few good CITs like the Fidelity, Vanguard, T. Rowe Price that are clones of their SEC mutual funds at a lower cost. Many CIT’s can hide private equity or annuities and their many hidden fees and risks. [ix]
Many, if not most, CIT based Target Date Funds and all the annuity TDF’s are a fiduciary breach based on the higher risks alone, not to mention the excessive fees.
GAMING THE BENCHMARK
Many plans rely on consultants to guide them in the selection of Target Date Funds. However, some consultants have conflicts in which they are compensated more for high fee non-index funds in backdoor payments. Plans blaming consultants on poor Target Date Fund choices does not absolve them from fiduciary liability, but in some cases they have been able to get conflicted consultants to pay a portion of the settlement. [x]
High fee Target Date Funds typically justify their existence by some manipulation of a benchmarks. They may hold investments which are not in the benchmark, which create different performance and risk characteristics. They may use different allocations, mostly to higher equity positions, to create the appearance of higher returns.
A 2020 study shows Target Date Funds ‘Create a Lack of Accountability”[xi] For example a 2040 T. Rowe or American Fund can appear to outperform a 2040 Vanguard fund because it has a 90/10 equity allocation compared to 80/20 with Vanguard. “Target Date Fund managers engage in fee-skimming by charging higher fees on the less observable, more opaque underlying funds” [xii] Opaque funds can be illiquid high-risk alternatives like private equity and hedge funds & annuities.
In some cases, the courts have given active managers the benefit of the doubt on their claim that it is conceivable they could outperform index plans, especially in down markets. The validity of this market-based argument has become harder. The recent Supreme Court decision letting the appeal in Brotherston vs Putnam Investments, LLC stand upholds the use of index funds for benchmarking purposes in calculating damages – regardless of performance.[xiii]
Plans should always document in their 401(k) plan minutes the following regarding Target Date Funds:
- The plan’s investment policy statement should include provisions on selecting and monitoring Target Date Funds. Does it address each asset class involved in the plan including inside the Target Date Funds?
- Each asset class in each Target Date Fund should be fully evaluated in terms of risk, fees, and performance as if they were a standalone option.
- Assets that are not SEC registered mutual funds or registered securities such as private equity, annuities need additional scrutiny and documentation.
- Additional documentation, including a Request For Proposals (RFP), should be required if the plan is using a recordkeeper vendor’s proprietary Target Date Funds.
- Select an appropriate benchmark to evaluate each asset class in the funds. Compare and justify the attributes of your fund if it has differences with the benchmark
- Understand the different fees and compare fund family fees, bearing in mind that Target Date Funds have multiple layers of fees.
- Do a RFP for Target Date Funds at least every 5 years.
- Carefully document the reasons that the fund was selected.
- Regularly monitor the funds.
- Document any and all reasons for not removing retained funds if performance has lagged peer funds.
Target Date Funds are now above 50% of all 401(k) assets.[xiv] They deserve a 50% level of fiduciary oversight or even more because of their lack of transparency.
[vii] AN ANALYSIS OF THE PERFORMANCE OF TARGET DATE FUNDS John B. Shoven and Daniel B. Walton, https://www.nber.org/system/files/working_papers/w27971/w27971.pdf Oct.2020