From the April 2010 issue of Treasury & Risk magazine

Revising Target-Date Funds

Target-date funds, those hot 401(k) investments, ran into trouble during the financial crisis. Many target-date funds performed poorly amid the sell-off, with the worst showing among funds designated for workers nearing retirement. Those losses have given rise to calls for changes in the funds.

After the Labor Department named target-date funds as a qualified default investment for 401(k)s in 2006, money poured in. A recent report by investment research firm Morningstar calculates the top 15 target-date families held $256.4 billion in assets at the end of 2009, almost quadruple the $69.4 billion they held in 2005.

The funds are designed to make it easy to invest. Employees just pick the fund whose date is closest to when they expect to retire, then rely on the fund's manager to gradually adjust the asset allocation to a more conservative mix as that date approaches. But in 2008, as markets melted down, the performance of target-date funds made it clear that various providers had very different ideas of what constitutes the correct asset allocation for older workers. The Morningstar report shows in late 2009, funds tagged 2010--that is, funds for workers on the verge of retiring--had equity allocations ranging from 26% to as high as 65%.

Some target-date funds "had significant amounts of equity at retirement," says Robyn Credico, senior defined-contribution consultant at Towers Watson. "That might be the right answer but there were certain plan sponsors who didn't understand that, nor did they communicate that to participants."

Some critics claim the high allocations to equities could reflect a conflict of interest among companies that operated proprietary target-date fund families--in which all the target-date funds' components are in-house funds--since investments in equities generally involve higher fees than fixed-income offerings. Critics also argue that proprietary funds are a bad idea because no one company has top-performing funds in every asset class.

But the Morningstar report concludes that proprietary target-date funds performed just as well as those that use outside managers. It agrees, though, that fund companies' explanations of their glide paths--how they alter the asset allocation over time--are lacking.

In response to charges of conflicts of interest, Sen. Herb Kohl (D-Wis.) has said he will sponsor legislation that would make the managers of target-date funds fiduciaries. And the Labor Department is working with the Securities and Exchange Commission on guidance on target-date funds for 401(k) participants and plan sponsors.

Meanwhile, fund companies are reworking their asset allocations, with changes ranging from cutting equity allocations in funds for workers nearing retirement to adding absolute return funds. To the extent target-date funds adopt more sophisticated investments, there's an even greater need for improved disclosure.


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