Fiduciary and Ethical Problems Could be a Minefield for TDFs

The $1.3 trillion Target Date Fund market is not all it’s cracked up to be.

That should come as a big surprise to millions of people who own these funds through their employers’ 401(k) plans, as well as others who were sold a simple, easy-to-understand, hands-off investment product that would allegedly take care of their investment exposures over an extended period, sometimes up to 25 years into the future.

Yet while these future implied promises of Target Date Funds (TDFs) were intended to give investors peace of mind, too many plan sponsors and their consultants charged with vetting these funds for fees, expenses, design, and suitability were often asleep at the wheel. These same 401(k) plan providers, who by definition assumed a role of working in the best interests of their own employees or client-investors, have failed to do their job, according to an expert in TDFs. In too many cases, plan sponsors have just gone with the largest TDF providers (T. Rowe, Vanguard and Fidelity), even though other TDF providers are better.

Fiduciaries are breaching their duty of care when it comes to Target Date Funds.

According to Ron Surz, president of Target Date Solutions, San Clemente, California, this $1.3 trillion market has some major ethical flaws created by people acting as fiduciaries that failed in four major areas:

•  Plan administrators did not adequately screen TDF investment managers;
• They failed to protect TDF beneficiaries and investors, especially as they approached their retirement dates (also known as the TDF’s  target date);
• They allowed the TDFs to be sold without monitoring fees and expenses;
• The fiduciaries fell prey to sales gimmicks from fund managers.

“The basic ethical dilemma here is that TDFs are being sold, not bought, and what is being sold is not safe,” Surz said. “You can’t blame the fund companies who sell TDFs because they are not fiduciaries; they’re vendors whose business is to make profits, but you can blame the plan’s fiduciaries (plan sponsors and their advisors) because they should be seeking the best solutions for their pension plans, rather than settling for their bundled service provider or the best sales pitch, or worse, a round of golf.”  

When TDF’s entered the 401(k) marketplace in the mid-to late-1990s, I was working at Principal financial as a senior writer. In that capacity, I wrote some of the earliest marketing materials for this new, easy-to-understand, and earlier-to-sell product. Still, while reading the internal descriptions of these funds, I came across a gap in what the funds were supposed to do a decade or more into the future. When I interviewed a senior portfolio manager about the Principal’s TDF lineup and asked him about that, he said, “We’ll worry about that when the time comes.”  

Maybe he knew he would be retired by then or else it would be another portfolio manager’s problem about whether the TDF went into a cash position or stayed fully invested in a more conservative portfolio, but in either case it was not an issue when the funds were launched.

The so-called “glide path” of TDFs over time remains a significant sales and research issue today, but it should be a primary concern to investors.  The reason is that as Surz notes, the last few years of any investment in a TDF, or any other retirement account, is that the previous few years of returns are crucial in determining the quality of life for retirees. From an investment point of view, the amount of money in an investor’s portfolio covering the last five years before and after retirement is called the “risk zone.”  And due to the “sequence of return risk,” how much money is withdrawn at what stage the market is in also significantly impacts the future size of a portfolio.  For example, if a retiree withdraws cash during a bear market, it will reduce their overall portfolio, so their future overall portfolio gains also will be reduced. 

So, What Does This Have to Do With TDFs?

Like all other equity-based investments, the 2008 bear market hurt TDFs despite their long-term perspective and diversified portfolios. Surz estimates that TDFs suffered losses of 30%. Yet, plan sponsors, in their role as fiduciaries, were never held accountable for compensating their employees’ 401(k) plan participants who lost money during this crash since the TDFs were considered Qualified Default Investment Alternatives. This meant TDFs were considered “safe harbors,” and it protected fiduciaries, but not TDF investors who suffered the losses.

While this got fiduciaries off the hook, they still had a primary ethical responsibility to their employees, Surz said. “Fiduciaries should be ashamed, and may be surprised by any aspect of fiduciary law that holds them to a higher standard called substantive prudence, which is doing what is best. The fiduciary duty of care requires that fiduciaries try to do what is best for beneficiaries. The duty of care is a responsibility to try to do what is ethical. You don’t have to be the best, but you must try to be the best. That is not what is happening now. Fiduciaries are breaching their duty of care,” Surz said in a paper, “Target Date Fund Unethical Practices.”

As for the future, Surz said that the 30% TDF losses from 2008 can easily be repeated again, especially since TDFs have developed new gimmicks, such as environmental, corporate governance, and socially responsible funds, as well as TDFs that follow market timing. If the TDF market suffers losses like it did in 2008, Surz said he has spoken with class action lawyers who would seek compensation for investors.

While market moves are unpredictable, the problem is that in TDFs , as well as in the entire financial planning and investment marketplace today, individual investors have assumed all market risks, while often paying excessive fees.

This task is daunting for professional investors and untrained, financially unsophisticated people. It also means fiduciaries should take their responsibilities seriously and focus on the design and risk profiles of TDFs. The alternative, Surz said, is that lawsuits may be a way to correct unethical, fiduciary violations that hurt unsuspecting investors. This may be sad, but the financial services industry has shown they often only make changes when faced with lawsuits.