Defined Contribution Plans
Key Information on Target Date Funds as Default Investments Should Be Provided to Plan Sponsors and Participants
Gao ID: GAO-11-118 January 31, 2011
To promote the adoption of appropriate default investments by retirement plans that automatically enroll workers, in 2007 the Department of Labor (DOL) identified three qualified default investment alternatives. One of these options--target date funds (TDF)--has emerged as by far the most popular default investment. TDFs are designed to provide an age-appropriate asset allocation for plan participants over time. Because of recent concerns about significant losses in and differences in the performance of some TDFs, GAO was asked address the following questions: (1) To what extent do the investment compositions of TDFs vary; (2) what is known about the performance of TDFs; (3) how do plan sponsors select and monitor TDFs that are chosen as the plan's default investment, and what steps do they take to communicate information on these funds to their participants; and (4) what steps have DOL and the Securities and Exchange Commission (SEC) taken to ensure that plan sponsors appropriately select and use TDFs? To answer these questions, GAO reviewed available reports and data, and interviewed TDF managers, plan sponsors, relevant federal officials, and others.
Target date funds vary considerably in asset structures and in other ways, largely as a result of the different objectives and investment philosophies of fund managers. In the years approaching the retirement date, for example, some TDFs have a relatively low equity allocation--35 percent or less--so that plan participants will be insulated from excessive losses near retirement. Other TDFs have an equity allocation of 60 percent or more in the belief that relatively high equity returns will help ensure that retirees do not deplete savings in old age. TDFs also vary considerably in other respects, such as in the use of alternative assets and complex investment techniques. In addition, allocations are based in part on assumptions about plan participant actions--such as contribution rates and how plan participants will manage 401(k) assets upon retirement--which may differ from the actions of many participants. These investment differences and differences between assumed and actual participant behavior may have significant implications for the retirement security of plan participants invested in TDFs. Recent TDF performance has varied considerably, and while studies show that many investors will obtain significantly positive returns over the long term, a small percentage of investors may have poor or negative returns. Between 2005 and 2009 annualized TDF returns for the largest funds with 5 years of returns ranged from +28 percent to -31 percent. Although TDFs do not have a long history, studies modeling the potential long-term performance of TDFs show that TDFs investment returns may vary greatly. For example, while one study found that the mean rate of return for all individual participants was +4.3 percent, some participant groups could experience significantly lower returns. These studies also found that different ratios of investments affect the range of TDF investment returns and offer various trade-offs. While some plan sponsors conduct robust TDF selection and monitoring processes, other plan sponsors face challenges in doing so. Plan sponsors and industry experts identified several key considerations in selecting and monitoring TDFs, such as the demographics of participants and the expertise of the plan sponsor. Some plan sponsors may face several challenges in evaluating TDFs, such as having limited resources to conduct a thorough selection process, or lacking a benchmark to meaningfully measure performance. Although plan sponsors may use various media in an effort to inform participants about funds offered through the plan, some plan sponsors and others noted that participants typically understand little about TDFs. DOL and SEC have taken important steps to improve TDF disclosures, participant education, and guidance for plan sponsors and participants. For example, both agencies have proposed regulations aimed at helping to ensure that investors and participants are aware of the possibility of investment losses and have clear information about TDF asset allocations. However, we found that DOL could take additional steps to better promote more careful and thorough plan sponsor selection of TDFs as default investments, and help plan participants understand the relevance of TDF assumptions about contributions and withdrawals. GAO recommends that DOL take actions to assist plan sponsors in selecting TDFs to best suit their employees, and to ensure that plan participants have access to essential information about TDFs. DOL raised a number of issues with our recommendations, and we amended one of them in response to their comments.
Recommendations
Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director:
Charles A. Jeszeck
Team:
Government Accountability Office: Education, Workforce, and Income Security
Phone:
(202) 512-7036
GAO-11-118, Defined Contribution Plans: Key Information on Target Date Funds as Default Investments Should Be Provided to Plan Sponsors and Participants
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United States Government Accountability Office:
GAO:
Report to Congressional Requesters:
January 2011:
Defined Contribution Plans:
Key Information on Target Date Funds as Default Investments Should Be
Provided to Plan Sponsors and Participants:
GAO-11-118:
GAO Highlights:
Highlights of GAO-11-118, a report to the congressional requesters.
Why GAO Did This Study:
To promote the adoption of appropriate default investments by
retirement plans that automatically enroll workers, in 2007 the
Department of Labor (DOL) identified three qualified default
investment alternatives. One of these options-”target date funds
(TDF)-”has emerged as by far the most popular default investment. TDFs
are designed to provide an age-appropriate asset allocation for plan
participants over time.
Because of recent concerns about significant losses in and differences
in the performance of some TDFs, GAO was asked address the following
questions: (1) To what extent do the investment compositions of TDFs
vary; (2) what is known about the performance of TDFs; (3) how do plan
sponsors select and monitor TDFs that are chosen as the plan‘s default
investment, and what steps do they take to communicate information on
these funds to their participants; and (4) what steps have DOL and the
Securities and Exchange Commission (SEC) taken to ensure that plan
sponsors appropriately select and use TDFs? To answer these questions,
GAO reviewed available reports and data, and interviewed TDF managers,
plan sponsors, relevant federal officials, and others.
What GAO Found:
Target date funds vary considerably in asset structures and in other
ways, largely as a result of the different objectives and investment
philosophies of fund managers. In the years approaching the retirement
date, for example, some TDFs have a relatively low equity allocation”-
35 percent or less”-so that plan participants will be insulated from
excessive losses near retirement. Other TDFs have an equity allocation
of 60 percent or more in the belief that relatively high equity
returns will help ensure that retirees do not deplete savings in old
age. TDFs also vary considerably in other respects, such as in the use
of alternative assets and complex investment techniques. In addition,
allocations are based in part on assumptions about plan participant
actions”-such as contribution rates and how plan participants will
manage 401(k) assets upon retirement”-which may differ from the
actions of many participants. These investment differences and
differences between assumed and actual participant behavior may have
significant implications for the retirement security of plan
participants invested in TDFs.
Recent TDF performance has varied considerably, and while studies show
that many investors will obtain significantly positive returns over
the long term, a small percentage of investors may have poor or
negative returns. Between 2005 and 2009 annualized TDF returns for the
largest funds with 5 years of returns ranged from +28 percent to -31
percent. Although TDFs do not have a long history, studies modeling
the potential long-term performance of TDFs show that TDFs investment
returns may vary greatly. For example, while one study found that the
mean rate of return for all individual participants was +4.3 percent,
some participant groups could experience significantly lower returns.
These studies also found that different ratios of investments affect
the range of TDF investment returns and offer various trade-offs.
While some plan sponsors conduct robust TDF selection and monitoring
processes, other plan sponsors face challenges in doing so. Plan
sponsors and industry experts identified several key considerations in
selecting and monitoring TDFs, such as the demographics of
participants and the expertise of the plan sponsor. Some plan sponsors
may face several challenges in evaluating TDFs, such as having limited
resources to conduct a thorough selection process, or lacking a
benchmark to meaningfully measure performance. Although plan sponsors
may use various media in an effort to inform participants about funds
offered through the plan, some plan sponsors and others noted that
participants typically understand little about TDFs.
DOL and SEC have taken important steps to improve TDF disclosures,
participant education, and guidance for plan sponsors and
participants. For example, both agencies have proposed regulations
aimed at helping to ensure that investors and participants are aware
of the possibility of investment losses and have clear information
about TDF asset allocations. However, we found that DOL could take
additional steps to better promote more careful and thorough plan
sponsor selection of TDFs as default investments, and help plan
participants understand the relevance of TDF assumptions about
contributions and withdrawals.
What GAO Recommends:
GAO recommends that DOL take actions to assist plan sponsors in
selecting TDFs to best suit their employees, and to ensure that plan
participants have access to essential information about TDFs. DOL
raised a number of issues with our recommendations, and we amended one
of them in response to their comments.
View [hyperlink, http://www.gao.gov/products/GAO-11-118] or key
components. For more information, contact Charles A. Jeszeck, (202)512-
7215, jeszeckc@gao.gov.
[End of section]
Contents:
Letter:
Background:
Investment Structures of TDFs Vary Considerably, and Their Design May
Reflect Assumptions That Do Not Match Participant Behavior:
TDFs Are Likely to Provide a Broad Range of Investment Returns:
Plan Sponsors May Face Challenges Selecting and Monitoring TDFs and
Communicating to Their Participants:
Federal Agencies Have Taken Actions to Address Issues Related to TDFs:
Conclusions:
Recommendations for Executive Action:
Agency Comments:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Studies Reviewed to Assess Ranges of Future TDF
Performance:
Appendix III: Comments from the Department of Labor:
Appendix IV: GAO Contacts and Acknowledgments:
Tables:
Table 1: Recent SEC and DOL Regulatory Proposals for TDF Disclosure
Requirements:
Table 2: Organizations Contacted during Review:
Figures:
Figure 1: Example of a TDF's Fund-of-Funds Structure:
Figure 2: Example of a Target Date Fund Glide Path:
Figure 3: Selected TDF Glide Paths:
Figure 4: Representation of TDF Glide Path with Tactical Allocation
Option:
Figure 5: Range of Returns from 2005 to 2009 for the 2010 TDFs with
the Largest Market Share:
Figure 6: 2010 TDF Returns in 2009 with Equity Allocations:
Figure 7: Potential Outcomes for TDF Ending Account Balances for
College Graduates:
Abbreviations:
CIT: collective investment trust:
DC: defined contribution:
DOL: Department of Labor:
EBSA: Employee Benefits Security Administration:
ERISA: Employee Retirement Income Security Act:
ICI: Investment Company Institute:
IRA: individual retirement account:
NAICS: North American Industry Classification System:
OCC: Office of the Controller of the Currency:
PPA: Pension Protection Act of 2006:
QDIA: qualified default investment alternative:
REIT: real estate investment trust:
SEC: Securities and Exchange Commission:
TDF: target date fund:
TIPS: Treasury Inflation-Protected Security:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
January 31, 2011:
The Honorable Herb Kohl:
Chairman:
Special Committee on Aging:
United States Senate:
The Honorable George Miller:
Ranking Member:
Committee on Education and the Workforce:
House of Representatives:
The financial security of millions of Americans in their retirement
years will substantially depend on their savings in 401(k) and other
defined contribution (DC) plans. To help ensure adequate financial
resources for retirement, participants in DC plans must make adequate
contributions during their working years and invest contributions in a
way that will facilitate adequate investment returns over time.
Typically, 401(k) plan sponsors have offered participants a menu of
investment options in which they may invest account balances.
The Pension Protection Act of 2006 (PPA) included various provisions
designed to encourage greater retirement savings among workers
eligible to participate in 401(k) plans, such as provisions that
facilitate plan sponsors' adoption of automatic enrollment policies.
[Footnote 1] Under such policies, eligible workers are automatically
enrolled unless they explicitly decide to opt out of participation.
Because an automatic enrollment program must also include a default
investment--a vehicle in which contributions will be invested absent a
specific choice by the plan participant--the act also directed the
Department of Labor (DOL) to assist employers in selecting default
investments that best serve the retirement needs of workers who do not
direct their own investments. Since that time, target date funds
(TDF)--that is, investment funds that invest in a mix of assets, and
shift from higher-risk to lower-risk investments as a participant
approaches their "target" retirement date--have emerged as by far the
most popular default investment.
Nonetheless, TDFs have been the subject of considerable recent
controversy. While TDFs are designed to decrease the risk of
investment losses as a participant approaches the target date, some
TDFs designed for those expecting to retire in 2010 experienced major
losses during the financial market downturn of 2008-2009, placing the
retirement security of many participants in jeopardy. Additionally,
TDFs with the same target retirement year performed quite differently
in recent years. In order to obtain more information about these and
other developments, you asked us to examine a number of issues related
to TDFs as qualified default investment alternatives (QDIA).
Specifically, we addressed the following questions:
1. To what extent do the investment compositions of different TDFs
vary?
2. What is known about the performance of TDFs?
3. How do plan sponsors select and monitor TDFs that are chosen as the
plan's default investment, and what steps do they take to communicate
information on these funds to their participants?
4. What steps have DOL and the Securities and Exchange Commission
(SEC) taken to ensure that plan sponsors appropriately select and use
TDFs?
To answer these questions, we conducted in-depth interviews with
officials representing selected TDFs, plan sponsors, retirement plan
consultants, DOL, SEC, and other experts. The eight TDF managers we
contacted account for about 86 percent of the TDF market, as measured
by assets under management. We also reviewed available documentation
describing the asset allocation of selected TDFs, as well as the
rationale behind these allocations. We obtained and summarized data
regarding recent performance of various TDFs from Morningstar.
[Footnote 2] We also reviewed nine studies that, based on various
techniques, projected a range of long-term investment outcomes for
TDFs. We also reviewed federal laws and regulations.
We conducted our work from December 2009 to January 2011 in accordance
with all sections of GAO's Quality Assurance Framework that are
relevant to our objectives. The framework requires that we plan and
perform the engagement to obtain sufficient and appropriate evidence
to meet our stated objectives and to discuss any limitations in our
work. We believe that the information and data obtained, and the
analysis conducted, provide a reasonable basis for any findings and
conclusions in this product.
Background:
Under DC plans, employees typically must decide whether or not to join
the plan, as well as specify the size of their contributions and
select one or more investments among the options offered by the plan.
About 13 percent of the full-time workforce with access to employer-
sponsored plans does not participate in such plans.[Footnote 3] As GAO
reported in 2009, existing studies have shown that automatically
enrolling employees in 401(k) plans can substantially increase
participation rates.[Footnote 4] Among other things, automatic
enrollment programs require plan sponsors to choose an investment that
participants will be defaulted into if they do not make an election on
their own. Historically, plan sponsors with such policies have used
relatively conservative, low-return investments as the default
investment because of fears of fiduciary liability from investment
losses. However, the PPA included a number of provisions designed to
encourage greater adoption of automatic enrollment, including limited
protection from fiduciary liability for plans that automatically
invest contributions in specific types of investments as defined by
DOL. For example, in the absence of direction from an employee, plans
that automatically invest contributions in such funds are treated as
if the employee exercised control over management of their savings in
the plan. As a result, fiduciaries of plans complying with DOL
regulations have some protection against liability for losses that
occur as a result of such investments. Fiduciaries--typically plan
sponsors--must still satisfy the Employee Retirement Income Security
Act (ERISA) fiduciary responsibilities when selecting and monitoring
investment options available to plan participants, including QDIAs.
