Ethics is knowing the difference between what you have a right to do and what is right to do. Judge Potter Stewart
Target date funds (TDFs) are the most popular investment in 401(k) defined contribution pension plans. They are on a growth trajectory that will take them to $4 trillion by 2020, from their current level of $1.5 trillion. That's 30% per year growth over the next 4 years.
On a percentage basis, TDFs will increase from 30% of all 401(k) assets to about half. There are currently 20 million participants in TDFs across 100,000 401(k) plans, and new subscribers default into TDFs every day. Approximately half of all new contributions are going into TDFs, and this percentage will increase to over 60% in just a few years according to research by Cerulli Associates.
Target date funds are a big deal, and with big deals come big responsibility.
The 20 million participants in TDFs tend to be younger since auto-enrollment places new employees in default investments until they make an investment selection. Accordingly, median account balances are small at around $15,000, but the average TDF account balance at retirement is $90,000.
In other words, the TDF marketplace consists of millions of small accounts that in aggregate total $1.5 trillion. Also, as comes as no surprise, account balances are highest for those nearing retirement, reinforcing the existence of a "risk zone" spanning the 5-10 years before and after retirement that heavily impacts retirement lifestyle due to what is called "sequence of return risk."
Precarious Prudence Without Legal Protection
Despite its growing popularity and importance, there is a lot of confusion surrounding target date funds. Some of this confusion leads to bad decisions that can harm beneficiaries and should expose fiduciaries to legal action, although no one was sued for investment losses in 2008. When beneficiaries are harmed by well-intentioned but misinformed fiduciaries, restitution is warranted because fiduciaries - plan sponsors and their advisors - should know better. In this case, the defenseless are millions of "little guys" with an average account balance of $90,000 at retirement, paying 100 basis points each to be in TDFs.
The law didn't protect beneficiaries from TDF investment losses in 2008; not a penny of the 30%+ loss was recovered. From an ethical perspective, no one likes to see the little guy get hurt, but the law allows it, or at least it did in 2008. We all want what is fair and just. As a practical matter, the applicable legal requirements for TDFs are fulfilled with "procedural prudence," namely acting as other experts act in a similar capacity.
In fact, as you'll see in this article, TDF fiduciaries rely on procedural prudence and the safe harbor protection of TDFs as Qualified Default Investment Alternatives (QDIAs). This is not sound ethical practice since it does not protect beneficiaries.
Fiduciaries should be ashamed, and may be surprised by an aspect of fiduciary law that holds them to a higher standard called substantive prudence, which is doing what is best. The fiduciary duty of care requires fiduciaries to try to do what is best for beneficiaries. The duty of care is a requirement to be ethical. You don't have to be the best, but you must try to be the best. That's not what is happening now. Fiduciaries are breaching their duty of care. Following the herd is not substantively prudent.
It appears that (A) opacity; (B) fees and expenses; and (C) illiquidity, conflicts of interest and related risks, all dramatically increased as the Fund's financial condition worsened-all contrary to prudent fiduciary practice. In my experience, such a trifecta of imprudence is all-too-common among failing pensions.
In the months and years to come, hundreds of corporate multiemployer and public pensions will approach insolvency. Participants in these pensions have a choice: do nothing and hope for the best, or fight back-band together, dig for answers and take action.
Participants whose retirement dreams have been devastated deserve to know why and those responsible should be held accountable. In my experience, there has never been a pension that failed that didn't have a roomful of experts saying it wouldn't.
In addition to Mr. Siedle's specific observations of unethical behavior, here are four unethical TDF practices that arise from just plain laziness:
Unethical TDF practices
- Not vetting the TDF selection.
- Failing to protect, especially near the target date.
- Paying excessive fees.
- Falling for gimmicks.
I use the word "unethical" to mean "not in the best interests of beneficiaries," as detailed in the following:
Not vetting the TDF selection
Fiduciaries believe they are protected by two safe harbors in their selection of target date funds:
- Properly structured TDFs are Qualified Default Investment Alternatives (QDIAs) under the Pension Protection Act of 2006. Form over substance.
- There is safety in numbers, so choosing one of the most popular TDF providers is prudent. Fidelity, T. Rowe Price and Vanguard manage 65% of the blossoming TDF market. You can't go wrong with a brand name. Or can you?
These beliefs fall in the "empty head but good heart" wishful thinking category. They are neither prudent nor ethical. Lazy fiduciaries choose their bundled service provider without researching alternatives. Vanguard, Fidelity and T. Rowe Price are fine firms, but their target date funds are not the best. Please see our Prudence Scores.
