Target-date funds were supposed to be the best thing since sliced bread when the 2006 Pension Protection Act popularized them as default investments in 401(k) plans.
But the sliced-bread investment innovation quickly turned investors into burnt toast just two short years later during the 2008 financial crisis, when the average 2010 target-date fund lost 25% — though such funds ostensibly envisioned a glide path to a retirement just two years away.
Because the Employee Retirement Income Security Act still hallows target-date funds as the most popular of the three safe options for use as qualified default investment alternatives — the other two being balanced funds and managed accounts — advisors who serve as plan fiduciaries need to know their ins and outs.
That is the rationale for the publication of a new book, Fiduciary Handbook for Understanding and Selecting Target Date Funds — due out in a week — by pension consultant Ron Surz, attorney John Lohr and ethicist Mark Mensack. (Surz is an occasional ThinkAdvisor contributor.)
Understanding the funds’ assumed fiduciary status, their popularity with investors and the opportunities for advisors to earn fees, but all too aware of the potential for these funds to blow up investors’ nest eggs again as they did in 2008, the authors endeavor to arm advisors with the ability to help clients and avoid unseen professional hazards.
For example, advisors may assume the government’s imprimatur may serve as a shield against all legal threats, but the authors point out there have been 522 ERISA-related fiduciary breach cases since 2013.
Most of those have concerned excessive fees, but the authors want advisors to think through selection and monitoring issues that could potentially put them, plan sponsors and asset managers on the hook the next time there is a crisis.
And the authors are emphatic that the next crisis is a matter of when, not if.
“Sometime in the future there will be a market correction of the magnitude of a 2008 or even a 1929. Unless risk controls are tightened, especially near the target date, fiduciaries will be sued as a result of losses. It remains to be seen whether the litigation will impact fund companies or fiduciaries, or both,” the authors write.
And that’s the thing of it. The authors’ core argument is that target-date funds are too risky, especially at the target date.
This is because the three mutual fund companies that dominate the target-date fund industry, T. Rowe Price, Fidelity, Vanguard — the book’s chief villains — have risky levels of stock ownership at the target date.
Though they do not play a fiduciary role (as do employers and advisors) relative to the retirement plans that offer their products, the big fund companies are essentially driving the whole risky process — one that has swung far away from the period before the Pension Protection Act of 2006, when cash was the dominant investment default for investors approaching retirement.
In contrast, the Big 3 companies have end-date equity exposure averaging 55%.
And the crux of the fiduciary problem may not be the Big 3 — who, again, aren’t fiduciaries. It’s that advisors aren’t researching and evaluating the Small 30 — the rest of the target-date fund universe available to plan participants.
“Choosing one of the Big 3 might be all right if competing TDFs were all inferior, but they are not. Most important, these Big 3 maintain the same equity exposure today at the target date as they had in the 2008 fiasco, setting the stage for a repeat calamity, this time much more devastating.”
Surz, Lohr and Mensack’s book is thus something of a cri-de-coeur beyond a mere technical explanation of “Duty of Care,” “Establishing Selection Criteria,” and “Benchmarks,” to cite just three of the book’s 10 chapters, commendably averaging just four pages of the book’s slim 51-page total.
The authors do not think fund companies will change anything of their own volition.
“You alone can improve target-date funds," they write. "Nothing will change unless and until you set the objectives for TDFs and seek solutions that can meet those objectives.”
The authors stress that fiduciaries may pay the price — financially, legally and ethically — for the less-than-exemplary state of the TDF industry.
“If you decide not to act, there could be a personal price to pay in the form of lawsuits. The duty of care requires that you protect the financially unsophisticated. It’s like the duty to protect your young children,” they write of the tens of millions of Americans whose retirement income security is at stake.