[Footnote 5] Specifically, plan sponsors who act as fiduciaries and
other fiduciaries must act solely in the interest of plan participants
and beneficiaries, in accordance with plan documents, act with
prudence, and offer a diversified set of investment options with
reasonable fees. After enactment of the PPA, DOL designated three
types of QDIAs including the following:[Footnote 6]
* A product such as a TDF (also known as a life cycle fund): A product
that takes into account the individual's age or retirement date and
invests in a mix of investments that become more conservative as the
participant approaches his or her retirement date.
* A product such as a balanced fund: A product that takes into account
the group of employees as a whole, instead of an individual, and that
invests in a mix of assets with a level of risk appropriate for the
group.
* An investment service such as a professionally managed account:
Unlike a TDF, which is an investment product, a managed account is an
investment service that typically allocates contributions among
existing plan options so as to provide a mix of assets that takes into
account an individual's age or retirement date and other circumstances.
Of the three options DOL identified, TDFs have quickly emerged as by
far the most popular QDIA among plan sponsors who have automatic
enrollment programs. As GAO reported in 2009, the percentage of
Vanguard Group plans with TDFs as a default investment grew from 42
percent in 2005 to over 80 percent in 2009.[Footnote 7] Pension
industry experts we spoke with believed the popularity of TDFs will
continue to grow in the future.
TDFs are a relatively new type of investment vehicle, and some large
TDFs have less than 6 years of history. They are often established as
mutual funds in a fund-of-funds structure. That is, the TDF is a
composite of multiple underlying mutual funds in different asset
classes. As figure 1 illustrates, TDFs consist of an equity component
and a fixed income component.[Footnote 8] The major asset classes, in
turn, may be composed of funds representing different sectors of the
major asset classes. For example, the equity component may consist of
some funds focused on equities of large U.S. corporations,
international equities, or equities of smaller companies. Similarly,
the fixed income component may consist of various bond funds, such as
funds consisting of government and corporate bonds.
Figure 1: Example of a TDF's Fund-of-Funds Structure:
[Refer to PDF for image: illustration]
Target date funds:
Equity component:
* Domestic large cap fund;
* Domestic small cap fund;
* Developed international fund;
* Emerging market fund.
Fixed income component:
* U.S. government bond fund;
* Investment-grade U.S. corporate bond fund;
* International bond fund;
* High-yield bond fund;
* Treasury inflation-protected securities (TIPS).
Source: GAO.
Note: This chart is for generic illustrative purposes only, and is not
intended to illustrate the TDF of a particular investment firm. It is
also not an exhaustive list of the asset types that may compose a TDF.
For example, a TDF may also hold cash.
[End of figure]
A TDF can also be established in forms other than as a mutual fund.
For example, TDFs may be offered as collective investment trusts
(CIT), which are bank-administered pooled funds established
exclusively for qualified plans such as 401(k)s. The responsible bank
acts as the fiduciary, and holds legal title to the CIT assets.
According to Morningstar, CITs offer a number of potential advantages
over TDF mutual funds. For example, they feature lower costs because
of factors such as reduced marketing expenses and fewer regulatory
filings. Also, because they are not regulated as mutual funds, they
can invest in certain vehicles that mutual funds cannot.
Also, some plan sponsors have established customized TDFs, instead of
relying on preexisting TDFs offered by investment management firms.
For example, a plan sponsor may develop a customized TDF using the
existing core investment options it offers. Customized funds can be
more precisely tailored to match a plan's objectives and demographics,
and offer a plan sponsor greater control over the underlying
investments of a TDF. However, one expert noted that because
customized funds involve costs greater than those of an already-
existing fund, they are generally more popular among larger plan
sponsors.
TDFs offer investors a number of potential advantages. First, they
relieve DC plan participants of the burden of deciding how to allocate
their retirement savings among equities, fixed income, and other
investments. TDFs offer participants a professionally developed asset
allocation based on their planned retirement date. TDFs thereby can
help plan participants and other investors avoid common investment
mistakes, such as a lack of diversification and a failure to
periodically rebalance their assets.
Second, TDFs are designed to strike a balance between an age-
appropriate level of risk and potential investment return. In general,
a TDF provider will include a series of funds designed for
participants expecting to retire in different years, such as 2010,
2015, 2020, 2025, and so on. A plan participant who is 30 years old in
2011, for example, might be defaulted into a 2045 TDF, while a 55-year-
old participant would likely be defaulted into a 2020 TDF. Typically,
a TDF will shift from primarily equities to fixed income investments
as a participant approaches his or her retirement date, in the belief
that fixed income investments generally pose lower risk. This shift
can be represented graphically as a line commonly referred to as the
glide path. In figure 2 the glide path is the line separating the
fixed income component of the investment mix from the equity component
of the investment mix. As this illustrates, TDFs allocate a relatively
large percentage of assets to equities early, when investors are
relatively young, and a much lower percentage as the retirement date
approaches. The asset allocation thus becomes more conservative over
time, because an older plan participant has a shorter time horizon,
fewer opportunities to make contributions to savings, and less ability
to recover from downturns in the market.
Figure 2: Example of a Target Date Fund Glide Path:
[Refer to PDF for image: stacked line graph]
Percentages are approximated from the image.
Years before target date: 35;
Equities: 90%;
Fixed income: 10%.
Years before target date: 30;
Equities: 90%;
Fixed income: 10%.
Years before target date: 25;
Equities: 90%;
Fixed income: 10%.
Years before target date: 20;
Equities: 85%;
Fixed income: 15%.
Years before target date: 15;
Equities: 75%;
Fixed income: 25%.
Years before target date: 10;
Equities: 70%;
Fixed income: 30%.
Years before target date: 5;
Equities: 65%;
Fixed income: 35%.
Target date:
Equities: 60%;
Fixed income: 40%.
Years after target date: 5;
Equities: 55%;
Fixed income: 45%.
Years after target date: 10;
Equities: 50%;
Fixed income: 50%.
Years after target date: 15;
Equities: 45%;
Fixed income: 55%.
Years after target date: 20;
Equities: 40%;
Fixed income: 60%.
Years after target date: 25;
Equities: 30%;
Fixed income: 70%.
Years after target date: 30;
Equities: 30%;
Fixed income: 70%.
Source: GAO representation of DOL and SEC guidance.
Note: This figure presents one of many potential glide path scenarios
for illustrative purposes--different TDFs may feature greater or
lesser allocations to equities and fixed income over time, as well as
different glide path slopes.
[End of figure]
Despite these benefits, TDFs have not been without controversy,
especially in the last few years. As a result of the severe financial
market turbulence of 2008, some TDFs designed for participants
retiring in 2010 lost considerable value, just over 40 percent in one
case. Further, according to some experts, many participants were
unaware of the risks associated with these investments and that such
losses were possible so close to the retirement date. Moreover, TDFs
with the same target date also exhibited wide variations in returns.
A number of federal agencies have regulatory responsibilities related
to TDFs. The Employee Benefits Security Administration (EBSA) of DOL
has general responsibility for protecting the interests of private
sector retirement plan participants, and enforcing ERISA's reporting,
disclosure provisions, and fiduciary responsibility provisions. SEC
seeks to protect investors and maintain fair, orderly, and efficient
markets, and facilitate capital formation under various securities
laws.[Footnote 9] Among its various investor protection
responsibilities, SEC oversees mutual funds and other key market
participants, and promotes disclosure of important market-related
information, maintaining fair dealing, and protecting against fraud.
SEC also carries out investor education programs, which include
producing and distributing educational materials. TDFs established as
CITs offered by national banks are regulated by the Department of the
Treasury's Office of the Comptroller of the Currency (OCC), which is
responsible for regulating and supervising national banks.[Footnote
10] TDFs established as CITs offered by state-chartered banks or other
institutions are regulated by state banking regulators, the Federal
Deposit Insurance Corporation, the Federal Reserve Board, or the
Office of Thrift Supervision, depending on the institution's charter.
As a result of the controversies surrounding TDFs and at the request
of Congress, DOL and SEC held a joint June 2009 hearing on TDFs. Among
other issues, the agencies sought testimony regarding how TDF managers
determine asset allocations, how they select and monitor underlying
investments, and how such information is disclosed to investors. In
October 2009, the U.S. Senate Special Committee on Aging held hearings
on TDFs and issued a subsequent report.[Footnote 11]
Investment Structures of TDFs Vary Considerably, and Their Design May
Reflect Assumptions That Do Not Match Participant Behavior:
TDF Allocations Vary Based on Different Objectives and Considerations:
TDFs differ considerably in the degree to which they reduce allocation
to equities in favor of fixed income investments approaching and after
the target date. Each of the eight TDF managers included in our review
allocated at least 80 percent of assets to equities 40 years before
retirement. However, the rate at which the equity component is
decreased and the size of the equity component at retirement can
differ considerably. As figure 3 illustrates, one of the TDFs in our
review has an equity allocation of about 65 percent at the target
date, while another has an equity allocation of about 33 percent.
[Footnote 12]
Figure 3: Selected TDF Glide Paths:
[Refer to PDF for image: multiple line graph]
Years before target date: 40;
Equities, Fund A: 95%;
Equities, Fund B: 8%;
Equities, Fund C: 9%;
Equities, Fund D: 85%.
Years before target date: 35;
Equities, Fund A: 95%;
Equities, Fund B: 76%;
Equities, Fund C: 9%;
Equities, Fund D: 85%.
Years before target date: 30;
Equities, Fund A: 95%;
Equities, Fund B: 75%;
Equities, Fund C: 9%;
Equities, Fund D: 85%.
Years before target date: 25;
Equities, Fund A: 95%;
Equities, Fund B: 73%;
Equities, Fund C: 9%;
Equities, Fund D: 85%.
Years before target date: 20;
Equities, Fund A: 9%;
Equities, Fund B: 67%;
Equities, Fund C: 83%;
Equities, Fund D: 78%.
Years before target date: 15;
Equities, Fund A: 86%;
Equities, Fund B: 62%;
Equities, Fund C: 75%;
Equities, Fund D: 7%.
Years before target date: 10;
Equities, Fund A: 79%;
Equities, Fund B: 55%;
Equities, Fund C: 68%;
Equities, Fund D: 6%.
Years before target date: 5;
Equities, Fund A: 72%;
Equities, Fund B: 46%;
Equities, Fund C: 6%;
Equities, Fund D: 5%.
Target date:
Equities, Fund A: 65%;
Equities, Fund B: 44%;
Equities, Fund C: 5%;
Equities, Fund D: 33%.
Years after target date: 5;
Equities, Fund A: 55%;
Equities, Fund B: 39%;
Equities, Fund C: 36%;
Equities, Fund D: 33%.
Years after target date: 10;
Equities, Fund A: 45%;
Equities, Fund B: 24%;
Equities, Fund C: 3%;
Equities, Fund D: 33%.
Years after target date: 15;
Equities, Fund A: 35%;
Equities, Fund B: 18%;
Equities, Fund C: 3%;
Equities, Fund D: 33%.
Years after target date: 20;
Equities, Fund A: 35%;
Equities, Fund B: 18%;
Equities, Fund C: 3%;
Equities, Fund D: 33%.
Years after target date: 25;
Equities, Fund A: 35%;
Equities, Fund B: 18%;
Equities, Fund C: 3%;
Equities, Fund D: 33%.
Source: GAO representation of data provided by selected TDF managers.
Note: One of these funds also includes commodities in the non-equity
portion of its asset mix. This allocation declines from about 9.8
percent of total assets 40 years before the target date to about 2.0
percent 25 years after the target date.
[End of figure]
In addition, some TDF glide paths reach their lowest equity allocation
at the presumed retirement date, while others continue to reduce the
equity allocation 10 or more years beyond the target date. In figure
3, for example, Fund B reaches its lowest allocation to equity--33
percent--at the target date, and this allocation is maintained for as
long as the participant remains in the fund. In contrast, Fund A
reaches the target date with an equity allocation of 65 percent, but
the equity allocation continues decreasing for 15 years after the
target date, ending at 35 percent.[Footnote 13]
Differences in the size of the equity component throughout the TDF's
glide path may be rooted in different goals and in the treatment of
various considerations such as the risk of losing money because of
financial market fluctuations--investment risk--and the risk that a
participant could outlive his or her assets--longevity risk. For
example, two TDF managers whose funds had relatively high allocation
to equity at the target date had TDFs designed to ensure that
participants do not deplete their assets in retirement. One of these
officials explained that even after retirement most participants need
the growth that equities can provide and that overreliance on cash and
bonds will not yield satisfactory results. According to analyses this
manager performed, assuming that participants withdrew 5 percent of
their initial savings each year, a strategy allocating 60 percent to
equity and 40 percent to bonds would significantly reduce the risk
that plan participants would deplete their assets during retirement,
compared with a strategy of holding only bonds and cash.[Footnote 14]
Another TDF manager with a relatively high equity allocation at the
target date shared similar views, noting that the risk of a
participant outliving retirement assets should be the key driver of
managing retirement portfolios, and that the manager maintains a
significant equity allocation to attain that objective. According to
analyses this manager performed, a relatively high equity allocation
better ensures that assets will last through a 30-year retirement than
a lower equity alternative.
In contrast, TDF managers with significantly lower equity allocations
throughout the fund's glide path cited other considerations. For
example, the two TDF managers with relatively low allocations to
equity at retirement we contacted stressed the potential volatility of
equities and the importance of avoiding major losses to retirement
savings near or after the target date. An official of one of these
funds explained that the goal of the TDF is not to ensure that savings
last through the retirement years, but to ensure that the maximum
number of participants achieve a minimum acceptable level of savings
at the retirement date. A representative of this TDF manager explained
that while this glide path sacrifices the possibility of high
investment returns for some participants, it is more important to
ensure that as many people as possible arrive at the retirement date
with an adequate level of savings. This is especially true for
defaulted investors who may pay little attention to investment
management, the official noted. As this official explained the
manager's philosophy, the "pain" of arriving at retirement with
insufficient savings outweighs the "pleasure" of arriving at
retirement with more than is needed. The glide path of this TDF ends
at the target date, and the TDF is not designed to manage assets in
the retirement years. Instead, according to a representative of this
TDF, it is assumed that participants will use accumulated savings to
purchase an annuity at retirement. Similarly, a representative of
another TDF said that a low equity allocation was chosen in order to
lessen the possibility of severe, unrecoverable losses near
retirement. An official of this TDF noted that the risk of investment
losses at and after retirement is compounded by the fact that a
participant is withdrawing money for living needs. The official noted
that while a market loss of 10 percent during the working years can be
made up by future contributions and market recovery, it may be
difficult to recover from a loss of 10 percent at or just after
retirement.
