The Target-Date Duty: Time for a new look at TDFs

Target-date funds have enjoyed remarkable acceptance by 401(k) fiduciaries, and why not? They “solve” the problem of lack of investment knowledge of many participants—and they are eligible for the QDIA fiduciary safe harbor for defaulted participants.

However, that acceptance may have been too fast. The bear market of 2008 taught us that many target-date funds can suffer staggering losses.

Those losses caught the attention of Senator Herb Kohl (D-Wisconsin), who chairs the Senate Special Committee on Aging, and of the Securities and Exchange Commission (SEC) and the Department of Labor (DoL). All three are investigating TDFs.

In light of these events, plan sponsors need to make sure that, in selecting and monitoring their TDFs, they engage “in an objective, thorough, and analytical process that involves consideration of the quality of competing providers and investment products,” to quote the DoL. For example, in selecting target-date funds, did your committee consider competing products—and compare them with the needs of your participants?

In my experience, many did not. That may have been because, at the time, there were few competing providers, little information about asset allocation and glide paths, no benchmarking services, and a requirement that proprietary TDFs be used. All of that has changed—with the exception that some recordkeepers still require that their own TDFs be used or, alternatively, charge more for recordkeeping services if they are not.

The Prudent Man Rule requires that fiduciaries act “with care, skill, prudence, and diligence under the circumstances then prevailing.” While the circumstances of a few years ago may have limited a fiduciary’s ability to evaluate TDFs, those circumstances have changed.

Experts tell me that there are two critical issues for evaluating TDFs. The first is to focus on the last 10 years of the glide path—where the largest account balances are (and where the greatest gains and losses can occur) and where the differences among TDFs are the greatest (think “aggressive” and “conservative”). Second, are they designed for participants to stay invested in the TDF after retirement—“through”—or are they designed without regard to how the participant invests after retirement—“to”?

Consider the following: If your TDFs have a glide path “through” retirement, are you educating your participants that you selected a TDF that is designed for participants to continue to use after they roll over their retirement benefits to an IRA? Did you know that your selection contemplated that participants should continue to invest in that TDF post-retirement? Or did you choose a “to” TDF whose glide path ended at retirement and did not anticipate the post-retirement investment of the participant?

What if the recordkeeper’s proprietary TDFs are not suitable for its participants, but the recordkeeper prohibits the use of unaffiliated TDFs? In that case, fiduciaries must make a difficult decision, because the recordkeeper’s requirements do not relieve fiduciaries from the duty to make prudent investment decisions. On the other hand, if the recordkeeper allows unaffiliated TDFs, but charges additional fees, the fiduciaries should consider whether those fees outweigh the impact of a better-suited TDF family. That depends on a variety of factors, including the amount of the additional fee, the percent of assets invested (and to be invested) in TDFs, and the value of better-suited TDFs to the participants. If the fiduciaries conclude that the value of prudently selected TDFs is significant, can the fiduciaries properly pay additional fees or expose all their participants to higher costs? Yes, they can; in fact, they may be obligated to do that.

These are difficult decisions about complicated issues. Committees should work with experienced 401(k) advisers to understand the issues and to engage in a prudent process to evaluate TDFs.