The growth of target date funds (TDFs) has exploded since the Pension Protection Act of 2006. In fact, in the first seven months of 2019, $36 billion poured into TDFs, raising the total to almost $1.3 trillion, according to Jason Zweig in a recent Wall Street Journal article. Our firm has witnessed this growth first-hand as the vast majority of our 401(k) clients utilize TDFs as their Qualified Default Investment Alternative (QDIA).
The widespread utilization of TDFs by participants is viewed as a positive step in the evolution of 401(k) plans. As we have pointed out previously, TDFs make it easy for participants to make an investment choice. Additionally, the TDF is a professionally managed fund which is automatically adjusted over the life of the participant. Plan sponsors potentially get some fiduciary risk relief due to TDF’s designation as a QDIA by the Pension Protection Act of 2006. Despite these benefits, should plan sponsors have any concerns about offering TDFs in the plan investment menu?
Potential Fiduciary Risks for Plan Sponsors
This topic was addressed in a recent article on FiduciaryNews.com, wherein Christopher Carosa highlighted how TDFs could increase a plan sponsor’s fiduciary liability. One such reason is the false sense of security sponsors have due to the widespread use of TDFs by plans and the fact that they qualify as a QDIA under DOL regulations. This could result in a less than adequate selection process, including simply selecting one of the widely used TDFs. In fact, it is easy to make the argument that a more thorough due diligence process should be utilized in the selection of TDFs. Some of the reasons include:
- TDFs will likely be the plan’s QDIA and, therefore, many participants will be automatically defaulted into these funds.
- TDFs will likely be the most utilized funds on the investment menu.
- The wide variety of TDFs available can mean big differences in expense ratios, underlying investments, glide paths and overall risk profiles.
- The temptation to use the plan’s record keeper’s proprietary TDFs given the potential financial incentives offered.
- TDFs do not insulate the plan sponsor from legal claims. Claims of excessive fees and poor performance are not unusual.
These reasons support the argument that plan sponsors should have a well-documented, prudent due diligence process.
Carosa also discussed the importance of educating both plan committees and participants on how TDFs work. He pointed out the prevalent misconception that TDFs will provide an adequate retirement income stream. As we discussed in a previous newsletter (April 2018 edition), most TDFs are managed to mitigate the fund balance volatility, not the retirement income stream volatility. We spotlighted the Dimensional Fund Advisors (DFA) Target Date Income Funds as the next generation TDF, focusing on a stable, predictable income stream in retirement. So long as your plan’s TDF is a more traditional one, this misconception needs to be clarified with appropriate education of both participants and 401(k) committees.
Impact of Stock Market Decline
The impact of the Great Financial Crisis of 2008-2009 on the 2010 TDFs is illustrative of the risk to retirement income streams. Participants in a typical 2010 TDF saw their account balances decrease approximately 25% just as they were about to enter retirement! The impact on their expected income stream is not hard to imagine. Many participants, under the misconception that their TDF would provide them a safe, predictable income stream, were certainly surprised and needed to adjust their retirement plans. This is clearly a situation that plan sponsors would want to avoid.
Could something similar happen today if the equity markets take a tumble? The three largest TDF providers as of December 31, 2018, and their percentage of TDF assets are as follows (per 401(k) Specialist):
These top three providers account for 63% of all TDF assets. I looked at each of their 2020 TDFs to see what percentage of that fund’s assets are in equities (in October 2019) and, thus, subject to stock market declines. Vanguard 2020 had approximately 51% of its assets in equities, and Fidelity and T. Rowe Price both had about 56%. If a similar market decline as 2008-2009 occurs today, the vast majority of participants in a 2020 TDF would experience a similar draw down as those in a 2010 TDF did a decade ago. This is clearly not a good situation for participants or plan sponsors.
The utilization of TDFs has increased and this trend is accelerating. While TDFs have many positive attributes, they are not all low risk investments that necessarily result in a stable, predictable retirement income stream. Accordingly, there can be an increase in 401(k) plan sponsor fiduciary liability. If necessary, plan sponsors should reevaluate the process they utilized in selecting their current TDF offering to ensure it was a well-documented, prudent process that resulted in an appropriate TDF for their employees.