Our contacts with TDF managers revealed that TDFs are also designed
based on certain key assumptions about participant actions that may
not match what many participants actually do. For example, the glide
paths of six of the eight TDFs we contacted extend beyond the target
date, and thus seek to manage assets beyond the target date. However,
some TDF managers and other experts indicated that this may be a
faulty approach for many participants. For example, one TDF manager
noted that its research revealed that of all workers who leave an
employer after the age of 60, within 6 years, only about 20 percent
are still invested in the plan. The official said that about 60
percent roll over into an individual retirement account (IRA), while
20 percent take a lump-sum distribution. A 2009 study of TDF asset
allocations and participant behavior found that participants
contribute less to their retirement accounts, and borrow and withdraw
more, compared with common industry expectations.[Footnote 15] This
study noted that the average participant withdraws over 20 percent of
his or her savings per year after retirement, and concluded that
partly for this reason, designing a glide path that extends beyond the
target date was undesirable. Other experts we contacted indicated that
TDFs designed to manage savings in the retirement years may make a
flawed assumption when they assume that participants will generally
withdraw and spend savings in a methodical, sustainable manner. For
example, a representative of a major retirement plan consulting firm
stated that participants typically attempt to retain their previous
lifestyle by drawing down assets more rapidly than is sound or than
TDF managers generally assume.
Conversely, TDF managers who end the glide path at retirement may also
be making assumptions that do not match participant actions. For
example, representatives of one TDF manager who ends the glide path at
retirement explained that the TDF is not designed to manage assets
beyond retirement. Instead, the manager bases its income replacement
calculations on the assumption that participants will cash out of the
TDF upon retirement, and buy an annuity to provide retirement income.
However, another TDF manager indicated that very few retirees buy an
annuity. Other experts noted that it is not clear how TDF participants
will manage withdrawals required for living needs. Further, because
widespread adoption of automatic enrollment is a relatively new
development, it is not known whether the withdrawal pattern of
defaulted investors will differ from existing patterns.
TDFs are also designed based on certain assumptions about contribution
rates that may not match what is known about prevailing contribution
patterns, or the impact of default contribution rates. Each of the
eight TDF managers we contacted considered contribution rates in
establishing its asset allocation strategy, and some explicitly noted
that these assumptions did not match the general pattern of
contribution rates. For example, one noted that while contribution
rates are generally lower than levels assumed by its model, it is
hoped that rates will increase as workers adjust to DC plans serving
as the sole employer-based retirement account. Another TDF manager
noted that available data indicated that participant actions are much
more varied and volatile than many TDF managers had assumed. According
to this manager, participants generally start saving later and do not
save at the rates generally assumed. Further, as we reported in 2009,
participants who are automatically enrolled can be significantly
influenced by the default contribution rate and default investment.
[Footnote 16] Specifically, we reported that studies had found that
some workers would have selected a contribution rate higher than the
default rate, had they enrolled in the plan voluntarily. These studies
found that default mechanisms have this impact because the default
requires no action on the part of the participant. Also some
participants may see default policies as implicit advice from the plan
sponsor. Because many participants are likely to be automatically
enrolled in a TDF, given its emerging role as the predominant QDIA,
the default contribution rate, as well as any automatic contribution
escalation policy, could have a significant effect on contribution
rates to TDFs.
Discussions with plan sponsors indicated that assumptions regarding
participant saving and withdrawal patterns involve trade-offs. For
example, several TDF managers told us that they had considered a range
of contribution and postretirement withdrawal scenarios--to ensure
that the TDF was suitable for a range of participants' saving and
spending patterns. However, there may be drawbacks to designing TDFs
in this manner. For example, one TDF manager noted that designing a
TDF in this way could penalize participants who save and withdraw in a
disciplined manner. This manager noted that the manager's TDF was
designed with certain optimal assumptions in mind, and was not based
on actual patterns of cash-out and postretirement spending behavior.
The TDF manager explained that designing a TDF to ensure that an
optimally behaving investor would not deplete his or her assets is a
significant challenge in itself--it would be more difficult, and
possibly counterproductive, to take into account actual investor
behavior. Another TDF manager indicated that the TDF is designed with
a higher equity allocation in the expectation that this will generate
higher returns, and thereby, to some extent, compensate for low
savings and high withdrawal rates of some participants. Some experts
criticized this approach as taking excessive risks to make up for
suboptimal participant behavior. For example, a representative of one
major consulting firm noted that such an approach could make an
underfunded retirement account run out of money even faster in the
event of poor market returns.
TDFs' Investment Approaches Differ in other Significant Aspects:
While the differences in equity and fixed income allocations
distinguish TDFs, these funds also vary in the content and management
of these components.
Underlying Composition of Equity and Fixed Income Components:
TDFs may vary in the allocations they make to different classes of
equity, such as domestic and international. A representative of one
TDF told us that the fund has a higher allocation to international
equity than most other TDFs because fund managers expect returns in
nondomestic markets to be higher in coming years, with little to no
additional risk. TDFs can also take distinctly different approaches to
selecting and managing their equity portfolios. While some TDF
managers we contacted seek mainly to gain exposure to the general
domestic or international equity funds, some TDF managers indicated
that the manager invests in order to ensure exposure to different
investment styles as well. For example, one TDF manager seeks to
invest in equities through both "quantitative" and "fundamental"
approaches.[Footnote 17] According to this TDF manager, using both
investment styles is intended to smooth the performance curve so that
the equity component of the TDF will outperform the market in a smooth
rather than erratic fashion.
The fixed income component of the TDFs we examined typically included
both traditional fixed income investments, as well as newer vehicles
such as high-yield bonds and Treasury Inflation-Protected Securities
(TIPS).[Footnote 18] Although high-yield bonds are generally much
riskier than investment-grade bonds, some TDF managers told us they
can serve as important diversifiers. One TDF manager said that the
returns of high-yield fixed income investments tend to have an inverse
relationship with investment-grade fixed income investments and
thereby help smooth out the returns of the fixed income component.
Nonetheless, because of their high risk, this TDF manager reduces the
high-yield bond allocation as a participant nears the target date.
Similarly, several TDF managers noted that TIPS are added to the fixed
income component in the years before retirement. As one manager
explained, the increase of fixed income securities later in the glide
path results in greater exposure to inflation, and TIPS offer some
inflation protection.
Passive versus Active Management:
Most of the eight TDF managers we contacted rely on varying degrees of
active management, generally in the belief that the returns of such
actively managed funds will exceed those of general market indexes
over time. For example, representatives of one TDF explained that they
believed that the financial markets are not perfectly efficient, and
that active management can outperform market indexes with only a
modest degree of additional risk.[Footnote 19] In contrast, one TDF
manager and one plan sponsor with a customized fund said they are
skeptical of active management, and rely primarily on passively
managed funds, which seek to attain performance equal to market or
index returns. According to an official of one manager, reliance on
passively managed funds offers lower fees to investors. Partly for
this reason, the official said that plan fiduciaries should opt for
reliance on passive approaches because of their growing use as default
investments. Further, such TDF managers expressed skepticism that
active managers can persistently outperform the market over time:
Some TDFs rely on relatively unconstrained active management, using
techniques similar to those used by some hedge funds. For example, one
TDF manager we contacted uses some underlying funds based on absolute
return strategies, which seek to achieve a positive total return that
exceeds the rate of inflation by a targeted amount regardless of
market conditions.[Footnote 20] These absolute return funds have no
fixed allocations and can shift assets from equities to fixed income
or to other asset classes in a relatively unconstrained manner. Also,
in an effort to achieve fund objectives, some of these funds use
financial instruments such as options, futures contracts, and swaps.
[Footnote 21] This TDF manager allocates about 60 percent of TDF
assets to absolute return funds at and after the retirement date.
Tactical Investment Allocation:
Some TDFs permit tactical allocation--the use of short-term investment
flexibility to depart from the stated investment strategy of the TDF--
while other TDF managers opposed the use of such flexibility. Several
TDF managers told us that they use tactical allocation in order to
limit volatility and avoid large short-term investment losses, or to
achieve greater long-term returns. For example, after the 2008-2009
market decline, one TDF manager adopted a tactical allocation policy
with the aim of limiting volatility. Managers of this fund likened
their tactical allocation to a shock absorber, and use a number of
techniques--such as assessing trends in short-term and intermediate-
term volatility and measuring correlations between asset classes--to
assess the likelihood of oncoming financial market shocks. On the
basis of these metrics, the fund may shift a portion of the equity
allocation to fixed income assets if a decline in the equity market is
foreseen. Another TDF manager noted that modest tactical asset
allocation shifts over time can enhance fund performance, depending on
the outlook in the financial markets. This fund will increase or
reduce allocations to various asset classes and sectors by plus or
minus 5 percent. Figure 4 illustrates an example of a tactical
allocation policy--the middle band represents the degree of
flexibility the fund manager has to deviate from the strategic equity
allocation.
Figure 4: Representation of TDF Glide Path with Tactical Allocation
Option:
[Refer to PDF for image: line graph]
Two graphs indicate asset allocation percentage for equities utilizing
volatility management.
Volatility management:
Percentage of equities Increases during times of normal volatility.
Percentage of equities Decreases during times of high volatility.
Source: GAO representation of example provided by a TDF manager.
[End of figure]
Three of the eight TDF managers we contacted do not use tactical
allocation, preferring to rely on their long-term strategy. One TDF
manager noted that severe market events such as the 2008-2009 decline
can be likened to a 100-year flood, and that the possibility of such
an event was considered in developing its TDF investment strategy.
Representatives of these funds indicated that they had confidence in
their long-term strategic allocation.
Use of Alternative Investments:
Some of the TDFs in our study invested in alternative asset classes
such as real estate investment trusts (REIT), other forms of real
estate, or commodities.[Footnote 22] TDFs that invest in alternative
assets generally do so to limit volatility or to protect against the
effects of inflation. For example, one TDF manager said that it
invests in commodities as a form of inflation protection, but noted
that because commodities are volatile, they are used earlier in the
glide path, for younger workers. Similarly, another TDF manager said
that it invests in REITs because they have some characteristics of
fixed income investments and some equity-like characteristics, but
have not historically correlated to either of these asset classes.
Some TDF managers we contacted who do not invest in such alternative
investments expressed some skepticism about the benefits of such
investments. For example, one TDF manager noted that nontraditional
asset classes and complex investment strategies also come with greater
risk and higher costs. For these reasons, the manager believes that
such strategies do not offer a reasonable trade-off for the vast
majority of retirement investors, especially for those defaulted into
401(k) investments.
Other Aspects of TDFs Can Affect Costs and Available Investments:
The fees charged by TDFs vary in both structure and size. For TDFs
composed of mutual funds, TDF fees are generally based on the costs of
the underlying mutual funds, excluding sales loads and redemption
fees. Some TDFs also apply an overlay fee representing the costs of
establishing and managing the TDF. For example, one TDF manager
explained that the firm does not charge an overlay fee because it
believes greater revenues will be earned in the absence of such a fee,
as the TDF attracts a greater volume of assets as a result. On the
other hand, a TDF manager who did include an overlay fee stated that
the effort involved in designing and managing the TDF itself justified
imposition of a fee of about 3 basis points--that is, 0.03 percent.
According to a 2010 industry analysis, asset-weighted expense ratios
ranged from 0.19 percent to 1.71 percent.[Footnote 23] In other words,
the costs of the most expensive TDF in the analysis were about nine
times the costs of the least expensive fund.
Some TDFs have a "closed" architecture in which underlying funds are
limited to mutual funds operated by the firm offering the TDF, while
other TDFs have an "open" architecture that may include both
proprietary mutual funds and mutual funds managed by other firms.
According to TDF managers and others, both types offer certain
advantages and trade-offs. For example, some advocates of an open
architecture asserted that this approach enables a TDF manager to
select the best-performing underlying funds, regardless of who offers
them. In addition, some have argued that open architecture removes a
potential conflict of interest--the possibility that a TDF manager
will invest in a new or poorly performing proprietary fund that is
unable to attract sufficient investments on its own. On the other
hand, a manager of a closed architecture TDF told us advocates of open
architecture assume that there are fund managers who consistently
outperform others. This TDF manager asserted that this is not the
case. Further, the manager asserted that for some TDF managers, the
TDF is or will become the flagship investment fund, and there would be
little incentive for a manager to intentionally use a poorly
performing fund as an underlying fund in the TDF. A 2010 study by
Morningstar acknowledged the debate over open versus closed
architecture, but noted that, based on its analysis, there was not a
clear performance differential between open and closed architecture
TDFs.[Footnote 24]
TDFs Are Likely to Provide a Broad Range of Investment Returns:
TDF investment returns have varied considerably in the last 5 years,
from year to year as well as between similarly dated TDFs in a single
year. Over the long term, studies that project TDF performance over a
full working career reveal that different age cohorts may experience
considerably different investment returns. Finally, comparisons of
TDFs with different asset allocations and with other investment
options such as balanced funds reveal a number of trade-offs.
Performance for Similarly Dated TDFs Varied over Recent Years:
In recent years, year-to-year performance of TDFs of the same target
date has varied considerably. As figure 5 illustrates, of the largest
TDFs with 5 years of demonstrated returns, the returns have varied.
Figure 5: Range of Returns from 2005 to 2009 for the 2010 TDFs with
the Largest Market Share:
[Refer to PDF for image: line graph]
Percentage return on investment:
Year: 2005;
Low: 3.44%;
Average: 4.89%;
High: 6.25%.
Year: 2006;
Low: 6.9%;
Average: 9.44%;
High: 12.84%.
