At $3 trillion and growing, target-date funds (TDFs) are the darlings of the 401k industry, but fiduciaries have made a bad bet, one that’s about to lose big time, perhaps by even 50% or more. Three trillion dollars could become less than $1.5 trillion.
Lawsuits are a logical consequence of this failure to protect unknowing participants who default their investment decision to their employer.
Most assets in TDFs are there as a Qualified Default Investment Alternative (QDIA). Fiduciaries should not have put naïve plan participants in such danger so close to the “Risk Zone,” one that spans the transition from work to retirement.
Bad odds
The average TDF is invested 50% in equities (stocks, real estate, etc.) and 35% in risky long-term bonds at the target date, so 85% in risky assets. This allocation is expected to have excessive losses in three years out of 20, where “excessive” is defined as a loss greater than 10%.
But the past 13 recovery years from the 2008 crash were extraordinary. There’s a 10% chance of avoiding an excessive loss over a 13-year period with this allocation, and here we are with no excessive losses in TDFs—we’ve been incredibly lucky. The stock market has returned a fantastic 600% over the past 13 years, leading many to expect a correction in this decade.
“QDIA-defaulted participants have no idea that they are in jeopardy of losing a substantial portion of their life savings.”
The popularity of TDFs in 401k plans began with the passage of the Pension Protection Act of 2006 that anointed TDFs as QDIAs. When the crash of 2008 occurred TDFs were still in their infancy at $200 billion.
Much of the growth since then has been in one of the greatest stock markets ever. Fiduciaries have been very lucky. The best-performing TDFs have been the riskiest, but it’s about to change.
In a Bayesian sense, the odds of an excessive loss in the near future are high simply because a correction is long overdue. Stock market corrections greater than 10% tend to occur every two years, and the past 13 years are the longest recovery on record.
But some TDFs are far less risky at the target date, holding less than 30% in risky assets, with the balance in very safe Treasury bills and short-term Treasury Inflation-Protected Securities (TIPS). These TDFs have an insignificant probability of excessive loss, even in the face of an awfully expensive stock market.
The objective of a TDF should be to make assets last a lifetime, a topic of great interest to retirement researchers. In their seminal article, Dr. Wade Pfau and Michael Kitces identified the optimal retirement glidepath. It starts very conservatively with less than 30% in risky assets and then re-risks to a maximum of 45% equities as investors age.
The low initial risk protects against sequence of return risk and the re-risking extends the life of the assets. To begin retirement conservatively you must end your working life conservatively, creating a U-shaped glidepath, which is both “To” and “Through” in TDF nomenclature.
The beginning of the reckoning
Our government has recently printed more than $13 trillion, which is more than the costs of our 10 most expensive wars combined. We’ve relied on Modern Monetary Theory (MMT), which says you can poke the inflation bear until it wakes up, but then take whatever money back in taxes. Much of the printing has been used to drive up stock and bond prices, and more recently in COVID relief.
But so-called Quantitative Easing (QE) is about to end as the Fed shifts its focus from manipulating bond prices to fighting inflation. This marks the beginning of the end of the Zero Interest Rate Policy (ZIRP) that will devastate both stock and bond markets. The sad reality is that the Fed is just pretending it remains in control.
The imminent market crash could be a doozy that irreparably harms participants who are near retirement.
Congress is understandably concerned
The breach of fiduciary duty in selecting risky TDFs hasn’t gone unnoticed.
On May 6, 2021, the Senate Health, Education, Labor, and Pensions (HELP) Committee, and the House Education and Labor Committee, sent a letter to the GAO seeking answers to 10 questions dealing with concerns over TDFs and the risk to retirement savers. They wrote:
“…we write to request the General Accountability Office (GAO) conduct a review of target-date funds (TDFs). The employer-provided retirement system must effectively serve its participants and retirees, and we are concerned certain aspects of TDFs may be placing them at risk.”
It will take time to hear from the GAO. In the meantime, I responded and offered my recommendations. Comments are welcome.
Fiduciaries don’t have to choose high-risk TDFs
There are two types of target-date funds—risky and safe. The risky group has been the most popular by far, and therein lies the bad gamble. Fiduciaries should have opted to protect defaulted participants, as exemplified by the Federal Thrift Savings Plan (TSP), the largest savings plan in the world.
The TSP TDF ends less than 30% in risky assets at the target, whereas the typical TDF ends 85% in risky assets. In addition to the TSP, the National Retirement Savings Plan of the Office and Professional Employees International Union (OPEIU) is also very safe at the target date.
Most fiduciaries believe that procedural prudence limits their choice to the Big 3 TDF providers—Vanguard, Fidelity, and T Rowe Price. But substantive prudence and doing what is right argues for safety at the target date. Defaulted participants have no idea that they are in jeopardy of losing a substantial portion of their life savings. This imminent crash will shock them. It’s just not fair.
Baby boomers will suffer most
Most of our 78 million baby boomers will spend much of this decade in the “Risk Zone,” when investment losses can irreparably spoil the rest of life. It’s a risk with the potentially dire consequence of depleting lifetime savings that cannot be replenished with paychecks, nor is there enough time remaining to recover with investment gains.
I wrote a book, Baby Boomer Investing in the Perilous Decade of the 2020s, to warn my fellow baby boomers and help protect their lifetime savings. Even “poor” baby boomers can live reasonably well in this country, but not if they lose their lifetime savings.
Lawsuits
Fiduciaries seldom get into trouble for making well-intentioned mistakes, especially if everyone else is making similar mistakes. But fiduciaries can and have been sued en masse for bad practices, like paying excessive fees, and for conflicts of interest, they all share.
In the case of TDFs, everyone wants protection. Fiduciaries want protection from lawsuits, so they choose the most popular TDFs. TDF participants want to be, and believe they are, protected from losses as they near retirement. Many even believe they’re guaranteed against investment losses.
The conflict of interest exists when popular TDFs do not serve the interests of participants and expose them to significant risk in that Risk Zone.
Conclusion
It’s too soon to tell if recent stock market losses are the beginning of a stock market crash, but it is undeniable that a crash will happen because they always do. Defaulted participants in TDFs could be devastated in the next such crash. It’s a shame.
Ron Surz is President of Target Date Solutions and CEO of GlidePath Wealth Management. He is also the author of Baby Boomer Investing in the Perilous Decade of the 2020s. He can be reached at Ron@TargetDateSolutions.com.