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One striking thing about the Department of Labor’s Target Date Fund (TDF) tip sheet was how much the ‘tips’ were simply a re-statement of general fiduciary rules applicable to choosing and monitoring any fund in a 401(k) plan fund menu. Even controversial ‘tips,’ such as “Inquire about whether a custom or non-proprietary target date fund would be a better fit for your plan,” could easily be applied to the selection of, e.g., an equity fund. But it is true that the added complexity of TDFs can make the fiduciary’s job harder.
In this article we briefly review some of the fiduciary challenges that TDFs present. We begin with a brief review of how TDFs work and the features of TDFs that increase the complexity of the fiduciary’s job. We then review the issues presented by TDFs in key areas of fiduciary exposure – fund selection, monitoring and benchmarking, and fees.
We assume a general familiarity with how TDFs work, but let’s review briefly. Here’s DOL’s definition of ‘target date fund:’
An investment fund product … that is designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant’s age, target retirement date (such as normal retirement age under the plan) or life expectancy.
TDFs go by different names, including target maturity funds and lifecycle funds. Generally, TDFs provide a suite of pre-mixed portfolios each targeting a specific investment horizon, e.g., a set of TDFs might offer 2020, 2030, 2040 and 2050 funds. The funds are re-mixed (generally, with greater allocations to fixed income and smaller allocations to equities) as the target cohort (e.g., persons retiring in 2030) ages.
The rate at which the asset allocation (between “varying degrees of long-term appreciation and capital preservation”) in a TDF changes over time, from less conservative to more conservative, is called the ‘glide path.’ There is a mini-controversy over how the glide path should be designed, known as the ‘to vs. through’ question: should the TDF glide path reach its most conservative asset allocation at retirement (‘to’) or at the end of life expectancy (‘through’)? No consensus as to the right answer to this question has been reached, but the alternative answers result in significantly different asset allocations at, e.g., age 65.
Two features (at least) of this design complicate the fiduciary’s task. First, because TDFs are a mix of asset classes (and often a mix of other sub-funds), judging performance is more complicated than simply comparing performance and fees with another fund. Second, because different TDFs use different glide paths, again fund-to-fund comparisons are problematic.
Either one of these features increases complexity, but in combination they increase it exponentially. How do you know a fund is under-performing? Is there a problem with the performance of a single underlying fund? Or is it a problem with the design of the glide path (in effect, the asset allocation strategy)? We discuss this issue in more detail below.
Finally, in addition to the complexity of the fiduciary’s task, because (typically) TDFs are the plan’s default investment, there is often more of the plan’s money in them than in most other funds. As a result, they (and their performance and fees) may be subject to a higher level of scrutiny. So, for TDFs, the fiduciary’s job is both harder and more crucial.
The two 401(k) fiduciary issues that seem to be getting the most attention from litigators are fees (which we discuss below) and “fund selection, monitoring and benchmarking.” Last year’s (very significant) Tussey v. ABB decision involved both of these issues (and involved a TDF). The black letter law on fund selection, monitoring and benchmarking is fairly straightforward. The fiduciary should have a prudent process:
For selecting an appropriate fund – appropriate for the particular investment class (e.g., equity or growth or long term bond) and appropriate as part of the plan’s fund menu.
For monitoring the ongoing performance of the fund, generally against an appropriate benchmark.
The question, of course, is, how do you benchmark (or, e.g., compare fees for) TDFs? If the TDF is simply a mix of other, single-asset-class sub-funds, then you could benchmark each of those sub-funds. Although it will not always be clear what you should then do — one component may be a super-performer and another an under-performer. The under-performer may be a significant piece of, e.g., the 2050 fund but an insignificant piece of the 2020 fund. With another glide path, it’s conceivable that the underperforming fund would become insignificant for the 2050 fund as well.
An illustration may help here. Assume the underperformance ‘problem’ is with the most conservative underlying investment and you are using a ‘to’ glide path (most conservative asset allocation at retirement) rather than a ‘through’ glide path (most conservative asset allocation as participant approaches life expectancy). If you switch to a ‘through’ glide path, the asset allocation to the problem investment goes down and (theoretically) overall performance goes up. Is that a solution to the fiduciary issue?
Obviously, the analysis here can go very deep. You could examine each sub-fund and swap out the ones that under-perform. You could design a custom glide path and consider various investment strategies (US vs. non-US assets, real assets, etc.) at various points along that path. But those alternatives are generally available only if you have your own, ‘custom’ TDF, an option that requires some commitment of sponsor money and time, may involve some fiduciary risk, and is generally only practical for larger plan sponsors.