Year: 2007;
Low: 3.61%;
Average: 6.65%;
High: 9.2%.
Year: 2008;
Low: -30.27%;
Average: -23.02%;
High: -10.75%.
Year: 2009;
Low: 12.76%;
Average: 22.34%;
High: 27.95%.
Source: GAO representation of Morningstar data.
Note: Morningstar provided data on the 15 largest 2010 TDFs in terms
of assets under management, which represent 98 percent of the TDF
market. For this representation, GAO selected the 8 funds that had at
least 5 years' worth of return data available. Some TDFs are so new
they do not have 5 years of return data. Furthermore, some TDFs
contain multiple share classes. Returns from the subclass of shares
with the most assets under management are represented.
[End of figure]
Investment returns also varied considerably between TDFs of the same
target date within each year. For example, according to data from the
2009 Morningstar Industry Survey, in 2008, returns for 2010 TDFs
ranged from a loss of about 41 percent to a loss of about 9 percent.
[Footnote 25] Conversely, with the market recovery in 2009, returns
for 2010 TDFs ranged from gains of about 7 percent to gains of about
31 percent. Figure 6 illustrates 1 year of returns (2009) for 2010
TDFs along with the equity allocations of these TDFs, showing that
there is a broad range of returns, even within 1 year, for similarly
dated TDFs.
Figure 6: 2010 TDF Returns in 2009 with Equity Allocations:
[Refer to PDF for image: plotted point graph]
Graph depicts:
Percentage return on investment: higher returns; and:
Percentage invested in equities: increasing risk.
Percentage return on investment: 23.34%;
Percentage invested in equities: 67%.
Percentage return on investment: 23.15%;
Percentage invested in equities: 65%.
Percentage return on investment: 23.44%;
Percentage invested in equities: 65%.
Percentage return on investment: 29.25%;
Percentage invested in equities: 62%.
Percentage return on investment: 27.95%;
Percentage invested in equities: 60%.
Percentage return on investment: 25.65%;
Percentage invested in equities: 58%.
Percentage return on investment: 21.39%;
Percentage invested in equities: 56%.
Percentage return on investment: 24.56%;
Percentage invested in equities: 55%.
Percentage return on investment: 19.32%;
Percentage invested in equities: 55%.
Percentage return on investment: 16.24%;
Percentage invested in equities: 53%.
Percentage return on investment: 23.87%;
Percentage invested in equities: 52%.
Percentage return on investment: 19.53%;
Percentage invested in equities: 52%.
Percentage return on investment: 19.36%;
Percentage invested in equities: 52%.
Percentage return on investment: 30.79%;
Percentage invested in equities: 51%.
Percentage return on investment: 24.82%;
Percentage invested in equities: 50%.
Percentage return on investment: 25.64%;
Percentage invested in equities: 49%.
Percentage return on investment: 24.92%;
Percentage invested in equities: 47%.
Percentage return on investment: 17.71%;
Percentage invested in equities: 44%.
Percentage return on investment: 27.94%;
Percentage invested in equities: 42%.
Percentage return on investment: 15.92%;
Percentage invested in equities: 41%.
Percentage return on investment: 18%;
Percentage invested in equities: 37%.
Percentage return on investment: 15.44%;
Percentage invested in equities: 36%.
Percentage return on investment: 23.11%;
Percentage invested in equities: 35%.
Percentage return on investment: 22.56%;
Percentage invested in equities: 35%.
Percentage return on investment: 22.75%;
Percentage invested in equities: 34%.
Percentage return on investment: 22.43%;
Percentage invested in equities: 30%.
Percentage return on investment: 25.3%;
Percentage invested in equities: 27%.
Percentage return on investment: 7.34%;
Percentage invested in equities: 26%.
Percentage return on investment: 12.31%;
Percentage invested in equities: 26%.
Source: GAO representation of Morningstar data.
[End of figure]
Because TDFs are designed to be long-term investments, short-term
gains or losses need to be put into proper context; that is that these
investments are expected to fluctuate in value over time. For example
one expert we spoke to emphasized that the reported TDF returns in the
last several years were based on the volatile economy. This volatility
was not unique to TDFs but seen in varying degrees by other
investments over that period of time.
Long-Term Performance of TDFs May Vary among Cohorts:
The data from each of the nine studies included in our review showed
that participants in different cohorts may experience different
investment results.[Footnote 26] For example, a 2006 study used
historical earnings data and simulated asset returns to project ending
account balances at the retirement date for (1) participants who began
investing in different periods of their careers, and (2) participants
of different educational levels.[Footnote 27] As figure 7 illustrates,
the study found that college graduates who experienced outcomes in the
lowest percentile of returns could possibly accumulate savings of
about $116,000, while the outcomes for those at the 90th percentile of
returns could possibly accumulate about $1,270,000--or potentially
more than 10 times the savings accumulated by the first percentile.
The mean accumulation outcomes for college graduates were about
$743,000. Similar ranges in potential outcomes were found for other
educational groups.[Footnote 28]
Figure 7: Potential Outcomes for TDF Ending Account Balances for
College Graduates:
[Refer to PDF for image: horizontal bar graph]
1st percentile: $116,100;
Mean: $742,500;
90th percentile: $1,270,200.
Source: GAO representation of J. Poterba, K. Rauh, S. Venti, and D.
Wise. ’Reducing Social Security PRA Risk at the Individual Level–
Lifecycle Funds and No-Loss Strategies."
[End of figure]
Another study found when completing simulations that while some
participant cohorts might achieve greater returns than other
participant cohorts, a small percentage of individual participants
might arrive at retirement with less money in real terms than they
contributed to their TDF over their working careers, because of poor
returns in the financial markets.[Footnote 29] Specifically,
simulations completed in the study resulted in a mean real internal
rate of return for the baseline portfolio of about 4.6 percent for all
participant cohorts, while two simulated cohorts achieved a 2.4
percent real internal rate of return, or less than half the rate of
return that the best-performing cohort achieved at 6 percent.[Footnote
30] Furthermore, the study found that the mean rate of return for all
individual participants was 4.3 percent, while individual participants
in the 99th percentile achieved 8.5 percent rate of return and the
bottom 10th percentile of individual participants experienced a rate
of return of 1.9 percent, and those participants in the 1st, or
lowest, percentile experienced a rate of return of minus 0.1 percent.
[Footnote 31]
[Side bar:
Studies of Cohort Risk:
In this report, participant cohorts are groups of similarly aged
participants whose length of working careers and retirement dates are
similar. Because financial market returns will differ over the working
lives of participants of different ages, even if all other factors such
as contribution levels and investment portfolios remained constant,
participants‘ cohorts are likely to experience significantly different
investment returns. Therefore the participants may reach retirement
with very different account balances. The risk of being in a cohort
that experiences relatively low investment returns is sometimes
referred to as cohort risk. It is important to note that while all TDF
investors experience cohort risk, cohort risk is not unique to TDFs. All
participants in DC retirement plans are exposed to this risk, because
DC plans place investment risks solely on individual participants.
The studies we reviewed examined the potential results of cohort risk
using various techniques and metrics, and are thus difficult to
compare side by side. For example, some studies used historical data
on market returns, while others used stochastic techniques, which
involve running simulations of thousands of different economic paths to
project potential outcomes. Also, the studies used different metrics
such as the internal rate of return, account balances at retirement,
or the probability of outliving one‘s assets.
End of side bar]
Trade-offs of Different TDFs' Asset Allocations:
Some of the studies we reviewed found that trade-offs exist between
higher-equity and lower-equity TDFs. For example, one study found that
TDFs using a higher-equity approach resulted in higher average returns
relative to a more conservative, lower-equity TDF.[Footnote 32]
However, the study also found that higher-equity TDFs increased the
chance for an infrequent poor outcome because of the increased risk
these investments carry. By comparison, a lower-equity approach will
increase the likelihood that the participant cohort will not lose as
much money in a downturn in the market, but forgoes the potential for
large returns in an upturn in the market. One study found that
reducing the risk of extreme outcomes by switching to a lower-equity
approach earlier in the glide path involved a heavy penalty in terms
of forgone accumulation of wealth.[Footnote 33] An additional study
simulated the use of the TDFs in retirement and found that
participants in lower-equity TDFs are subject to a higher shortfall
risk--ranging between 14 percent and 22 percent.[Footnote 34] However,
TDFs with lower equity allocations may also help participants avoid
extremely poor investment returns.[Footnote 35]
Comparison of TDFs with Other Types of Investments:
Some of the studies we reviewed analyzed the potential long-term
performance of TDFs compared with other investments, such as balanced
funds and all-bond funds.[Footnote 36] In one study, the moderate TDF
outperformed the balanced fund in three of the seven age cohorts
examined, while the balanced fund performed better in the other four
cohorts.[Footnote 37] Further, this study found that the mean return
of the aggressive TDF exceeded that of the balanced fund, while the
balanced fund mean return exceeded those of the conservative and
baseline TDFs.[Footnote 38] Another study found a balanced fund to
have similar average returns to a baseline TDF, but with a wider
variance in returns.[Footnote 39] The study also modeled a 50/50
balanced fund and found that the balance fund generally performed
better than the simulated TDF used for comparison. For example, the
study calculated the after-tax income in retirement for a college
graduate earning $55,000 per year who had invested in a TDF versus in
a 50/50 balanced fund. If the participant's TDF performed in the top
or middle set of outcomes, then the 50/50 fund would outperform the
simulated TDF. However, at the bottom 10 percent of possible outcomes,
the TDF and 50/50 balanced fund performance would be similar, thereby
making payouts from both types of funds at retirement almost the same.
The results of a study we reviewed that compared TDFs with an all-bond
fund found that TDFs would outperform the all-bond fund. The study
modeled conservative, moderate, and aggressive TDFs.[Footnote 40]
Assuming markets behave as they have historically, all three TDFs were
projected to have higher average returns than the all-bond fund. The
TDFs average return rate ranged from 3.9 to 5.1 percent, while the all-
bond fund had an average return rate of 2.1 percent.
Plan Sponsors May Face Challenges Selecting and Monitoring TDFs and
Communicating to Their Participants:
Plan sponsors and industry experts we spoke to identified several key
considerations in selecting and monitoring TDFs, such as ensuring the
TDF fits with key characteristics of the workforce. Plan sponsors face
a number of challenges in selecting and monitoring TDFs, and some may
not take a thorough approach to TDF selection. Although plan sponsors
communicate to participants using different media, plan sponsors and
others we contacted indicated that the level of understanding of TDFs
among plan participants was fairly low, particularly among defaulted
participants.
According to Plan Sponsors and Industry Experts, Plans Should Take
Several Steps When Selecting and Monitoring TDFs as QDIAs:
Clearly Defined Goals and Objectives:
Plan sponsors and other experts we contacted noted that the unique and
complex nature of TDFs necessitates certain steps in the selection and
monitoring processes, above and beyond the steps plan sponsors would
take for any 401(k) investment.[Footnote 41] As one expert noted, TDFs
are structured as a long-term, all-in-one investment solution, rather
than a single investment product within a broader retirement
portfolio. Several plan sponsors and others stated that plan sponsors
should first clearly define their goals and objectives for the 401(k)
plan's default investment and then choose TDFs that match these
objectives. For example, if the goal of the 401(k) plan is to serve as
the sole retirement vehicle for most participants, then a plan sponsor
may wish to consider more conservative TDFs as its default investment.
Conversely, if the goal of a 401(k) plan is to serve as a
supplementary savings vehicle to accompany a defined benefit plan, a
more aggressive TDF may be appropriate.
Matching TDF to Participant Population:
Several plan sponsors and industry experts noted that each plan
sponsor's participant population has certain characteristics that
should be taken into account when determining which TDF to select as a
default investment. For example, one plan sponsor said that its
employees generally share similar relevant characteristics--most of
its participants will retire before 65 years of age, have access to a
defined benefit plan, maintain a reasonable savings rate, and receive
401(k) employer match in company stock. Therefore, the sponsor chose
to develop its own customized TDF that would better match its
workforce, rather than an off-the-shelf product. Several industry
experts noted that a plan sponsor's industry, particularly the salary
level and job security or turnover, should be considered when deciding
which TDF to choose as the plan's default investment. For example, one
expert noted that a glide path with a lower equity allocation would
better suit a sponsor with a high-turnover workforce. This is because
a participant would be less likely to suffer significant investment
losses if he or she were to separate and cash out his or her 401(k) in
a depressed equity market. While some plan sponsors and plan
consultants may examine the participant population, small plan
sponsors with unique and homogeneous workforces may benefit from
simply identifying several key characteristics of their participant
population and using that insight to inform their choice of TDFs as
their default investment.
Similarly, some plan sponsors and others noted that plan sponsors
should make an effort to match the TDF glide path and underlying
assumptions with other workforce characteristics. In particular,
industry experts and plan sponsors cited the importance of considering
participants' behavior as it pertains to contribution rates,
retirement age, withdrawal patterns during a participant's working
career, and actions in retirement, such as drawdown rates.[Footnote
42] Little is currently known about participants defaulted into TDFs,
because they are relatively new vehicles that only recently have
gained popularity as default investments. Consequently, many plan
sponsors we spoke with examined their entire participant population to
inform their TDF selection process. Similarly, given that QDIAs
themselves are relatively new, it is unclear what the behavior of the
defaulted population will be over time. Industry experts said that in
some cases, a large majority of participants may take a lump-sum
withdrawal at retirement, purchase an annuity, or reinvest the balance
in a vehicle that the sponsor knows little about. In that case,
according to one industry expert, a plan sponsor may wish to consider
a TDF that reduces its market risk as the fund nears the retirement
date because participants will be taking money out of their TDFs at
retirement. In contrast, if most plan participants are going to
withdraw funds from the plan at a steady rate throughout retirement,
then a plan sponsor may wish to consider a TDF with a more aggressive
glide path near the retirement date because the participant would have
a longer time to recover from any downturns in the equity market.
Furthermore, one industry expert said plan sponsors should examine
participant contribution rates and withdrawal patterns, especially the
percentage of participants who take preretirement distributions
starting at 59½ years old. According to this expert, such
distributions could substantially affect the volatility of cash flows
and the investment time horizon for the TDF.
