Plan Fiduciaries: Don’t Crash and Burn With Your TDF Glidepath
WHAT IS A TDF, HOW DOES IT WORK, AND HOW DO RETIREMENT PLANS UTILIZE THEM?
TDF managers use a concept, known as a glidepath, in order to manage the investment allocations of the fund. Under this concept, younger participants tend to invest in a TDF that is more heavily invested in equities(e.g. stock funds). This is based on the theory that younger investors, who are farther away from retirement than older investors, would be willing to take more risk in an effort to gain more upside potential. As these younger participants age, the allocation of the fund moves toward less risky investments with less upside potential (such as bond funds).
The aim of TDFs is to simplify the investment allocation decision process. As an example, an individual hoping to retire in 2025 would purchase just one fund that would automatically move from a more aggressive position to a more conservative allocation as retirement nears. TDFs have exploded in popularity since 2007 when they were recognized as satisfying ERISA’s requirements for a Qualified Default Investment Alternative (QDIA). A QDIA was created under the Pension Protection Act 2006 and requires all retirement plans to maintain a default investment option for those individuals that do not select any investment choice.
“Some TDFs are “retirement” date funds that arrive at the most conservative allocation on the actual target date. However, some TDFs are “into and throughout retirement” funds and may still have a significant allocation to equities at retirement. Neither choice is incorrect, but a failure to understand this key difference and communicate this to participants could be a fiduciary landmine.”
A 2010 Morningstar study found that half of all large retirement plans (5000+ participants) incorporate an automatic investment feature in their 401(k). Of those selecting a default feature, an astounding 96% have selected TDFs as the QDIA. Many employers of smaller plans, on the advice of their advisors, have followed suit and include TDFs as the QDIA in their plans. To be clear, TDFs may be a perfectly suitable investment choice for many plans, but only after a careful analysis. As a fiduciary, employers and their advisors need to look at more than just the obvious benefits of TDFs. In order to satisfy this fiduciary obligation, an analysis should include a thorough understanding of the TDFs glidepath, fees and expenses, quality of underlying funds and the process for educating participants on these types of investments.
The typical allocation glidepath of a TDF reallocates the underlying investments from aggressive to conservative investments as the target date approaches. Since there is no industry standard for reallocating the underlying investments of the fund, fiduciaries need to understand their chosen TDFs’ glidepath. Some TDFs are “retirement” date funds that arrive at the most conservative allocation on the actual target date (or retirement date). However, some TDFs are “into and throughout retirement” funds and may still have a significant allocation to equities at retirement; the theory being that an individual will continue to move to a bond (conservative) allocation throughout retirement and over the individual’s remaining life expectancy. Neither choice is incorrect, but a failure to understand this key difference and communicate this to participants could be a fiduciary landmine.
WHAT ARE THE ECONOMIC ISSUES RELATED TO TDFS?
Plan participants, who do not understand the inner workings of their TDF investments, may not be properly prepared for changes in the market. For example, an increase in interest rates could have an adverse effect on the fair value of their bond funds. Also, a TDF that is structured “into and throughout” retirement may be more heavily invested in equities. As a result, Plan participants may not be prepared for losses incurred in a down market. These losses could be difficult to recoup if the participant is currently retired.
WHAT ARE THE FIDUCIARY ISSUES AND HOW CAN THEY BE NAVIGATED?
In the event the TDF underperforms, or it doesn’t perform well with respect to its peer group, such an event could cause risk of liability to Plan fiduciaries. As a result, fiduciaries need to understand the inner workings of any TDF that they select for their retirement plan.
Navigating fiduciary issues for TDFs can help mitigate potential liability to the fiduciary. The following table offers some suggestions for dealing with common risks related to TDFs:
| IDENTIFIED RISK | SUGGESTION FOR ADDRESSING RISK |
|---|---|
| Using a TDF as a QDIA If a Plan Fiduciary selects a TDF as a QDIA, the fiduciary has a risk that the TDF may not match the Plan participant demographics. |
Plans may want to consider using an investment other than a TDF as the QDIA of the Plan. However, if a TDF is used as a QDIA, Plan fiduciaries are well advised to evaluate that the TDF for the Plan meets the demographics of the majority of the Plan participants and properly educate all participants on the investment strategy of the TDF, which serves as the QDIA. |
| Documenting fiduciary obligations regarding TDFs Documenting the evaluation, decision, and monitoring process, regarding the Plan’s investments is critical to demonstrate that the fiduciary is meeting their responsibility to oversee the plan in a prudent manner. |
Use of an outside expert can help mitigate risk to the Plan fiduciaries. However, regardless of whether the Plan utilizes an outside expert for investment decisions, the Plan fiduciary is still ultimately responsible for the investment performance of the Plan. Plan fiduciaries should maintain evidence that they met this responsibility by documenting their selection and ongoing evaluation process of the TDFs used by the Plan. |
| Proper education of participants regarding their investment in TDFs An uneducated participant can lead to that participant making incorrect investment decisions, thereby leading to increased exposure to the Plan and Plan fiduciaries. |
Plan fiduciaries are well advised to document the Plan’s education process of their participants. Such education should occur no less than annually. In addition, having Plan participants acknowledge receipt of that education is a best practice. |
| A lack of understanding of TDF fees by Plan participants As a fiduciary, Plan sponsors are required to analyze and understand all fees and expenses including those charged by the underlying investments in their 401(k) plan. As a general rule, TDFs with more stocks than bonds are more expensive to manage. So understanding the glidepath of TDFs directly impacts expenses/fees. A TDFs’ expense ratios can vary widely, by more than 110 basis points (1.10%) according to a 2010 Morningstar study. A more expensive fund may not be an issue by itself, but a fiduciary should be able to justify why higher fees are being paid (e.g., better performance, lower overall plan pricing, etc.). |
Plan fiduciaries should document that they carefully evaluated the underlying fees related to these investments. In instances where such fees may be higher than peer investments, fiduciaries should document the rationale for these higher fees. |
| Considerations for Closed Funds TDFs are fund of fund strategies, meaning they invest in other mutual funds. Most TDFs are closed architecture funds. A closed architecture fund invests only in the funds of one family. This makes a lot of sense for the TDF manager because it is easier for the manager to control those individual fund managers and all the fund fees accrue back to the fund family parent. However, this could present a potential conflict for the 401(k) Plan sponsor. The Plan fiduciary is charged with “prudently” selecting investment options for the Plan’s participants. If the TDF manager is combining the fund families’ poor performing funds with the good ones, the fiduciary may not be exercising “prudent” judgment in their investment selection. |
If committed to using a TDF, Plan fiduciaries should document the investment selection and monitoring process used to choose one TDF over another. |
CONCLUSION
TDFs are currently the subject of proposed regulation by both the SEC and the DOL, which will most certainly result in greater disclosure to investors and Plan participants.
TDFs can be a great solution for a retirement plan, but only after a thorough analysis. They are not simple “set it and forget it” investments. Careful analysis, diligent monitoring and continuous education are the key to fulfilling the Plan sponsor’s fiduciary duty. Business owners should consider utilizing an independent qualified advisor to assist them with their fiduciary obligations.
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If you need more information regarding this or any other topic affecting your retirement plan, visit our Withum ERISA Knowledge Corner online, follow us on Twitter at WSB_ERISA or contact us at [email protected] to arrange a free consultation today.
The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your plan’s individual facts and circumstances.
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