Surveys show that the overwhelming majority of 401(k) plans offer target date funds as part of their investment lineup. Usually, target date funds are the plan’s designated qualified default investment alternative, or QDIA, which means that large numbers of participants who don’t make their own investment decisions are invested in these funds.
Yet despite their popularity, target date funds in different fund families vary greatly in management styles, fees, and the proportion of equity, fixed income, and other asset classes at different ages. Custom funds are different from off-the-shelf funds. In addition, target date funds often have unappreciated risks.
Many fiduciaries responsible for selecting their 401(k) plan’s target date funds don’t understand how these funds work. The risk of staying ignorant is increasing. Lawsuits challenging target date fund selection are on the rise, and plan fiduciaries need to be able to defend their choices in response to these suits.
New products, such as target date funds that provide lifetime income options or make private equity investments are becoming available. For all of these reasons, if target date funds are included in a plan’s investment menu, it is essential for fiduciaries to develop a prudent process for evaluating target date funds in partnership with their investment professionals.
Here are some common misunderstandings about these funds:
Aren’t these funds approved by the Department of Labor?
If you have selected target date funds as your QDIAs, that doesn’t mean that you are protected from lawsuits. The Department of Labor established these funds as one of three safe harbor QDIAs, but fiduciaries are not relieved of their obligations to prudently select an appropriate fund and to monitor its performance and fees.
Aren’t target date funds a risk-free investment choice?
No. Many fiduciaries think that target date funds are a safe solution for participants who don’t make their own investment choices, but all investment options have varying degrees of risk.
Fiduciaries may think that target date funds just change the mix of equity and fixed income over time to become less risky as the participant ages, but target date funds—especially custom funds—can also invest in real estate, private equity, and other alternative investments that fiduciaries need to evaluate.
For example, a 2020 Department of Labor Information letter confirmed that it could be prudent for target date funds to include private equity investments, but fiduciaries need to consider the associated liquidity issues and fees.
Just to make things more complicated, under a Trump administration regulation that hasn’t yet been delayed or withdrawn, a fund with stated ESG goals could not be a plan’s QDIA, and this rule would also apply to target date funds used as QDIAs, though there is a delayed compliance date.
Traditional equity and fixed income investments also have their own risk. The mix, or glide path, of investments is not the same from fund family to fund family for participants assumed to retire at the same date. Some funds have significant equity exposure even after participants are assumed to have retired.
A recent article by Capital Group/American Funds was headed “Look Out For Bond Risk in Target Date Funds” and pointed out that the credit exposure for the bond investments in target date funds also varies among funds and has been increasing, especially for older participants with more fixed income exposure. The reason is that in the current low-interest rate environment, managers are assuming more credit risk to get a higher return.
Aren’t target date funds the only QDIA option?
No. Though target date funds can certainly be an appropriate QDIA fund selection, many fiduciaries are not aware that balanced funds and managed accounts can also be QDIAs. Among the reasons for considering these are that target date funds have a “one size fits all” approach that treats all participants in the same age group in the same way.
They don’t take a participant’s other assets or risk tolerances into account. We hear stories of participants who lie about their ages to come into a fund that better matches their risk tolerance and studies show that many participants invest only part of their account in target date funds, even though they are intended to be a participant’s only investment. In addition, target date funds can be expensive and complicated.
Balanced funds are easy to understand and explain to participants, and many have a long performance history. They are likely to have lower fees than target date funds with their fund of funds structure. In fact, a few studies have argued that when fees are taken into account, balanced funds may outperform target date funds over time.
Managed accounts may take individual considerations into account in making investments and are free of some of the conflicts that arise when fund families use their own proprietary funds as the underlying target date fund investments.
A newer option for fiduciaries is a combination of the target date and managed account options. Some plans will switch participants over to a managed account as the participant nears retirement age.
How can fiduciaries protect themselves?
It was interesting to note when reviewing complaints in recently filed lawsuits that some plaintiffs argued that Fidelity Freedom Funds (Fidelity’s target date family) were an imprudent investment, while another complaint claimed that the fiduciaries were imprudent because they did not invest in the Fidelity Freedom Funds.
This illustrates how plaintiff’s counsel will often select a benchmark or alternative investment that they claim should have been selected simply because it differs from the plan’s current choice. However, courts recognize that there isn’t one correct way to invest, and courts will not review decisions with 20/20 hindsight. In order to protect themselves, fiduciaries whose plans have target date funds can:
- Make sure that the plan’s investment policy statement includes provisions on selecting and monitoring target date funds.
- Compare their vendor’s proprietary funds to other available alternatives.
- Select an appropriate benchmark to evaluate the funds. Be prepared to challenge any inappropriate benchmark cited to show lagging performance and high fees by plalntiffs in participant lawsuits. This can result in a win in court, as shown in a recent decision dismissing a lawsuit filed against Intel challenging Intel’s target date fund investments. The court refused to accept the benchmarks used by plaintiffs, saying that it had not been demonstrated that the benchmarks were appropriate.
- Understand the different fees and compare fund family fees, bearing in mind that target date funds have multiple layers of fees. ERISA does not require selecting the least expensive fund or using only index funds.
- Consider doing an actual rfp for target date funds.
- Carefully document the reasons for the fund selected.
- Regularly monitor the funds.
- Document reasons for not removing retained funds if performance lags peer funds.
Carol I. Buckmann is a partner with New York-based Cohen & Buckmann, P.C., an executive compensation, pensions, and benefits law firm.