Despite the importance placed on workforce characteristics by some of
the plan sponsors and experts we contacted, current DOL regulations do
not require that plan fiduciaries, such as plan sponsors, consider
factors other than a participant's age or target retirement date when
deciding whether a TDF, among categories of investment alternatives
described in the regulation, are QDIAs within the meaning of the
regulation. While the current regulations do not preclude
consideration of other factors, DOL has specifically stated that plan
fiduciaries are not required to include other considerations in their
selection of QDIAs. In the preamble accompanying the final QDIA
regulations in 2007, DOL stated that the agency took this position in
order to provide plan fiduciaries with certainty that they had
complied with the regulation.[Footnote 43] However, as mentioned in
the preamble, plan fiduciaries still must satisfy their general
fiduciary responsibilities of prudence and loyalty when selecting and
monitoring any particular TDF, and these duties require plan
fiduciaries to consider other factors in selecting a particular TDF.
Plan Sponsor Expertise and Resources:
Because some TDFs are more challenging to monitor than others, some
industry experts said plan sponsors should consider their level of
expertise and available resources when selecting TDFs. Plan sponsors
and industry experts stressed the importance of monitoring and
assessing any changes to the TDF glide path or investment strategy
because TDFs are not static investments. A TDF may deviate from or
change its stated glide path over time, change underlying funds and
fund managers, or change investment strategies within an asset class--
all of which can have a significant effect on the fund's composition,
performance, and fees. Therefore, as one industry expert stated, plan
sponsors with limited expertise and resources should not select TDFs
with high tactical allocations or other actively managed strategies
that allow the TDF manager to deviate significantly from its glide
path because they require more active oversight. Similarly, one
industry expert said plan sponsors whose investment committees meet
only once annually and rely primarily on their record keepers' reports
to monitor their investments should not choose TDFs that would require
more due diligence monitoring, such as customized funds.
Some Plan Sponsors Face Challenges When Selecting and Monitoring TDFs:
Limited Due Diligence:
Our discussions with plan sponsors and industry experts indicated that
sponsors vary in their approach to TDF selection and monitoring, in
part because of several key challenges that some plan sponsors face.
First, some plan sponsors, particularly small plan sponsors, who spend
the vast majority of their time running their business and
administering other benefits and payroll, may have limited resources
in-house to conduct a thorough TDF selection process and ongoing
monitoring activities. One industry expert noted that this may be a
problem, particularly in the small end of the marketplace, where plan
sponsors may simply choose any TDF in the marketplace once they
determine that all TDFs qualify as QDIAs. Another industry expert
stated that most plan sponsors could not even document that they had
considered a range of investment managers in their TDF selection
process.[Footnote 44] Furthermore, some small plan sponsors may not
grasp the basic concepts of TDFs and would not know the steps
necessary to properly evaluate and select a TDF. Therefore, some plan
sponsors with limited in-house resources may look outside to service
providers for advice or to conduct some or all of the steps of the TDF
selection and monitoring processes; however, they may be unaware that
the service provider may not be a plan fiduciary and may have
conflicts of interest in providing advice.[Footnote 45]
Benchmarking Limitations:
The majority of experts and plan sponsors we spoke to said that plan
sponsors have difficulty comparing and evaluating the performance of
TDFs because of the limitations of currently available benchmarks.
According to several experts, traditional benchmarks, such as
Morningstar star ratings, that compare the returns of all funds within
a category--such as all domestic large cap funds--relative to each
other, may not be very useful in evaluating TDF performance. This is
because the objectives, asset allocation, investment strategy, and
underlying funds that make up a TDF can vary among one another and
over time. For example, a TDF with a relatively low allocation to
equity may underperform a TDF benchmark during a lengthy rise in the
equity market, but this may be an expected short-term consequence of
the long-term TDF strategy. If a sustained decline in equity values
occurs near or after the target date, the same TDF may outperform the
benchmark. One plan sponsor pointed out that TDFs are a relatively new
product type and most of them do not have long track records, yet
these vehicles have long-term investment objectives (e.g., 40 years at
a minimum and much longer if the postretirement phase is included.)
Therefore, experts noted that simply comparing returns over a 1-, 5-,
or 10-year time period might not be useful in evaluating the long-term
appropriateness of the fund.
Some plan sponsors said they developed custom composite benchmarks to
evaluate the performance of their individual TDFs. Other industry
experts noted that custom composite benchmarks are useful only in
measuring whether a manager succeeds in outperforming the general
market but that they lack the ability to evaluate a TDF's glide path
strategy or investment objectives. Several industry experts and plan
sponsors we spoke to said there is no universally accepted benchmark
that can be used to evaluate all TDFs. As an alternative to
benchmarks, one plan consultant recommended that sponsors use forward-
looking metrics that evaluate the risk/reward characteristics and the
range of possible long-term performance outcomes of the TDFs--such as
retirement income replacement rates and longevity risk (e.g., the risk
that a participant will run out of money before death) as alternative
evaluation tools.[Footnote 46] Several plan consultants said plan
sponsors would be best served to examine the fund's glide path and
objectives, rather than focus solely on performance.
Role of Record Keepers:
Several industry experts we spoke to said record keepers may influence
a plan sponsor's TDF selection process.[Footnote 47] Several industry
experts said some record keepers require plan sponsors to use their
TDFs or may offer discounts to entice plan sponsors to use their TDFs.
Since the costs and time associated with switching a record keeper can
be high--for example, this could entail changes in computer systems,
record-keeping and payroll processes, and converting account balances--
plan sponsors may feel they have little choice and may not even
consider other options. According to Brightscope data, in 2009, 96
percent of 401(k) plans with TDFs that were clients of the largest
record keepers use the record keeper's proprietary TDFs.[Footnote 48]
Two of the 10 plan sponsors we spoke to said they did not look beyond
their record keeper's TDFs when selecting their plan's default
investment. One said it chose not to search for other TDFs in the
marketplace because it valued the bundled services approach that its
record keeper could provide. This sponsor added that this arrangement
made it easy for the plan sponsor to manage the 401(k) plan because it
interacts with one provider for most issues it encounters. Another
plan sponsor said it used an outside consultant to conduct its TDF
search. However, the first step in the consultant's search process was
to get a list of funds that were supported by its record keeper.
Ultimately, the consultant provided only one recommendation--the
record keeper's TDF--to the plan sponsor's investment committee.
Plan Sponsors Provide Defaulted Participants Information on TDFs Using
Various Media:
Although most plan sponsors we spoke to offered multiple avenues of
communications to their participants, the level of information on TDFs
provided to plan participants varied greatly from plan sponsor to plan
sponsor. Plan sponsors we spoke to provided information to
participants on all 401(k) investments using a variety of media, which
included new employee packets, flyers, newsletters, Web sites, call
centers, and in-person educational sessions. In addition, some plan
sponsors provided communications specifically focused on TDFs. For
example, one plan sponsor sent a newsletter to participants after the
2008 market downturn that included an article explaining how TDFs
should be used. Another sponsor said it provided a Morningstar fund
fact sheet on all its 401(k) investments, including TDFs, and the
initial and annual QDIA notifications, and provided no further
information on TDF investing in general, or the composition of the
TDFs offered in the 401(k) plan. In contrast, another plan sponsor
said its employee benefits staff meets with new employees to review
the TDF's glide path, discuss the age-based nature of the TDFs, and
the importance of choosing a TDF with a target date closest to their
planned retirement date. They also explained the risks and return
characteristics of the TDFs and how they become more conservative over
time. New employees also received a packet that included information
on the available TDFs. Some plan sponsors relied on service providers
to develop and distribute information on TDFs to their participants.
One plan sponsor we spoke to said that all participant communications
come directly from its record keeper and TDF manager.
Several plan sponsors said they sent initial and annual notifications
directly to defaulted participants explaining that participants have
been automatically enrolled in the 401(k) plan and defaulted into a
specific TDF. However, defaulted participants may receive limited or
no information on the principles and objectives of TDF investing, in
general, or specific information on the glide path and composition of
the TDFs chosen as the plan's default investment. If this information
is not included in the annual communications sent to defaulted
participants, then participants must actively seek out information on
the TDFs they are invested in through other media, such as Web sites,
educational tools and videos, and newsletters.
Plan sponsors and other experts described a number of challenges in
effectively educating participants about key aspects of TDFs. Plan
sponsors generally indicated that participants understand little about
TDFs beyond the basic concept that TDFs are aged-based funds that
become more conservative over time. The sponsors also indicated that
participants defaulted into TDFs know less about TDFs than an average
participant. One consultant said that defaulted participants are
typically disengaged and, in general, could not name the fund that
their contributions are going into or answer the most fundamental
questions about TDFs. Furthermore, several plan sponsors we spoke to
said that participants had misperceptions about TDFs, particularly
those contributing to TDFs with target dates in the relatively near
future. Such participants often believed that their investments were
protected because they were close to the retirement date, and were
shocked when the values declined significantly, as they did in 2008-
2009.
Federal Agencies Have Taken Actions to Address Issues Related to TDFs:
Since DOL and SEC held a hearing regarding TDFs in the wake of the
2008-2009 market decline, the agencies have taken several steps to
enhance participant protections. These included efforts that focused
on educating plan sponsors and participants, and proposed regulations
that, if finalized, would require TDF managers and plan sponsors to
improve information provided to participants.
Guidance on Selecting and Monitoring TDFs:
In early 2010, DOL and SEC jointly published an investor bulletin that
provided participants education and outlined considerations for plan
participants when choosing a TDF.[Footnote 49] The investor bulletin
explained the goals, functions, and risks associated with TDFs while
directing participants to carefully consider whether TDFs are the best
option for them. The investor bulletin also explained that TDFs are
designed to make investing for retirement more convenient by
automatically changing the asset allocation for the participant's
account over time. DOL and SEC emphasized that TDFs carry risk and do
not guarantee sufficient retirement income at the retirement date.
Because defaulted participants have not generally taken an active role
in their investments, some experts expressed doubt that the bulletin
would be of value to these participants.
According to DOL officials, the agency is also developing guidance
directed at plan sponsors. DOL stated that the guidance was
necessitated by the growing popularity of TDFs in 401(k)-type plans
and the fact that TDFs are not uniformly designed investment products.
According to DOL, the guidance will be designed to assist plan
sponsors in their evaluation and selection of TDFs as plan
investments, aiming to help plan fiduciaries enhance retirement
security for participants. DOL noted that such guidance is needed in
light of the importance of understanding the unique characteristics
that distinguish TDFs from other types of investments, the differences
among the various TDFs available, and how these differences can affect
the retirement savings of participants. As of January 24, 2011, the
guidance had not been released.
Actions to Enhance TDF Disclosure to Participants by Plan Sponsors:
In recent months, both DOL and SEC have issued proposed regulations
that would help ensure that plan participants obtain better
information about TDFs. SEC proposed regulations addressing the
marketing and naming of TDFs in June 2010.[Footnote 50] According to
the preamble of SEC's proposal, the proposed regulations are intended
to address concerns that have been raised regarding the potential for
investor misunderstanding that could arise from TDF names and
marketing materials. In November 2010, DOL released proposed
regulations on target date disclosures.[Footnote 51] According to DOL
officials, their proposal was largely motivated by the joint public
hearing held by DOL and SEC in June 2009, after which the agency
determined that improvements could be made to the information
disclosed to participants concerning their investments in TDFs. SEC
and DOL proposed regulations that are summarized in table 1.
Table 1: Recent SEC and DOL Regulatory Proposals for TDF Disclosure
Requirements:
Prohibiting potentially misleading statements about TDFs:
SEC-proposed regulations for TDF marketing materials: Certain
statements would be considered potentially misleading[B];
* stating that TDFs are a "simple" investment plan that requires
little or no monitoring by the participant, or;
* emphasizing a single factor, such as an investor's age, as the basis
for determining that an investment is appropriate;
DOL-proposed amendments to QDIA and other disclosure regulations for
TDFs[A]: Not applicable[C].
Inclusion of general advisory statements:
SEC-proposed regulations for TDF marketing materials: Advertisements
would be required to advise participants that:
* factors in addition to age or retirement date should be considered
by investors, and;
* the TDF investment is not guaranteed and that the loss of money is
possible including at and after the target date;
DOL-proposed amendments to QDIA and other disclosure regulations for
TDFs[A]: With regard to TDFs, fiduciaries must provide;
* a statement that participants may lose money by investing in a QDIA,
including losses near or following retirement, and that there is no
guarantee that investment in the QDIA will provide adequate retirement
income.
Disclosure of specific information about TDFs:
SEC-proposed regulations for TDF marketing materials: Advertisements
would be required to disclose information such as:
* TDFs that use the target date in the fund name must disclose asset
allocation as of that date, immediately adjacent to the first use of
the fund name;
* a table, chart, or graph that illustrates asset allocation over the
life of the TDF;
* an explanation of the asset allocation changes over time, when the
TDF will reach its final allocation, and a description of the final
asset allocation; and;
* whether asset allocations can be changed without shareholder vote;
DOL-proposed amendments to QDIA and other disclosure regulations for
TDFs[A]: For all QDIAs:
* basic information such as name of the investment issuer;
* objectives and goals;
* principal strategies and risks;
* historical performance, and;
* information on plan fees;
Specifically for TDFs:
* asset allocation at the retirement/target date;
* a table, chart, or graph that illustrates the TDF asset allocation
over time;
* an explanation that the asset allocation changes over time and a
description of the final asset allocation;
* an explanation of the age group for whom the fund is designed, and
the relevance of the target date; and;
* any assumptions made about a participant's contribution and
withdrawal intentions on or after the target date.
Source: GAO summary of SEC and DOL proposed regulations.
[A] The proposed DOL requirements specific to TDFs would apply to both
participants invested in a QDIA by default and to those who actively
choose to invest in a TDF.
[B] While TDFs are the immediate impetus for the proposed amendments,
the proposed amendments would apply to all types of investment
companies.
[C] Although DOL's proposed regulations do not address this issue, in
its notice of proposed rulemaking, DOL requested comments as to
whether and to what extent its final rule should include elements or
concepts contained in SEC's rulemaking.
