Target-Date Funds Go Under the Microscope

At hearing, senators evaluate calls for reform.

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As retirement-age workers scramble to pick up the pieces from the downturn, Congress is putting target-date funds under the legislative microscope. At a hearing yesterday, senators expressed concern about the costs and structure of the funds, which are common options in 401(k) plans. In particular, they mulled over the possibility that target-date funds, also referred to as life-cycle funds, do not disclose enough information and that their management style lends itself to conflicts of interest.

[See Many Target-Date Funds Miss Their Mark.]

The portfolios of target-date funds typically start out with significant stock exposure and shift to more conservative fixed-income holdings as investors near retirement. They have ballooned in popularity since 2006, when employers got the option to make target-date funds the default investments in their workers' retirement plans. During last year alone, target-date funds saw $57 billion in new investments.

[Also see 7 Tips for Investing in a Target-Date Fund.]

Target-date funds took a beating in 2008. Even those with 2000-2010 target dates, which in theory should be particularly conservative, were down by an average of 22.5 percent, according to Morningstar. And now, as Congress becomes increasingly concerned with retirement safety, the funds are drawing scrutiny. "Target-date funds are a privileged animal," says John Rekenthaler, Morningstar's vice president of research and new products. "Their level of responsibility is higher than that of the typical mutual fund because people aren't making a choice to own them; they're just being put in there. They can opt out, but nevertheless, other fund purchases are active decisions."

As a result, Rekenthaler, who testified at yesterday's hearing in front of the Senate's Special Committee on Aging, says the funds should be required to contextualize rather than just list their fees and to provide more information about how allocations will change over time. A stickier question, though, pertains to conflicts of interest. Target-date funds generally employ a fund-of-funds structure, meaning that instead of buying individual stocks and bonds, they purchase shares in other mutual funds. So fund companies can build the portfolios partly—if not entirely—by buying shares of other funds that they operate. "Clearly, that's an opportunity to self-deal," says Michael Case Smith, the target-date fund manager at the New York-based investment management firm Avatar Associates.

Smith, who also testified yesterday, says fund companies can use the target-date model to circumvent the principles outlined in the 1974 Employee Retirement Income Security Act. That's because currently, target-date fund companies are not subject to ERISA's fiduciary standards. According to Smith, this setup can lead to exploitation. "If I'm a large-cap manager, I don't make more by putting IBM in my portfolio and not Microsoft," he says. "Quite a different story when I'm a fund company and I have a target-date fund, and I'm taking participants' money in 401(k) and I'm buying shares not of IBM and Microsoft but of those same mutual funds that are plan assets if they're not inside that structure."

This regulatory push has encountered opposition from the fund industry. "Treating the adviser of a target retirement date fund as an ERISA adviser would be incorrect as a matter of law, would upset 35 years of plan regulation, and would be bad public policy," the Investment Company Institute, the trade group for mutual funds, said in a statement.

Instead, the ICI and others feel that the market will provide the appropriate balance. While Rekenthaler supports additional disclosure requirements, he says the government can stop short of regulating away the use of proprietary funds. "Target-date funds are a big area. There's a lot of money in there, and even more money and more scrutiny is coming," Rekenthaler says. "There will be questions about the weaker-performing funds. There's just going to be market pressure for the target-date providers to open up and to start hiring some of the better, lower-cost managers outside of their own firms."

Still, market pressure depends on active investors, which target-date funds often lack. Since they are default holdings in many retirement plans, many investors don't subject them to scrutiny. "The least-involved investors own target-date funds, people who otherwise wouldn't own a mutual fund," says Rekenthaler.

This could be particularly problematic as investors near retirement age, since different funds pursue different strategies. Though there is generally little difference among the various funds in initial risk, managers often diverge significantly in the later years, with some still staying heavily invested in stocks even as their investors prepare for retirement. "It's fairly easy to model people in the accumulation stage," says Rekenthaler. "It's a lot harder as people reach retirement, because then the needs really do vary."

As a result, investors need to be aware of the trajectories that their funds are taking. "As people get closer to retirement, they need to be more involved with their target-date funds," says Rekenthaler. "Retirees have got to step up."

Corrected on 11/09/09: A previous version of the story misspelled John Rekenthaler's name.