GAO Study of Target Date Funds

The Target Date Funds (TDFs) were adopted as default investments in 40101(k) plans when the Department of Labor determined that money market funds might not be suitable in that role.  Plan sponsors adopted these funds just in time for them to be in place as markets melted down in 2008.  In general, the TDFs showed declines in value, as would be expected of funds invested in risky assets such as stocks and bonds.  However, the performance of TDFs was surprising and disappointing in that:

• certain of the TDFs that were designed for employees retiring in 2010 experienced significant losses in 2008;
• TDFs with the same target retirement date but from different fund families had widely divergent performance;
• In general, losses incurred by the TDFs were larger than participants or plan sponsors expected.

The General Accounting Office studied the marketplace and issued a report on  it findings on February 23.  Not surprisingly they found that differing fund performance can be traced to differing investment objectives and policies.  The GAO found no consistency in the construction and management of TDFs from one fund family to another.  Thus there was one TDF that had a 65% equity allocation in its 2010 TDF as late as June of 2008.  Some companies retained discretion over the asset allocation decision within a policy band.  In some cases, rebalancing was not pursued ant time over the 2008 - 2010 period.  Essentially, the only thing that these funds shared was a category name.

The GAO has recommended that plan sponsor explicitly consider and document characteristics of their employees and plan participants in selecting TDFs as investment options in 401(k) plans, and creating additional educational material from plan sponsors.  That's fine and dandy, but an advisor will truly add value for his client by:

1. Identifying TDF families that have strict investment policies governing the allocation among asset classes, and validating that the fund companies adhere to their policies;
2. Use TDFs that have an equity allocation that methodically declines toward a small (less than 25%) allocation at maturity;
3. Use TDFs that use passive funds for their asset class allocations to ensure participation in the relevant market (in the jargon, reduce "tracking error");
4. Keep costs low by avoiding a fee more than 10 basis points for administering these mechanical, passive portfolios.

These four guidelines will give a plan sponsor comfort that the TDFs' performance is entirely dependent on the market, and will not underperform because of a poor decision made by someone else.  This framework will ensure that a participant investment risk assumed closely reflects his investment time horizon.  And with proper documentation, the sponsor has demonstrated effective discharge of his fiduciary duties.