Select Target-Date Strategies May Reduce Costs, Conflicts, Risk

Copyright 2008 Institute of Management & AdministrationAll Rights Reserved Managing 401(K) Plans

July 2008

HUMAN RESOURCES Vol. 2008 No. 7

2404 words

Select Target-Date Strategies May Reduce Costs, Conflicts, Risk

Service providers that offer target-date funds are making some changes in their offerings that may lower plan costs and potential conflicts of interest, insure against participant investment risk, and reduce the risk of lawsuits.

Many 401(k) plans include target-date or life-cycle funds as investment options for plan participants in general or as part of a qualified default investment alternative for plans with automatic enrollment. Target-date funds are heralded for their simplicity, diversification, long-term investment features, and "select and forget" characteristics.

Target-date funds generally maintain a diversified portfolio allocated between equities and fixed-income investments. In a process known as the fund's glide path, the fund's asset allocation gradually becomes more conservatively concentrated in fixed income investments as the fund's target retirement date draws closer. However, the fund's underlying investments, its exact allocation and rebalancing strategy, as well as the fund's expenses charged to investors can vary substantially from fund to fund.

Although target-date retirement funds come in a variety of formats, they are most often offered to plan sponsors as a fund-of-funds arrangement consisting of off-the-shelf proprietary mutual funds selected by the fund operator, which is often a mutual fund company. It has been argued by some that such products can involve unnecessary costs to plans, self-dealing by fund providers, and potential conflicts of interest among plan advisers who recommend such funds. The end result, it is argued, is that plan sponsors may unnecessarily be exposing themselves and their plans to increased liability.

To counter such risk exposure, a number of target-date retirement fund providers have been widening the choices for plan sponsors by, for example, building their target-date retirement plans with low-cost index or exchange-traded funds (ETF), forsaking the use of proprietary products as the fund's underlying investments, and accepting full fiduciary responsibility for all of the target-date fund's investment decisions.

Other providers are offering products that seek to alleviate investment risk for participants through net asset value insurance or by offering a "one-size-fits-all" solution that gives participants a choice of having their investments constructed for them or of having the ability to construct their investments themselves.

Risk of Fiduciary Liability

Target-date retirement funds have been criticized for potentially having embedded costs and conflicts of interest. These embedded costs arise because funds often impose a fee for the fund itself, as well as a separate fee for each underlying mutual fund. Potential conflicts of interest exist because a mutual fund operator may include within the target-date fund individual mutual funds that the operator has been having a difficult time selling or may include high-cost funds that are designed more to maximize the mutual fund's revenues than to benefit plan participants.

Michael Case Smith, director of research, Zacks IFE, a division of Zacks Investment Research, Chicago, told IOMA that plan sponsors risk exposing themselves to potential lawsuits from their participants by failing to take into account potential conflicts of interest and the reasonableness of fees assessed in the target-date retirement plans they select for their participants.

Moreover, Smith said that when target-date plan managers allocate participant assets among their variable-fee mutual funds, any allegation of self-dealing stemming from, for example, the manager's allocation of plan assets to high-fee funds places the plan sponsor at risk for failure to adhere to its fiduciary responsibilities of prudence and loyalty to participants under the Employee Retirement Income Security Act (ERISA).

In addition, Smith said that plans hoping to construct in-house customized target-date funds to avoid the problems inherent in off-the-shelf products are significantly increasing the plan's fiduciary liability since the plan will be responsible for the fund's underlying investments, asset allocation, and glide path.

According to Smith, plan consultants, advisers, and brokers who may assist in developing such customized programs may be conflicted in their recommendations since their compensation often comes from the funds they recommend and, in any event, they are not considered to be plan fiduciaries under ERISA.

Customized Programs

To overcome the risk of increased liability, Zacks, according to Smith, seeks to reduce plan sponsors' fiduciary liability through customized programs for plan sponsors having at least $200 million in plan assets and through a product designed with the large investment and brokerage house T.D. Ameritrade for smaller plans.

In its customized program, Smith said Zacks accepts responsibility as a plan investment manager within the definition of ERISA Section 3(38) and will sign a letter pursuant to ERISA specifying that Zacks is the fiduciary responsible for all of the investment aspects of each target-date fund it offers.

By using Zacks, plan sponsors significantly reduce their potential liability as they are no longer responsible for the target fund's underlying investments, asset allocation, or glide path, Smith said. Instead, the plan sponsor's fiduciary responsibility is limited to the selection and monitoring of Zacks as the investment manager, Smith said.

Plans further reduce their exposure to lawsuits, Smith added, because conflicts of interest are eliminated by Zacks' refusal to use proprietary products and because of lower overall fees.

Smith said Zacks charges between 5 and 10 basis points (0.05 percent to 0.10 percent) for its services, which is in addition to annual fees of about 35 basis points (0.35 percent) that large plans typically pay on their funds.

Smith said that small and midsize plans can select a target-date fund offered by T.D. Ameritrade, in which Zacks is inserted by the brokerage firm as an independent third-party investment manager. As such, Zacks constructs target-date funds by selecting 500 individual stocks and bonds, thereby avoiding any conflicts associated with proprietary products, Smith said.

According to Smith, this is the "safest target-date vehicle for small plans," since "self-dealing isn't even possible." These target-date funds are currently offered at an annual expense ratio of 65 basis points (0.65 percent), he said.

Use of Passively Managed ETFs

Another provider seeking to overcome high fees and questions over potential conflicts of interests is the New York City investment asset allocation firm Avatar Associates, which creates target-date funds by selecting passively managed ETFs rather than higher-cost actively managed mutual funds. According to Avatar's president and chief investment officer, Ted Theodore, not only are ETFs transparent and low-cost, but, because his firm receives no compensation from the ETFs it selects, there is no potential conflict of interest involved in the fund's investment selection process.