[End of table]
As table 1 shows, the regulations proposed by DOL and SEC contain some
similar provisions that, if finalized, would help ensure that both
plan participants and investors generally obtain more accurate
information about TDFs. However, there are also some differences in
the two agencies' proposed regulations, and the variations in these
regulatory approaches are likely a reflection of the fact that each
agency has its own purpose and its own authorities and
responsibilities. For example, the DOL proposal would require that
plan participants receive information on the assumptions about a
participant's contributions and withdrawal intentions, which may be
especially important for participants relying on a TDF as their main
retirement savings vehicle.
SEC received 51 comments on its proposed regulation, and several
commenters noted that additional disclosures might have very little
impact on a large portion of TDF investors--specifically those who are
and will be defaulted into the TDFs. For example, one commenter noted
that many defaulted participants may have minimal interest in
investing their account assets themselves. Further, the commenter
noted that such participants are likely to remain in the default
investment throughout their employment with the plan sponsor.
Therefore, this commenter said it is especially important for plan
sponsors to select an appropriate TDF on behalf of all defaulted
participants. On the other hand, two commenters said SEC's proposed
amendments could help defaulted participants to better understand the
TDF's investment strategy and asset allocation plan, especially if
these defaulted participants later choose to become more active
investors.
Other Organizations Have Made Alternative Proposals Regarding TDF
Regulation:
In recent years, industry organizations and others have offered
alternative perspectives that could be considered by DOL and SEC as
they proceed with their regulatory and guidance efforts.
In June 2009, the Investment Company Institute (ICI), a mutual fund
trade organization, published a set of principles aimed at improving
disclosures by TDF managers.[Footnote 52] For example, the document
recommended that TDFs prominently disclose the fund's assumptions
about the participants' withdrawal rates at and after the target date,
and offered sample language that TDF managers might use. It noted that
this information is important because a TDF's asset allocation can
vary significantly approaching and after the target date based on such
withdrawal assumptions. Also, it noted the importance of illustrating
the assumptions that influenced the development of the glide path, and
the possibility of glide path adjustments, such as a change in the
strategic allocation to equities. The principles also stated that the
relevance of the target date used in the fund name should be
prominently disclosed. For example, the principles noted that such
disclosure might prominently state that the fund name refers to the
approximate year a participant would plan to retire and stop making
contributions to the TDF. Furthermore, if the target date is also the
date at which the participant is expected to cash out of the fund,
this information could be disclosed as well.
Both ICI and AARP have also offered lists of issues that plan sponsors
should consider in selecting TDFs.[Footnote 53] ICI noted several
considerations concerning plan participant characteristics, such as
whether participants also have access to other retirement benefits,
like a defined benefit plan, that plan sponsors should consider when
choosing a TDF. AARP suggested that plan sponsors consider plan
demographics such as workforce age and participant contribution rates.
AARP also proposed that plan sponsors consider the TDF manager's
investment objectives and assumptions used for determining these
investment strategies and asset allocations. According to AARP, these
could include assumptions about contribution and withdrawal rates,
retirement horizon, and income needed in retirement.
Conclusions:
TDFs are relatively new investments and have gained considerable
popularity among plan sponsors as default investments only over the
last several years. They are a significant development in the
financial services and retirement plan industry, and may become the
most common investment option in DC plans in the years ahead. Along
with the growth of automatic enrollment policies, TDFs as QDIAs help
"automate" certain aspects of DC plan participation that have been
left to the discretion of plan participants in DC plans. However, TDFs
do not address some of the other limitations of the DC plan system.
For example, as with any other DC plan, plan participants contributing
to TDFs still bear the full burden of investment risk. While studies
have shown that many TDF investors are likely to do well, some
percentage of participants may realize relatively poor real returns on
their investments over their working life.
Further, plan sponsors and others have indicated that the process of
selecting TDFs as default investments for 401(k) plans can vary
considerably from one plan sponsor to another. To some degree,
differences among plan sponsors are inevitable, because larger plan
sponsors will generally have the resources to do more planning and
research than smaller plan sponsors. However, the responsibilities of
a plan sponsor to thoughtfully select and monitor TDFs are all the
more important when participants are automatically enrolled and
defaulted into the investment chosen by the plan sponsor. While plan
sponsors and others we spoke to identified important steps, we found
that there are also opportunities to help improve plan sponsor
selection of TDFs. Developing guidance and tools could help to improve
plan sponsor awareness of the key aspects and differences of TDFs in
the marketplace. For example, some plan sponsors may place unwarranted
reliance on TDF benchmarks, a practice that may be misleading given
the long-term nature and different asset allocation strategies of
TDFs. Information about the limitations of these benchmarks could help
plan sponsors improve their approach to TDF selection. In addition,
some plan sponsors and industry experts stressed the importance of
considering workforce characteristics beyond age or retirement date in
selecting a TDF. Such characteristics could include the existence of a
defined benefit plan, salary level, turnover rate, or participant
behavioral characteristics, such as contribution rates and withdrawal
patterns.
We commend SEC and DOL for their ongoing efforts to help ensure that
plan sponsors and participants select and use TDFs appropriately. In
light of the recent emergence of TDFs as a typical default investment,
we acknowledge some additional actions may best be taken after more is
learned about how default investors use TDFs over the longer term.
However, in the interim, DOL could take some additional steps. For
example, it is important to note that some participants may not grasp
the asset allocations of their TDF and the investment theories on
which the allocations are based. This is especially likely for many of
the participants who, given the overwhelming popularity of TDFs as
QDIAs, will be defaulted into a TDF and may take a passive approach to
their retirement savings. With minimal effort, defaulted participants
who may have little interest in investments or the TDF asset
allocation strategies could benefit from short, simple educational
information about key assumptions that TDF managers make about plan
participant actions. Accordingly, DOL's proposed amendments to the
QDIA regulation include a requirement that plan sponsors provide any
assumptions made about participants' contribution and withdrawal
intentions on or after the target date to plan participants. However,
it is not obvious from the proposed regulation that plan participants
would receive information clearly explaining the potential connections
among the assumptions made about participant contributions and
withdrawals, the participants' related actions, and their ability to
establish and sustain a financially secure retirement.
The current QDIA regulations do not require that plan sponsors
consider workforce characteristics beyond a participant's age or
retirement date in selecting TDFs as default investments, and the
proposed regulatory amendments do not address this issue. As DOL
explained when issuing the final QDIA regulations, consideration of
other workforce characteristics, apart from age or retirement date,
was not required in deciding whether TDFs, among the categories of
investment alternatives described in the regulation, are QDIAs within
the meaning of the regulation. This is because DOL wanted to give plan
sponsors certainty that they had complied with the regulations. We
agree that such certainty has value. However, much has been learned
about TDFs in the years since the initial regulation was developed. In
particular, it is clear that TDFs' asset allocations differ
considerably, that these differences reflect different trade-offs
regarding key risks, and that specific TDFs may therefore be well
suited to the workforce characteristics of some plan sponsors, but not
those of others. In satisfying their fiduciary obligations of prudence
and loyalty in the selecting and monitoring of particular TDFs as
QDIAs, plan fiduciaries may need to be aware of these differences.
Recommendations for Executive Action:
We recommend that the Secretary of Labor direct the Assistant
Secretary of the Employee Benefits Security Administration to:
1. amend the QDIA regulations so that fiduciaries are required to
document that they have considered, to the extent possible, whether
other characteristics of plan participants, in addition to age or
target retirement date, are relevant factors in choosing a QDIA;
2. provide guidance to plan sponsors regarding the limitations of
existing TDF benchmarks and the importance of considering the long-
term TDF investment allocations and assumptions used in developing the
TDF asset allocation strategy; and:
3. in its final regulation on target date disclosure, expand the
requirement that plan sponsors provide information regarding key
assumptions concerning contribution and withdrawal rates by requiring
that participants receive a statement regarding the potential
consequences of saving, withdrawing, or otherwise managing TDF assets
in a way that differs from the assumptions on which the TDF is based.
Agency Comments:
We provided a draft of this report to the Department of Labor, the
Department of the Treasury, and the Securities and Exchange Commission
for review and comment. The Department of Labor noted that the report
accurately highlighted many of the structural and disclosure issues
surrounding TDFs, and the challenges that face plan fiduciaries in
selecting TDFs. However, DOL did not agree with our first
recommendation, which called for it to require that plan fiduciaries,
to the extent possible, consider characteristics of plan participants,
other than age or retirement date, when choosing a QDIA. Labor
reiterated, as we noted in our report, that it had considered and
rejected this approach in developing the final QDIA regulations. DOL
further stated that it is not clear whether GAO intended that
fiduciaries consider some or all of the characteristics GAO mentioned,
or how a fiduciary should interpret or apply such characteristics in
selecting a TDF. DOL agreed, however, that it may be appropriate for a
fiduciary to consider the characteristics that GAO cited, and
indicated that the agency will include such considerations in its
guidance to plan fiduciaries.
We stand by our recommendation. A great deal has been learned about
TDFs since DOL developed its QDIA regulations. As we noted in our
report, the asset allocations, risk levels, and assumptions concerning
participant disposition of assets at and after the retirement date
differ considerably among TDFs. Most recently, as the events of 2008
showed, these differences can have considerable impact on plan
participants who are near retirement and thus particularly vulnerable
to large investment losses. In light of this, we believe that a
consideration of other participant characteristics in the QDIA
selection process, to the extent that such information is available to
a fiduciary, would better protect plan participants. We agree that it
is important for fiduciaries to be certain that they have complied
with all applicable regulations, but we believe that our
recommendation would not add undue uncertainty or unnecessary
complications to the QDIA selection process. Indeed, highlighting the
importance of other workforce characteristics, as DOL proposes to do,
without amending the QDIA regulations could cause more uncertainty
regarding fiduciary obligations. However, in light of DOL's concerns,
we have amended our recommendation so that it calls for DOL to require
that plan sponsors consider whether other workforce characteristics
are relevant, and document that they have done so. Combined with the
guidance that DOL is developing, such a requirement would at least
cause a plan fiduciary to consider whether a particular TDF is a
reasonable fit for its workforce. As DOL noted in the QDIA regulation,
consideration of other characteristics would be permissible but not
required.
DOL indicated that it would consider our other two recommendations in
the course of its ongoing regulatory and guidance efforts. We
understand that DOL would not wish to take a position while its
efforts are ongoing. However, we believe that the timing of our
recommendation is particularly apt in light of these efforts, and we
are hopeful that our work will inform DOL as it works to finalize the
regulations.
DOL cited a number of concerns with our third recommendation, which
called for the agency to require sponsors to provide information on
the potential consequences of saving, withdrawing, or otherwise
managing their TDF assets in a way that differs from the assumptions
on which a TDF is based. Specifically, DOL said that this would be a
very complicated and subjective undertaking, which could affect a plan
sponsor's decision to offer a TDF. We disagree. The Department of
Labor already proposes to require sponsors to provide information
about a TDF's assumptions concerning participants' contribution and
withdrawal intentions. Our recommendation seeks to ensure that plan
participants understand the significance of these assumptions. An
additional statement of the kind we advocate could simply point out to
plan participants that contributing at a rate lower than or
withdrawing at a rate higher than a TDF's design assumptions could
lessen the likelihood of a secure retirement.
We did not receive formal comments from the Department of the Treasury
or the Securities and Exchange Commission, and received technical
comments from the three agencies, which we incorporated as appropriate.
As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution until 30 days after the date
of this letter. At that time, we will send copies of this report to
the Secretary of Labor, the Secretary of the Treasury, the Chairperson
of SEC, appropriate congressional committees, and other interested
parties. We will also make copies available to others upon request. In
addition, the report will be available at no charge on GAO's Web site
at [hyperlink, http://www.gao.gov].
If you have any questions concerning this report, please contact
Charles Jeszeck at (202) 512-7215. Contact points for our Office of
Congressional Relations and Public Affairs may be found on the last
page of this report. GAO staff who made major contributions to this
report are listed in appendix IV.
Signed by:
Charles A. Jeszeck:
Director, Education, Workforce, and Income Security Issues:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
Our objectives were to answer the following research questions:
1. To what extent do the investment compositions of different target
date funds (TDF) vary?
2. What is known about the performance of TDFs?
3. How do plan sponsors select and monitor TDFs that are chosen as the
plan's default investment, and what steps do they take to communicate
information on these funds to their plan participants?
4. What steps have the Department of Labor (DOL) and the Securities
and Exchange Commission (SEC) taken to ensure that plan sponsors and
participants appropriately select and use TDFs?
To answer the first question, we obtained and reviewed existing
literature about TDFs and their investment approaches and interviewed
a variety of retirement plan industry experts (see table 2 for a list
of organizations we contacted). Second, we conducted case studies with
eight TDF managers, which included in-depth semistructured interviews
with representatives of the TDF manager and reviewed available
documents describing the nature of and reasons for TDF asset
allocations. Through these discussions and reviews, we obtained
detailed information on each provider's glide path philosophy,
underlying funds and holdings, fee structure, and investment strategy
and objectives. We also gained a fuller understanding of the
investment philosophy, underlying assumptions, and concerns for
different types of risks that underlie their approaches.
Table 2: Organizations Contacted during Review:
Organizations contacted: TDF managers:
* Eight firms that offer and manage TDFs;
Contact regarding objective 1: [Check];
Contact regarding objective 2: [Check];
Contact regarding objective 3: [Empty];
Contact regarding objective 4: [Empty].
Organizations contacted: Consultants and service providers:
* Aon Hewitt;
* Captrust Financial Advisors;
* Mercer;
* Summit Financial Group;
* Target Date Analytics;
* Towers Watson;
Contact regarding objective 1: [Check];
Contact regarding objective 2: [Check];
Contact regarding objective 3: [Check];
Contact regarding objective 4: [Empty].
Organizations contacted: Government:
* Employee Benefits Security Administration (EBSA), DOL;
* U.S. Department of the Treasury;
* SEC;
Contact regarding objective 1: [Check];
Contact regarding objective 2: [Check];
Contact regarding objective 3: [Check];
Contact regarding objective 4: [Check].
Organizations contacted: Plan sponsors;
* Ten plan sponsors that use TDFs as their 401(k) plan default
investment;
Contact regarding objective 1: [Empty];
Contact regarding objective 2: [Empty];
Contact regarding objective 3: [Check];
Contact regarding objective 4: [Empty].