Thus, as a practical matter, this sort of ‘deep’ analysis has little utility where you are simply buying a fund provider’s TDF. In that case, a sponsor typically does not have the option to replace a sub-fund with a better performer or to redesign the glide path. The TDF family is generally a fund provider’s product, and the provider controls which sub-funds are in and which are out and how the glide path works. Your only alternative is to go to another fund provider and evaluate whether that TDF, all things considered (including whatever problematic sub-funds that TDF may have), produces better results.
Until the benchmarking problem is solved – and until everyone agrees on the solution – these issues won’t go away. ERISA, however, does not ask the impossible. A fiduciary facing the challenge of selecting, monitoring and benchmarking a TDF will have to make sure that all the issues are raised and considered prudently. And that process should be documented.
Despite (or perhaps because of) considerable ongoing litigation of 401(k) fees, the black letter law on fees for investment services remains somewhat obscure. It could be reduced to: “the plan should not overpay.” But how you tell if the plan is overpaying, or for that matter how a plaintiffs’ lawyer can prove the plan is overpaying, remains unclear. A couple of themes, however, have emerged:
Institutional vs. retail. In many cases plaintiffs have asserted (more or less) that big companies should get a ‘good deal’ on fund fees, commensurate with their size. A common element of plaintiffs’ complaints is that the plan uses ‘retail’ funds. Sponsors that select a ‘retail’ TDF will generally want a good (and well-documented) reason for doing so.
Revenue sharing. As we noted in our article on Tussey, revenue sharing is likely to be a target in future litigation. We would also comment that Tussey puts a premium on the fiduciary knowing exactly how much revenue sharing costs. Generally, however, tracking revenue sharing for a TDF is no more difficult than it is for other funds.
Certainly, in evaluating the reasonableness of TDF fees, a good question to ask is: “What fees would be paid if the plan bought the underlying sub-funds separately?” Some providers may still charge an additional fee for simply operating the TDF, but generally the fee for the TDF should more or less reflect the fees for the underlying funds. Thus, generally, a fiduciary will want to consider doing a ‘bottom-up’ analysis to determine whether the fees for the TDF are more or less what they would be if the plan bought the funds separately. The provider may be able to help with this.
There is also the issue identified in the ‘tip sheet’ — “whether a custom or non-proprietary target date fund would be a better fit for your plan.” Obviously a “custom or non-proprietary” TDF may not be a practical option for many sponsors. But large employers may be able to cut fees by using, e.g., a mix of the plan’s current ‘core’ funds. And even some smaller sponsors may have enough leverage to insist on the inclusion of, e.g., a better performing TDF offered by an unaffiliated provider. Given DOL’s identification of this issue, fiduciaries will want to at least consider whether or not this makes sense.
In this regard, let’s note that in one way using a TDF made up of a portfolio of mutual funds makes the evaluation of fees easier, because information on the fees of the sub-funds is publicly available. If you are using non-public collective trusts or separate accounts, developing bottom-up fee information may be more problematic.
In a perfect world there would be much more clarity on this issue (“what is a reasonable TDF fee?”). Unfortunately it seems that policymakers and litigators are basically asking sponsors and fiduciaries to produce that clarity, by spending more effort identifying and comparing costs.
Clearly, the QDIA regulation identified TDFs as a ‘safe harbor’ default option. As we discuss in our article on reenrollment litigation, however, problematic facts – e.g., the re-default to TDFs just before the 2008 global financial crisis – can produce litigation. Sponsors and fiduciaries will want to make sure that all requirements of the QDIA regulation are satisfied, so that they are prepared to defend their actions in situations where default investment options result in large losses for some participants.
Moreover, the shift to using TDFs as the default, and in some cases as the preferred, investment option has focused attention on these funds. Much more money is in them than in the pre-QDIA days. The result: litigators are likely to focus on TDFs – in the way that they have focused on, e.g., stock funds – more than on other funds. Again, this development will make fiduciary procedures and compliance with respect to TDFs a priority.
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Both Tussey and the more recent Krueger v. Ameriprise Financial were cases involving (among other things) claims based on TDF performance (or under-performance) and fees. In Tussey the court found that fiduciaries had not followed appropriate procedures in de-selecting the Vanguard Wellington Fund and selecting the Fidelity Freedom Funds (a Fidelity TDF ‘family’). Moreover, an element of the court’s decision against the plan fiduciary was its finding that “the Wellington Fund consistently outperformed the Freedom Funds from 2000 to 2008.” As we discuss in our article, Krueger can be read as requiring a higher standard of ‘prudence’.
We expect more litigation on these issues — both fund selection, monitoring and benchmarking, and fees — often involving TDFs. We will continue to follow them.