Theodore said his firm charges an annual fee of 25 basis points (0.25 percent) for its ETF selection and management services. This, he said, is in addition to the charges assessed by the ETFs themselves, by the plan recordkeeper, and by a financial expert that assists plan sponsors in developing the appropriate asset allocation and glide path for the plan's participants.

The firm also offers a separate, more customized option for participants that takes into account more than a participant's age or expected retirement date in determining the required investment strategy, according to Theodore. He said an independent firm typically uses anywhere from five to seven metrics to discern the unique characteristics of each participant and uses that information to design an asset allocation strategy for each participant. Theodore said his firm will implement this strategy for each individual participant and will do this at a lower total cost than charged by most individual managed account programs.

His firm's ETF services are particularly suited to small and midsize plans, Theodore said. Very large plans--those with assets in the billions--will often be offered the use of cheaper alternatives through customized index funds, he noted.

Low-Cost Index Fund Option

Another company seeking to offer plan sponsors lower-cost options for their target-date plans is Vanguard in Valley Forge, Pennsylvania. Although offering a fund of funds platform, Vanguard does not charge an extra layer of fees beyond the charges assessed by the underlying mutual funds and includes only passively managed index funds in the target-date fund.

Scott J. Donaldson, senior investment analyst with Vanguard's investment strategy group, told us the company concluded from its analysis that such a strategy works best for the type of investors who are most likely to be automatically enrolled in such a vehicle--those who either do not want to make their own investments or who lack the time.

He said Vanguard believes that such investors want their plan money professionally managed, but nevertheless might decide to opt out of their retirement plan investments if these investments are "too complex" or produce returns below the market return.

Donaldson said his company believes that a passively managed index fund strategy works best for such investors since such a strategy eliminates the risk inherent in an actively managed strategy that the manager will actually produce returns below that of the market and because the higher cost of active management is likely to "overwhelm" the benefits of such a strategy over the "longer time horizons" required by most plan participants. According to Donaldson, while you "can't control markets, you can control costs."

On the subject of costs, Donaldson said the total annual cost to plans using Vanguard's target-date funds varies between 19 (0.19 percent) and 21 (0.21 percent) basis points, depending on the plan's size. Very large plans are given additional cost breaks, he said.

Asset Class, Passive-Active Strategy

In its target-date funds, Vanguard uses index funds representing the domestic and international equity markets, along with U.S. fixed income. In its most conservative fund, Vanguard also uses inflation-protected securities as part of its fixed-income allocation along with a small percentage of cash held in a money market fund, Donaldson said. Although other companies have added high-yield bonds, real estate investment trusts, and even commodities to their asset mix, Donaldson said that Vanguard did not believe such investments to be appropriate for target-date funds.

Smith, of Zacks, agreed with Donaldson that such investments were inappropriate for such funds. In addition, he said placing target-date plan money in asset classes such as international emerging markets, real estate, commodities, and other investment options provides fund companies with an added opportunity to direct participant assets to high-fee funds.

Contrary to Vanguard's view favoring passive management for such retirement plan vehicles, some firms believe their active management investment skills can be employed to protect plan investors in down markets while enabling them to participate when markets are up. One such firm is Manning & Napier Advisors Inc., Fairport, New York, which says it adjusts its glide path based on market conditions. A spokeswoman for the firm told IOMA that the firm invests in a relatively small number of equity and debt instruments and can change the fund's asset allocation as it sees fit within a "glide range."

Equity Exposure Risk

Expressing another view as to the risks faced by plan participants was Juan Ocampo, chief executive officer of Trajectory Asset Management, New York City. According to Ocampo, the "principal risk inherent in target-date funds is that they are not sufficiently risk controlled." He told IOMA the "industry as a whole has not reached consensus regarding the appropriate level of market risk that an investor should be exposed to at the ‘target' date, and so we see competing funds in the marketplace today with very different levels of equity exposure at their target dates."

"The most aggressive target-date funds hold considerable exposure to equity markets at their target dates; for an investor who plans to start taking distributions at the target date, one or two down years leading up to the target date will take a considerable bite out of the investor's nest egg," Ocampo said.

To control this risk, Ocampo said Trajectory has created what he described as a "unique protection feature" offered through the AIG High Watermark Funds that Trajectory manages. Under this strategy, underwritten by Prudential Financial, "investors who hold their shares to the target date (and reinvest their dividends) are entitled to the highest value the funds have reached over their lifetime, regardless of whether the investors held their shares at the time that value was reached," he said.

He said the annual expense ratio of the funds are 165 basis points (1.65 percent), which includes a 35 basis point (0.35 percent) charge for the protection feature offered by Prudential.

Target Funds & Brokerage Window

Another problem identified with target-date funds is that they may not satisfy the needs of all plan participants, who may vary greatly in their ability and desire to direct their own retirement plan investments. In an attempt to deal with this dilemma and to satisfy all types of plan investors, Nationwide Financial Services Inc., in Columbus, Ohio, offers a retirement plan program that pairs a target-date fund with a mutual fund window to give participants a choice as to how active they want to be regarding their investments.

Under its Nationwide Retirement Innovator program, Nationwide offers the bulk of plan participants who want little involvement with their investments a core fund lineup with portfolios specifically designed for accumulating savings for retirement. Other participants who want to be more involved in their investments can craft their own portfolios by using the mutual fund window. These participants don't need to establish a separate trading account or pay additional fees, according to literature Nationwide has distributed to describe the program.

Calls to Nationwide for comments on the program were not returned as of press time.

June 25, 2008