Failing to protect, especially near the target date
In 2008, TDFs lost more than 30% and there was a public outcry to never let such losses happen again, especially to those in or near retirement. It was a shocking wake-up call. Beneficiary lifestyles were devastated while at the same time, fiduciaries were not only unscathed, they were unphased, choosing to increase risk in the years that followed. Rather than correcting 2008's problem, TDFs have become riskier because (1) U.S. equity allocations have increased in order to compete in the performance horse race and (2) bonds have become very risky because of Quantitative Easing.
Just because fiduciaries got away with large losses in 2008 doesn't mean excessive risk is right or that fiduciaries will continue to get away with it. The basic ethical dilemma here is that TDFs are being sold, not bought, and what is being sold is not safe. You can't blame the fund companies because they are not fiduciaries; they're vendors whose business is making profits. Fiduciaries are to blame. Fiduciaries should be seeking the best solutions for their pension plans rather than settling for their bundled service provider or the best sales pitch, or worse, a round of golf.
Since most participants either withdraw their assets or purchase an annuity when they retire, the duration of TDF assets should more closely approximate the participant's retirement date. In other words, allocations at the target date should be very safe, mostly in short-term bonds. Prior to the Pension Protection Act's declaration of QDIAs, the common practice was to default participants into cash or stable value. This may have been too conservative for younger employees, but it was just about right for those nearing retirement.
Paying excessive fees
Books were written and TV shows were aired about the excessive fees in 401(k) plans, but nothing changed until lawsuits were won. As reported by the 401(k) HelpCenter, the list of litigants is long and includes Insperity, Allergen, TIAA, JPMorgan, Wells Fargo, Oracle, T. Rowe Price, Aon Hewitt, Edward Jones…
So now fund companies are racing to the bottom on fees because fiduciaries fear lawsuits. Lawsuits are the stick that changed this unethical behavior. It's a shame that ethical behavior requires successful lawsuits, but that has been the history of such matters. Excessive fees still remain in hidden places that fiduciaries need to ferret out, or they could wait for lawyers to discover them.
The current focus on fees is distracting attention away from more important considerations like glide path design, risk control and diversification.
Falling for gimmicks
Not surprisingly, opportunists have entered the TDF game, including:
- custom funds
- market timing
- ESG funds.
Spurred on by the DOL's 2013 Tips, some vendors are selling custom target date funds as a means to match workforce demographics. These one-size-fits-all glide paths cannot match a diverse group of employees. The best "custom" fund matches the one demographic that all defaulted participants have in common: lack of financial sophistication. In other words, safety first is the way to match the one demographic that can actually be matched.
The DOL is wrong in thinking that a one-size-fits-all vehicle can somehow be tailored to individual participant circumstances. It is also wrong in emphasizing the "to-through" distinction because it's a distinction without a difference.
Another gimmick is market timing, modifying the glide path in response to a vendor's crystal ball predictions. The implied promise is that these providers will get out of the way of the next 2008. Time will tell of course, but history suggests that this is a very tough call. A more reliable course of action is to use a glide path that always protects near the target date.
The most recent gimmick is ESG (Environmental, Social, Governance) Funds, intended to make the investor feel good. Since TDFs are chosen by fiduciaries rather than participants, the good feeling is targeted to fiduciaries who really should focus on more important matters like selecting the best.
Target date funds should be bought, not sold. With $1.5 trillion in TDFs, the stakes are much higher today than they were in 2008 when TDFs were only $150 billion, which is just 10% of the current assets.
It is unconscionable for lazy, go with the flow (To/Through), fiduciaries to jeopardize a dignified retirement for even a single participant. Ethical fiduciaries will research and implement superior alternatives for defaulted participants.
It is equally unconscionable for asset management companies to market TDFs under the wrong premise… that being performance over prudence. The intention of TDFs is to provide a safe path to retirement and not inject unneeded and potentially catastrophic risk particularly in the later stages of a participant's working life. It's not just good business or good investing… it is the cornerstone of the covenant every fiduciary has made with all participants.
Incentives modify behavior and come as carrots and sticks. Ethical decisions that protect employees are the carrots. Fiduciaries can feel proud for doing the right thing. Ethics did not motivate fiduciaries to seek low fees. Sticks, namely successful lawsuits, got the job done. So it may be with other unethical practices.
For more information, please visit our Fiduciary Corner.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.