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Scrutinizing Target-Date Funds
Closer scrutiny of target-date funds by the U.S. Department of Labor and the Securities and Exchange Commission is likely to prompt new regulatory initiatives by both government agencies. A lengthy day-long joint DOL-SEC hearing on June 18 highlighted a number of issues facing employers that include target-date funds as options in company-sponsored plans, especially when the target-date funds are designated as a default investment. In late 2007, the DOL approved target-date funds as a qualified default investment alternative or QDIA. Sharp losses in target-date funds in the market crash of 2008 and 2009, however, have heightened concern about the workings of such funds -- even as target-date funds have become increasingly popular investment options One concern expressed during the hearing is that some funds with the same target date have widely divergent allocations to equities and fixed-income investments. There is "a very substantial variation" in the investment allocations of 2010 funds, according to an analysis by Aon Consulting of 25 providers of 2010 funds -- held by employees just one year away from their retirement date, according to Scott Macey, senior vice president at the organization. "In fact, at the extreme, even for 2010, the equity allocation of funds -- with the most equity allocations -- was approximately three times the fund that had the least equity allocations," Macey says. "Even among the two middle quartiles -- those that had the most common equity and fixed-income allocations -- there was approximately a 100 percent differential," Macey said. "One might have 20-percent allocation to equities and another 40 percent, for example." Given such wide divergence in asset allocations, some plan sponsors expressed concern regulators might try to impose strict limits on equity and fixed-income allocations within the target-date funds. "I urge the agencies to draft regulations which do not mandate the features and characteristics of target-date funds," testified Allison R. Klausner, assistant general counsel for benefits at Honeywell International Inc., who testified on behalf of the American Benefits Council at the hearing. "Any regulations promulgated should permit plan fiduciaries to make prudent decisions appropriate for its body of plan participants," Klausner said. "We ask the agencies to respect that one size and one style will not be best for all plans." Target-date funds have become increasingly popular with both employers and participants -- as such funds are offered either as options or as the default funds, for those who do not make different selections. A study by the Vanguard Center for Retirement Research, for example, found that seven of 10 defined-contributions plans administered by the Malvern, Pa.-based mutual fund group offered a target-date fund, according to the testimony of John Ameriks, head of Vanguard's Investment Counseling & Research Group. "More than one-third of plan participants opted for them," he told the government panel of regulators. "The report notes that three factors were fueling the adoption of target-date funds: the funds' simplified approach to investment decision-making, the growing use of automatic enrollment within plans, and target-date funds' designation as a qualified default investment option under the Pension Protection Action of 2006," Ameriks said. Ameriks also urged the regulators to be cautious in their review. "When evaluating the performance of target-date funds, it is important to acknowledge the extreme severity of the financial meltdown we have just experienced," he said. "Virtually all types of investment portfolios -- defined-benefit plans, endowments, and even the general accounts of commercial insurers -- have suffered significant losses."
Glide Path One key question the regulators will likely be considering is whether the wide divergence in asset allocations by funds with the same target dates is, in itself, a problem. "Is there anything inherently wrong with that?" Macey asked. "Probably not," he said. "I suspect there is some misunderstanding, especially among participants and some plans sponsors and plan fiduciaries at the wide variation." The misunderstanding revolves around the "glide path" that differing funds might choose, according to Phil Suess, worldwide partner with Mercer Investment Consulting in Chicago. The glide path is the rate at which the asset allocation is reduced for equities and increased for fixed-income investments. "In retrospect, I think one of the key points here is that each of these products is different," Suess says. "You say target-date funds, but within the realm of target-date funds, there's an array of different approaches, using different products and different strategies." The differences go beyond the share of assets allocation to equities, he says. "Over the last year, index-fund-based target date funds did quite well," Suess says. The reason? The funds invested primarily in fixed-income indices, which had a higher exposure to government bonds relative to the actively managed fixed-income funds, which did not. Thus, Suess says, a fund with high exposure to actively managed fixed-income assets in a 2010 fund would not have done well, even though its equity exposure was very limited. Another point often missed is that target-date funds with the same target dates have differing glide paths because of differing objectives of the fund. Several witnesses at the June 18 DOL-SEC hearing, in fact, discussed the glide-path differences and whether the goal was to set the path "to retirement or through retirement," says Jan Jacobson, senior counsel for retirement policy at the American Benefits Council, based in Washington. " 'To retirement' means your lowest equity allocation is in place at the time of your retirement date; 'through retirement' [means] you're expected to continue with the target-date retirement fund even after you retire and take the money out as you need it." Jacobson says. Jacobson also pointed out that employers might have differing goals. "A company that has an ongoing defined-benefit plan [in addition to a defined-contribution plan] might have a different idea of an appropriate target-date fund [offered within a defined-contribution plan] than would a company that has just a 401(k) plan," she says.
Default Issue The focus of new regulatory initiatives is likely to revolve around target-date funds that are offered as default investments -- including greater disclosure requirements to plan sponsors and fiduciaries, Jacobson says. There might be disclosure that tells the plan sponsor, for example, that "the target-date means the equities bottom out 15 years later, so the glide path keeps going down past the retirement date," she says. Based on the questions asked at the hearing, it appeared the DOL regulators were more focused on disclosure, while the SEC was more focused on the make-up of the funds. "If there would be any regulations on allocations or glide paths -- and I'm not saying there would be -- based on the questions from the SEC, this is more likely to come from them," Jacobson says. One idea that emerged at the hearing was to have sub-categories of target-date funds to identify them as conservative, moderate or aggressive, according to Macey. "I kind of like that concept," he says. "Obviously, in order to do that, somebody has to set some standards about what we are going to label as conservative, moderate or riskier." At a minimum, both the SEC and DOL are likely to at least issue a guidance on the issue, according to Macey. "I don't think you can just close the record and do nothing," he says. There might be guidance, for example, about the glide path and what disclosures should be made about it, he says. There might also be some guidance about the risk-allocation levels of various near-term target-date fundss. "I wouldn't expect them to set regulatory standards that a near-term fund can only be invested 10 percent in equities or 20 percent in equities," he says. "I don't they are going to manage the market like that." Instead, the DOL is likely to "clarify guidance as to what a fiduciary should look at to evaluate a target-date fund," he says. They may also require plan sponsors to provide more meaningful information to plan participants. Macey also expects the providers to come up with new guidance to plan sponsors in response to the rising profile of target-date funds and their performance. This is likely to include additional information, disclosure and "broader statements of missions and objectives of target-date funds," including how they operate, information on the glide path and associated risk. David Certner, legislative counsel and legislative policy director at AARP, who testified at the June 18 hearing, called on the DOL to "develop a selection and monitoring target date tool ... to assist fiduciaries to better meet their fiduciary duties in selecting target-date funds." "The tool should provide suggested areas of inquiry for evaluation, including, but not limited to, asset classes; allocation; number and quality of underlying funds; 'glide paths;' and fees and expense ratios for both the fund itself and any other mutual funds in which the target date fund invests," Certner testified. Both the DOL and SEC have left the record open another 30 days for further comments to be submitted to the regulators.
June 23, 2009 Copyright 2009© LRP Publications |
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