Target-date Fund Practices Targeted in Senate Hearing

In opening the hearing of the U.S. Senate Special Committee on Aging, titled “Default Nation: Are Target-Date Funds Missing the Mark?”, Chairman Herb Kohl (D-Wisconsin) noted that this was the third hearing in a series the committee had held on the subject of strengthening the 401k system (see  Senate Hearing Asks, Are Target-Date Funds Missing the Mark? ).   He also noted that target-date funds were “developed for the average worker who may understand the importance of saving, but may not appreciate the complexities of investing.”

However, regarding target-date funds, Senator Kohl said “the more we learn, the more concerns we have.”

Citing data that suggests that 96% of Fidelity-administered plans that had implemented automatic enrollment as of March 2009 had chosen target-date funds as their default investment option, Kohl said that “a conversation about target-date funds is really a conversation about the future of America’s retirement security.

“Inappropriately High Level of Risk”

He went on to note that the composition of target-date funds “vary widely”, and said that many contained “an inappropriately high level of risk”, noting that many invested in 2010 series funds “lost as much as 41% of their 401(k) savings in 2008.”

Kohl referenced the hearing the Committee held in February (see  Senate Committee Takes Aim at Target-Dates ), and said that at that point discovered that there was “no standard” on what was labeled as a target-date fund, nor was their any regulation on their composition.   He noted the Committee’s call for regulators to look into the matter, and referenced a joint hearing held by the Department of Labor and Securities and Exchange Commission in June in response (see  EBSA/SEC to Hold Target-Date Fund Hearing ), saying he was “Hopeful that we’ll see more oversight of this product”, which he said was “on track to become the #1 savings vehicle in America.”  

Key Problems

That said, Kohl said there were three “key problems” with target-date funds that the Committee was focused on; a lack of transparency in design, that many funds charged “excessive fees” that eroded the value of assets over time, and that “fund managers have a conflict of interest in constructing target-date funds and must resist the temptation to put their interests above those of the participants.”

Kohl noted that the Committee had previously addressed the issues of hidden fees in 401k plans that can have a big impact on 401(k) balances, and that he had introduced legislation with Senator Harkin (D-Iowa) to require disclosure of 401k fees.   He also said that the Committee had examined the long-term effect of 401lk loans and withdrawals – and that he would soon introduce a bill to implement GAO’s recommendations to reduce the effects of those activities.  

“For after all,” he said, “in our efforts to encourage Americans to save for retirement, we must also make sure that they are also able to save smartly.”

Testimony was offered by representatives from several regulatory bodies and institutions.   Speaking to the issue of potential conflicts of interest, Michael Case Smith of Avatar Associates raised concerns about the fiduciary status (or lack thereof) of the firms that put together target-date funds, often with proprietary offerings, and on platforms where participants - and even plan sponsors - didn't really have access to the full variety of choices in the marketplace (see http://www.marketwire.com/press-release/Avatar-Associates-975144.html ).   He said that when target-date funds own shares of other mutual funds - typically proprietary funds, and that that can "imbed conflicts of interest" when the fund company determines its own mix, a structure that he said "can, directly or indirectly, influence their compensation."   Since the shares of the underlying fund assets aren't plan assets, rules against self-dealing don't apply - and Smith said his firm does not think that ERISA's exemption was not designed with target-date fund structures in mind.

SEC Focus

Also testifying was Andrew Donahue, Director of Investment Management, United States Securities and Exchange Commission, who said that there two areas of focus where enhanced regulation may be appropriate; fund names (if the name is materially misdirecting or misleading) and fund sales materials.   There was discussion that the use of a date in the fund name may convey a sense of appropriateness to an individual situation that may not apply.   Additionally, he noted that fund sales materials may effectively be conveying a sense that the structure/operation of the funds is simple when it isn't, or perhaps suggesting "uniformity or simplicity when those are not present."   He noted that the marketing materials for target-date funds were not as "nuanced" as the prospectus materials for those offerings.

In prepared testimony, Assistant Secretary of Labor Phyllis Borzi acknowledged that the differences in funds and performance "generate questions", and that Labor Department was concerned that these investments provide workers with a secure retirement.   She also expressed concern not only that plan participants don't understand what's inside these funds, but that plan fiduciaries don't, either.  

However, on the topic of participant disclosure, she acknowledged "You can have the best disclosure in the world, and you can't make people read it."  

The hearing is viewable online at http://aging.senate.gov/