Organizations contacted: Other organizations:
* AARP;
* American Benefits Council;
* Academic Expert at Kennedy School of Government, Harvard University;
* Academic Expert at the University of California, Los Angeles;
* Academic Expert at the University of Chicago Booth School of
Business;
* Academic Expert at University of Mississippi School of Law;
* Academic Expert of the Wharton School of the University of
Pennsylvania;
* American Society of Pension Professionals and Actuaries (ASPPA);
* Committee on Investment of Employee Benefit Assets (CIEBA);
* Fiduciary Counselors;
* Investment Company Institute (ICI);
* Morningstar;
* Profit Sharing/401k Council of America (PSCA);
* Reish & Reicher;
Contact regarding objective 1: [Check];
Contact regarding objective 2: [Check];
Contact regarding objective 3: [Check];
Contact regarding objective 4: [Check].
Source: GAO.
[End of table]
We selected eight TDF managers for cases studies to provide an
understanding of the range of investment approaches taken by TDFs in
the marketplace. These eight TDF managers we contacted reflect about
86 percent of the TDF market, by assets under management. Using
Morningstar's Target Date Series Research Paper: 2009 Industry Survey,
we selected TDF managers based on several criteria:
* Size of assets under management: We interviewed the top three TDF
managers, whose funds account for over 70 percent of the TDF market,
as well as other smaller fund managers, according to net asset
information collected by Morningstar as of July 30, 2009.
* Equity allocation at retirement: We interviewed at least one manager
with a high equity allocation (65 percent or more) in its 2010 fund
and at least one manager with a low equity allocation (45 percent or
less) in its 2010 fund.
* Returns relative to size of equity allocation: We interviewed fund
managers whose 2010 funds performed either significantly better or
worse in 2008 returns than other 2010 funds with relatively similar
equity allocations. This factor was chosen because we wanted to
understand what drove this difference in returns.
* Active versus passive management: We interviewed one fund manager
that invested primarily in passively managed underlying funds and
seven fund managers that invested primarily in actively managed
underlying funds.
* Length of glide path: We interviewed at least one TDF manager who
employs a "To" glide path (i.e., a glide path that ends at the
retirement date) and at least one manager that employs a "Through"
glide path (i.e., a glide path that continues to change after the
retirement date). TDF glide paths were determined through TDF
prospectuses, marketing materials, and Web sites and verified by fund
managers.
To address the second question, on the performance of TDFs, we
reviewed historical data and performed a literature review of studies
completed that project the potential future long-term performance of
TDFs. The historical data were obtained from Morningstar. We obtained
return data from 2005 to 2009 for the largest 15 TDFs with at least 5
years of performance data. Some TDFs were not included in the sample
because the funds had been in existence for less than 5 years. We
interviewed Morningstar officials regarding the data's reliability and
their processes for ensuring the reliability of their data,
establishing that the data were both relevant and complete.
To determine the potential long-term performance of TDFs, we conducted
a literature review and analyzed the results of selected studies. A
literature review was conducted and documented with the help of the
team librarian. Using a snowballing technique, the studies selected
from the literature review were reviewed, and any other relevant
articles mentioned in the studies initially selected through the
literature review were obtained and then reviewed as well. Once this
list of studies was compiled, the team contacted industry experts,
knowledgeable stakeholders, and academics to review the list of
studies compiled and identify any additional relevant studies. The new
studies were then reviewed. We narrowed down our list of studies based
on several screening criteria:
* Was the study based on original quantitative research using actual
historical data, stochastic techniques, or other quantitative methods?
* Was the study free from bias and not conducted or commissioned by an
organization that develops or markets TDFs or competing investment
products or provides services and advice to plan sponsors about TDFs?
* Did the study pass GAO's data reliability standards for
completeness, accuracy, and consistency of the data, ensuring that the
study was free from bias?
Ultimately, nine studies were chosen based on the screening criteria
and served as the basis of our findings on the potential future long-
term performance of TDFs.
To answer the third question, we first reviewed relevant federal laws
and regulations and relevant literature and spoke with federal
officials and employee benefits attorneys to understand fiduciary
requirements as they relate to qualified default investment
alternatives (QDIA) and TDFs. Second, we interviewed key national
organizations and pension industry experts to understand the concerns
faced by plan sponsors and their participants regarding TDFs. This
included representatives from organizations that represent plan
sponsors, such as the Committee on Investment of Employee Benefit
Assets, Profit Sharing/401(k) Council of America, and participants,
such as AARP. In addition, we interviewed several plan consultants,
such as Aon Hewitt, and several record keepers, such as Principal
Financial Group, to understand how they work with plan sponsors to
select and monitor TDFs. Third, we conducted 10 case studies with plan
sponsors of all sizes, which included in-depth semistructured
interviews and a review of relevant communication materials given to
participants. Through these discussions and reviews, we obtained
detailed information on their TDF selection process, ongoing due
diligence monitoring activities, and communication provided to
participants about TDFs. The results of our plan sponsor case studies
were limited by the willingness of plan sponsors to speak with us.
We selected 10 plan sponsors for case studies using a two-step
process. First, we used Form 5500 data from DOL to identify plan
sponsors that have TDFs as an investment option in their 401(K) plans.
We used the Form 5500 data to segment plan sponsors into three groups--
small, medium, and large--based on the number of total active
participants in their 401(k) plans. Small plans were defined as having
25 to 249 active participants, medium plans as 250 to 4,999 active
participants, and large plans as 5,000 or more active participants.
Second, we selected plan sponsors from each group to be interviewed as
a case study based on three selection criteria: (1) industry of the
plan sponsor, (2) level of industry wage earnings, and (3) TDF chosen
as default investment. We determined the first criterion by using the
North American Industry Classification System (NAICS) codes in the
Form 5500 data. We chose plan sponsors across a variety of industries,
including financial services, consumer products, professional
services, educational services, and agriculture, among others. The
second criterion was determined by using the U.S. Bureau of Labor
Statistics' national monthly wage analysis data to determine if the
plan sponsor is in either a high-or low-wage-earning industry. We
chose plan sponsors in both high-wage and low-wage industries. We
determined if plan sponsors met the third criterion by contacting the
plan sponsor's staff in charge of human resources/benefits and through
Pensions & Investments data and other industry news articles, where
available.[Footnote 54] Ultimately, we chose to interview six large
plan sponsors, two medium-sized plan sponsors, and two small plan
sponsors.
To answer the fourth question, we reviewed relevant federal laws and
regulations and interviewed agency officials as well as external
experts to analyze recent actions taken by DOL and SEC regarding TDFs.
First, we reviewed relevant federal laws and regulations that govern
TDF disclosures and that govern the use of TDFs in defined
contribution plans. Second, we interviewed DOL and SEC officials
throughout our engagement and reviewed testimony and documents from
the DOL-SEC joint hearing on TDFs in June and July 2009. Third, we
reviewed recent actions taken by DOL and SEC, such as the DOL-SEC
joint investor bulletin on TDF investing published in May 2010, and
SEC's proposed regulation for the marketing and naming of TDFs, and
EBSA's proposed regulation on target date disclosures. Finally, we
reviewed comments submitted on recent proposed federal regulations and
spoke with representatives of plan sponsors and plan participants, TDF
managers, industry and academic experts, and national organizations
that represent TDF managers.
[End of section]
Appendix II: Studies Reviewed to Assess Ranges of Future TDF
Performance:
Basu, A. K., and M. E. Drew, "Portfolio Size Effect in Retirement
Accounts: What Does It Imply for Lifecycle Asset Allocation Funds?"
Journal of Portfolio Management, Spring (2009): 61-72.
Bodie, Z. and J. Treussard, "Making Investment Choices as Simple as
Possible, but Not Simpler," Financial Analysts Journal, vol. 63, no.
3, (2007): 42-47.
Brady, P., "What Does the Market Crash Mean for the Ability of 401(k)
Plans to Provide Retirement Income?" National Tax Journal, vol. LXII,
no. 3 (2009): 455-476.
Bridges, B., R. Gesumaria, and M. Leonesio, "Assessing the Performance
of Life-Cycle Portfolio Allocation Strategies for Retirement Saving: A
Simulation Study," Social Security Bulletin, vol. 70, no. 1 (2010): 23-
43.
Pang, G., and M. Warshawsky, "Asset Allocations and Risk-Return
Tradeoffs of Target-Date Funds," Journal of Pension Benefits, (2010):
24-35.
Park, Y., "Plan Demographics, Participants' Saving Behavior, and
Target-Date Fund Investments," EBRI Issue Brief, no. 329 (2009): 1-41.
Poterba, J., J. Rauh, S. Venti, and D. Wise, "Reducing Social Security
PRA Risk at the Individual Level: Lifecycle Funds and No-Loss
Strategies," NBER Working Paper Series 06-07, (2006): 1-43.
Shiller, R., "The Life-Cycle Personal Accounts Proposal for Social
Security: An Evaluation," NBER Working Paper Series 11300, (2005): 1-
34.
Spitzer, J., and S. Singh, "Shortfall Risk of Target-Date Funds During
Retirement," Financial Services Review, vol. 17 (2008): 143-153.
[End of section]
Appendix III: Comments from the Department of Labor:
U.S. Department of Labor:
Assistant Secretary for Employee Benefits Security Administration:
Washington, D.C. 20210:
January 5, 2011:
Mr. Charles A. Jeszeck:
Director, Education, Workforce, and Income Security Issues:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. Jeszeck:
Thank you for the opportunity to review the Government Accountability
Office's (GAO) draft report entitled "Key Information on Target Date
Funds as Default Investments Should be Provided to Plan Sponsors and
Participants." In general, the draft report does a good job of
highlighting many of the structural and disclosure issues surrounding
target date funds and the challenges facing a number of plan
fiduciaries in the selection and monitoring of such funds.
As the draft report acknowledges, the Department of Labor (Department)
has taken a number of steps, intended to address issues relating to
target date funds. In particular, we note that, following a joint
public hearing on target date funds, the Department and the SEC issued
an investor alert to help investors and participants in 401(k) and
similar plans understand the operations of and risks attendant to
target date funds. The Department also published proposed amendments
to its qualified default investment alternative (QDIA) regulation (29
CFR § 2550.04c-5) and participant-level disclosure regulation (29 CFR
§ 2550.404a-5). Upon adoption, these amendments will ensure that all
participants and beneficiaries, whether or not defaulted into a target
date fund, receive information to assess whether a particular target
date fund is appropriate for them. Among other things, the proposals
require a narrative explanation of how the target date fund's asset
allocation will change over time, the point in time when the fund will
reach its most conservative allocation, a graphical illustration of
how the fund's asset allocation will change over time, and an
explanation of what the target date means. The Department invited
interested parties to submit comments on the proposals by January 14,
2011. In addition, as discussed with the GAO staff, the Department is
preparing informal guidance designed to assist plan fiduciaries in
their consideration of target date funds as investment options for
their plans.
Turning to the specific recommendations for executive action set forth
in the draft report, we submit the following for your consideration.
GAO recommendation: Amend the QDIA regulation so that fiduciaries are
required, to the extent possible, to take into consideration other
characteristics of plan participants, in addition to age or target
retirement date, when choosing .a QDIA, regardless of the type of QDIA
chosen.
The Department does not agree with this recommendation. The Department
considered and rejected the approach recommended by the GAO in
developing the final QDIA regulation. The apparent basis for GAO's
recommendation is that "some plan sponsors and industry experts
stressed the importance of considering workforce characteristics
beyond age or retirement date in selecting a TDF." In this regard, the
draft report states that "such characteristics could include the
existence of a DB plan, salary level, turnover rate, or participant
behavioral characteristics, such as contribution rates and withdrawal
patterns." It is not clear from GAO's recommendation whether an
amendment to the QDIA regulation should require consideration of all
or some of these characteristics in selecting a target date fund. Nor
the does the draft report explain how a plan fiduciary should
interpret or apply such characteristics in selecting a target date
fund.
While the Department does not believe the QDIA regulation should be
amended to require considerations beyond age and retirement date, the
Department does believe that it may be appropriate for plan
fiduciaries to take into account many of the considerations identified
in the draft report in selecting target date funds for their plan. In
this regard, the Department will be including similar considerations
in its guidance for plan fiduciaries.
GAO recommendation: Provide guidance to plan sponsors regarding the
limitations of existing target date fund benchmarks and the importance
of considering the long-term target date fund investment allocations
and assumptions used in developing the target date fund asset
allocation strategy.
The Department cannot agree with this recommendation because it has
not yet completed its review of information and factors that
fiduciaries should consider in evaluating a target date fund(s) for
their plan. As noted above, the Department is in the process of
developing tips to assist plan fiduciaries with the selection and
monitoring of target date funds. The Department will consider the
GAO's recommendation as it works to complete this guidance.
GAO recommendation: In its final regulation on target date disclosure,
expand the requirement that plan sponsors provide information
regarding key assumptions concerning contributions and withdrawal
rates by requiring that participants receive a statement regarding the
potential consequences of saving, withdrawing or otherwise managing
target date fund assets in a way that differs from the assumptions on
which the target date fund is based.
The Department cannot agree to any specific recommendation in advance
of its completing consideration of all the public comments received on
the proposed regulation. As noted above, the Department is soliciting
comments on amendments to the QDIA and participant-level disclosure
regulations that are designed to improve the information furnished to
plan participants about target date funds, whether such funds are
default investments or merely available investment options under the
plan. The GAO's recommendation that sponsors include in such
disclosures a statement regarding the potential consequences of
saving, withdrawing or otherwise managing target date funds in a way
that differs from the assumptions on which the target date fund is
based would appear to be a very complicated and subjective undertaking
which could affect a plan sponsor's decision to offer any target date
fund option(s).
Again, thank you for the opportunity to review the draft report.
Should you or your staff have any questions concerning the statements
or requests contained herein, please do not hesitate to contact us.
Sincerely,
Signed by:
Phyllis C. Borzi:
Assistant Secretary:
[End of section]
Appendix IV: GAO Contacts and Acknowledgments:
GAO Contact:
Charles A. Jeszeck, Director, (202) 512-7215 or jeszeckc@gao.gov:
Staff Acknowledgments:
David Lehrer, Assistant Director, and Michael Hartnett, Analyst-in-
Charge, managed this review. Ryan Siegel and Nicole Harkin, in
consultation with Gene Kuehneman and Kenneth Bombara, also led
portions of the research and made significant contributions to all
portions of this report.
Luann Moy and Jay Smale provided methodological assistance. Susannah
Compton provided assistance with report preparation. Sheila McCoy,
Roger Thomas, and Rachel DeMarcus provided legal assistance. Ashley
McCall assisted in identifying relevant literature. James Bennett
developed the report's graphics. Susan Offutt provided comments on
this report. Claudine Pauselli, Lara Laufer, Jeff Miller, Amber Yancey-
Carroll, Sharon Hermes, and Paul Schearf verified our findings.
[End of section]
Footnotes:
[1] Pub. L. No. 109-280 (2006) Section 902 of PPA added Code sections
401(k)(13), 401(m)(12) and 414(w). In 2009, the Internal Revenue
Service promulgated final regulations addressing automatic enrollment.
Automatic Contribution Arrangements, 74 Fed. Reg. 8,200 (February 24,
2009) (to be codified at 26 C.F.R. pts. 1 and 54).
[2] Morningstar is a provider of research that provides data on
stocks, mutual funds, and similar vehicles.
[3] Congressional Research Service, Pension Sponsorship and
Participation: Summary of Recent Trends, Washington, D.C.: Sept. 11,
2009.
[4] See GAO, Retirement Savings: Automatic Enrollment Shows Promise
for Some Workers, but Proposals to Broaden Retirement Savings for
Other Workers Could Face Challenges, [hyperlink,
http://www.gao.gov/products/GAO-10-31] (Washington, D.C.: Oct. 23,
2009).
[5] See § 624(a) of the PPA and 29 C.F.R. § 2550.404c-5.
[6] 29 CFR §2550.404c-5(e) In addition to these three QDIAs, a plan
sponsor may also invest a participant's contributions in a capital
preservation fund--a fund designed to preserve principal and provide a
reasonable rate of return--for the first 120 days of participation.
The final QDIA regulation was promulgated in 2007.
[7] See [hyperlink, http://www.gao.gov/products/GAO-10-31].
[8] TDFs may also hold cash, and some also include investments in
alternative assets, such as commodities.
[9] Among these laws are the Securities Act of 1933, 15 U.S.C s.77a
et. seq. (Pub. L. No. 111-229); the Securities Exchange Act of 1934,
15 U.S.C. § 78a (Pub L. No. 111-257); the Investment Company Act of
1940, 15 U.S.C. s.80a-64 (Pub. L. No.111-257, as amended); and the
Investment Advisers Act of 1940 (15 U.S.C. § 80b-1-§80b-21; Pub. L.
No. 111-257).
[10] See 12 C.F.R § 9.18(a)(2). According to 2009 data compiled by
Morningstar, about 79 percent of TDF assets were held in the form of
mutual funds, and 16 percent were in the form of CITs. The balance was
held in other forms.
[11] U.S. Senate Special Committee on Aging, Target Date Retirement
Funds: Lack of Clarity among Structures and Fees Raises Concerns,
Summary of Committee Research, prepared by the majority staff of the
Special Committee on Aging, U.S. Senate, October 2009.
[12] Figure 3 includes only four examples for purposes of visual
clarity. Of the eight TDFs included in our study, the illustration
depicts TDFs with a relatively high and a relatively low allocation to
equity at the retirement date, as well as two intermediate examples.
[13] According to officials at Morningstar, the large majority of TDFs
used by retirement plans continue the glide path beyond retirement.
Six of the eight TDFs included in our review do so.
[14] This TDF plan manager noted that a rule of thumb for spending in
retirement is to withdraw only 4 to 5 percent of the initial savings
amount to ensure savings are not depleted. Hence, a 5 percent
withdrawal rate may be on the high side of what the analysis
considered prudent.
[15] JP Morgan Asset Management, Ready! Fire! Aim? 2009: How Some
Target Date Fund Designs Continue to Miss the Mark on Providing
Retirement Security for Those Who Need it Most, December 2009.
[16] [hyperlink, http://www.gao.gov/products/GAO-10-31].
[17] A fundamental approach to selecting equities considers all the
factors that affect its cash flow, profits, the industry it operates
in, and the economy in general. In contrast, a quantitative approach
is a statistical approach and considers such factors as earnings
momentum and price momentum.
[18] Investment-grade bonds are bonds with high credit ratings,
meaning that the issuer is likely to meet its obligations, and can
thus offer lower interest rates. High-yield bonds are bonds with a
credit rating below investment grade. TIPS are securities whose
principal is adjusted by changes in the Consumer Price Index. With
inflation, the principal increases, and with deflation, the principal
decreases. TIPS pay interest at a fixed rate, which is applied to the
adjusted principal.
[19] According to investment theory, an efficient market is one in
which the price of an asset reflects all information known about that
asset, and therefore reflects its true value. As a result, there is
little to no opportunity for investment managers to profit by
consistently outperforming indexes of the broad market.
[20] According to this TDF manager, if the absolute return strategies
are successful, they would outperform the general securities markets
during periods of flat or negative market performance, underperform
during periods of strong market performance, and typically produce
less volatile returns than the general securities market.
[21] An option is the right to buy or sell a specific security at a
specified price at or within a specified time. This may be done
regardless of the current market price of the security. A futures
contract is an obligation to make or take delivery of a specified
quantity of an underlying asset at a particular future time at the
price agreed on when the contract was made. A swap is a type of
derivative in which two parties agree to exchange assets or cash flows
over an agreed period. They can be based on equity indexes, bonds of
different maturities, baskets of securities, individual securities, or
interest rates.
[22] For purposes of this report, we define alternative assets as
investments other than those intended to achieve exposure to equities,
fixed income investments, or cash. Such investment can include real
estate, commodities, and private equity.
[23] Josh Charlson, David Falkof, Michael Herbst, Laura Pavlenko, and
John Rekenthaler, Target Date Series Research Paper: 2010 Industry
Survey, Morningstar.
[24] Charlson and others, Target Date Series Research Paper.
[25] Charlson and others, Target Date Series Research Paper.
[26] For a listing of all nine studies we reviewed see appendix II.
[27] J. Poterba, J. Rauh, S. Venti, and D. Wise, "Reducing Social
Security PRA Risk at the Individual Level - Lifecycle Funds and No-
Loss Strategies," paper presented at the Eighth Annual Joint
Conference of the Retirement Research Consortium, Washington, D.C.
(2006). The authors calculate a wide range of outcomes based on
education, investment strategy, and assumptions about historical asset
return distributions. The authors model contributions to retirement
accounts over a participant's working life, until retirement at age
63, and combine these contributions with information on the simulated
performance of different investment vehicles using actual lifetime
earnings histories. They then carry out simulations for various
earnings histories with simulated patterns of asset returns to make
their conclusions. The authors structure their portfolios so that the
percentage of stocks held in the portfolio is equal to the number 110
minus the age of the household head, with the remaining balance held
in TIPS.
[28] The study also reported that the outcomes for the lowest
percentile of those with a high school diploma could possibly
accumulate only about $83,000, while the outcomes for those in the
90th percentile could possibly accumulate $1,001,000--12 times the
amount accumulated by the first percentile.
[29] B. Bridges, R. Gesumaria, and M. Leonesio. "Assessing the
Performance of Life-Cycle Portfolio Allocation Strategies for
Retirement Saving: A Simulation Study." Social Security Bulletin, vol.
70, no. 1 (2010): 23-43.
[30] In this study the baseline portfolio invests 85 percent of total
value in equities through age 29, with the equity share declining
linearly until it reaches 15 percent at age 60, where it remains
thereafter. The remainder of the portfolio is invested in the bond
fund. The bond fund consists of one-half long-term federal Treasury
bonds and one-half 6-month private sector money market instruments.
[31] The study conducted a series of stochastic simulations of 28
birth cohorts between 1915 and 1942, using historical investment
returns for the years 1926 to 2008. The study was based on actual
lifetime earnings histories. Real asset returns are derived by
adjusting nominal values for inflation. Bridges and others, "Assessing
the Performance of Life-Cycle Portfolio Allocation Strategies for
Retirement Saving: A Simulation Study," 23-43.
[32] Bridges and others, "Assessing the Performance of Life-Cycle
Portfolio Allocation Strategies for Retirement Saving: A Simulation
Study," 23-43.
The study, which used four TDFs that varied in terms of risk exposure
and various participant ages, used historical return data in modeling
the results. The aggressive TDF resulted in a real internal rate of
return averaging 5.1 percent, with the outcomes ranging between -9.5
percent and 17.8 percent. By comparison, the conservative TDF had an
average return of 3.9 percent. Returns for the conservative TDF ranged
from -5.6 percent to 13.2 percent. The conservative TDF investment
model started with 70 percent invested in equities through age 29 and
then linearly declines to 10 percent at age 60.
[33] A. K. Basu and M. E. Drew, "Portfolio Size Effect in Retirement
Accounts: What Does It Imply for Lifecycle Asset Allocation Funds?"
The Journal of Portfolio Management, Spring (2009): 61-72. This study
used four hypothetical TDFs invested in equities, fixed income
investments, and cash to perform the modeling.
[34] John Spitzer and S. Singh. "Shortfall Risk of Target-Date Funds
During Retirement," Financial Services Review, (2008): 143-153.
[35] Bridges and others, "Assessing the Performance of Life-Cycle
Portfolio Allocation Strategies for Retirement Saving: A Simulation
Study," 23-43.
[36] Some studies compared TDFs with other investment products and
portfolios. However, for the purpose of this report we are focusing on
balanced funds and all-bond funds.
[37] Bridges and others, "Assessing the Performance of Life-Cycle
Portfolio Allocation Strategies for Retirement Saving: A Simulation
Study," 23-43.
[38] According to the study, the 50/50 balanced fund average annual
returns were 4.9 percent as compared with 4.2 for the conservative
TDF, 4.6 for the moderate TDF, and 5.3 for the aggressive TDF
respectively.
[39] P. Brady "What Does the Market Crash Mean for the Ability of
401(k) Plans to Provide Retirement Income?" National Tax Journal, vol.
LXII, no. 3 (2009): 455-476.
[40] Bridges and others, "Assessing the Performance of Life-Cycle
Portfolio Allocation Strategies for Retirement Saving: A Simulation
Study." The study compared an all-bond fund composed of half long-term
Treasury bonds and half 6-month private sector money market funds with
a simulated TDF.
[41] ERISA fiduciaries are required to act solely in the interest of
plan participants and their beneficiaries and select and monitor plan
investments with the care, skill, prudence, and diligence under the
circumstances then prevailing that a prudent man acting in like
capacity and familiar with such matters would act. There are a number
of steps plan sponsors should take when selecting and monitoring any
type of investment in their 401(k)s, including reviewing fund fees and
expenses to make sure they are reasonable, assessing and monitoring
fund management, and reviewing performance periodically. 29 U.S.C.§
1104.
[42] Plan participants can withdraw funds from a 401(k) account in
advance of retirement through a number of means, such as a loan or a
withdrawal due to financial hardship. See GAO, 401(k) Plans: Policy
Changes Could Reduce the Long-Term Effects of Leakage on Workers'
Retirement Savings, [hyperlink,
http://www.gao.gov/products/GAO-09-715] (Washington D.C.: Aug. 28,
2009).
[43] Default Investment Alternatives Under Participant Directed
Individual Account Plans; Final Rule, 72. Fed. Reg. 60,452, 60,461
(October 24, 2007) (codified at 29 C.F.R. pt. 2550). In the same
preamble, DOL explained that with respect to balanced funds, another
QDIA option, fiduciaries are required to take into account the
demographics of the plan's participants in selecting a balanced fund
as a QDIA. 72 Fed. Reg. 60,461, 60,462.
[44] According to a nationally recognized ERISA expert, such omissions
may be considered a breach of fiduciary duty, in light of ERISA's
requirement that plan sponsors prudently select and monitor plan
investment options, and carefully consider the quality of competing
providers and investment products, as appropriate.
[45] On October 22, 2010, DOL published a proposed rule to amend the
definition of an ERISA fiduciary that would require any person, with
certain exceptions, who gives advice or recommendations as to the
selection of investment managers of plan assets to become an ERISA
fiduciary. Definition of the Term "Fiduciary," 75 Fed. Reg. 65,263
(Oct. 22, 2010) (to be codified at 29 C.F.R. pt. 2550). A forthcoming
GAO report will discuss the potential conflicts of interest of service
providers offering advice to plan sponsors and plan participants in
more detail.
[46] Retirement income replacement rates refer to the percentage of a
participant's final salary that is matched by the participant's
retirement payments, if the participant was to purchase an annuity
with the balance of his or her retirement account at the retirement
date.
[47] A record keeper is a service provider that provides record-
keeping services such as plan administration, monitoring of plan and
participant and beneficiary transactions (e.g., enrollment, payroll
deductions and contributions, offering designated investment
alternatives and other covered plan investments, loans, withdrawals,
and distributions), and the maintenance of covered plan and
participant and beneficiary accounts, records, and statements.
[48] Brightscope is an independent provider of 401(k) ratings and
financial information to plan sponsors, advisers, and participants.
[49] DOL and SEC "Investor Bulletin: Target Date Retirement Funds,"
May 6, 2010.
[50] Investment Company Advertising: Target Date Retirement Fund Names
and Marketing, 75 Fed. Reg. 35,920 (June 23, 2010) (to be codified at
17 C.F.R. pts. 230 and 270).
[51] Target Date Disclosure, 75 Fed. Reg. 73,987, (November 30, 2010)
(to be codified at 29 C.F.R. pt. 2550). The comment period for the
proposed regulation closed on January 14, 2011.
[52] ICI, Principles to Enhance Understanding of Target Date Funds,
June 2009.
[53] ICI is a national organization representing the mutual fund
industry. AARP is a nonprofit, nonpartisan membership organization
that provides advocacy for and services to those approaching and in
their retirement years. AARP's suggestions were presented in a letter
dated July 16, 2009, from David Certner, AARP, to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission and the Office of
Regulations and Interpretations, Employee Benefits Security
Administration, Department of Labor. See [hyperlink,
http://www.sec.gov/comments/4-582/4582-28.pdf], last accessed Dec. 3,
2010.
[54] Pensions & Investments is an international newspaper of money
management that delivers news, research, and analysis for its
readership, including executives who manage the flow of funds in the
institutional investment market.
[End of section]
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