After losing a quarter of their value on average in 2008, and sending ripples of outrage and cries for regulation through Washington, target-date funds bounced back in 2009, making up a majority of their steep losses.

Some believe a return to profit may ease investor worry about these retirement funds and move the push for regulation to the back burner. But others think now is the time to ratchet up regulation before the next recession burns more investors.
Target-date funds are retirement plans that combine stocks, bonds and other investments and become more conservative as the investor approaches retirement age. These mutual funds take the guesswork out for investors by allow them to choose the year they intend to retire and then the asset allocations are chosen for them. Voila.
Yet reality is never as easy as it sounds. Like the stock market, these target-date funds got slammed during the recession, losing an average of 23% in 2008. And the 2010 funds, intended for those retiring at or around 2010, became the subject of scrutiny and anger as investors feared that they had lost a good portion of their retirement money.
As Washington grew concerned that investors were being duped by conflicts of interest and false advertising, in stepped Senate Special Committee on Aging Chairman Herb Kohl, D-Wis. Kohl announced last month that he would be introducing legislation that would require target-date fund managers to take on fiduciary responsibilities, which would mean they’d have to put investors’ interests above their own, as well as face increased regulation and legal liability. He also questioned investing in junk bonds as part of a target-date fund’s underlying investments. Morningstar found that six of the nine largest U.S. target-date funds invest in high-yield, high-risk corporate bonds.

But a new Morningstar report written by senior fund analyst Josh Charlson reveals that the average 2010 fund clawed its way back in 2009, with a 20% return. The top performer, according to the report, rose 29%. Even more importantly, Charlson points out, are the returns of target-date 2010 funds since Oct. 1, 2007, the peak before the financial meltdown. From Oct. 1, 2007 through Nov. 30, 2009, the average 2010 fund has lost about 4.5%, according to Charlson. This leaves some wondering if much of the talk about regulation may have been just, well, talk.

“I don’t think that regulation per se is going to be the answer,” Charlson said in a phone interview on Monday.  “I think more transparency and disclosure would be a positive. And I think it will be better if regulators nudge the companies in the right direction. But I hope we don’t see regulations on what kind of asset allocation these target funds have to carry. I think the bounce back and performance will take some of the pressure off.”
But Mike Alfred, chief executive at BrightScope, an independent provider of 401(k) ratings and financial intelligence to plan sponsors, advisors, and participants, hopes this is not the case. Yes, the returns have come back significantly, Alfred said, but the problems with the funds haven’t gone away. “The conflicts of interest seem to be as rampant today as they were one year ago,” Alfred said. “It’s the market—not the target-date funds themselves—that is improving. The decline in the stock market revealed a lot of the problems with target-date funds, but the recovery in the stock market doesn’t necessarily fix all of those problems.”
The biggest conflict of interest Alfred sees is how investment managers design the glide path, or the amount of equity that the target-date fund has in it over time. An investor who chooses a 2050 target-date fund should expect more investment in equities than an investor with a 2010 target-date fund, as funds get more conservative the closer they are to maturity. For the 2010 funds, equities range from 30% to 70% in the major fund families; signaling that the glide paths are chosen arbitrarily by the fund managers. “The equity percentage is based on the potential profits of the investment manager, more than what is best for the investor,” said Alfred. “How else can you explain why one target-date fund lost 41% while another lost just 9%?”
Another problem, Alfred said, is that sometimes investment companies put new funds with no return histories as part of a default option, where employees are automatically enrolled, in a 401(k) plan. In these “qualified default investment alternatives” both the plan sponsors and investment companies are not responsible for ensuring the plans are transparent or the risks are fully disclosed to employees. Under current law, the Labor Department does not require fund companies to act as fiduciaries, making employers responsible for ensuring that the funds are appropriate for their employees. Meanwhile, fund companies, such as Alliance Bernstein, Fidelity Investments, Oppenheimer, T. Rowe Price and the Vanguard Group, don’t have open architecture plans, which allow investors to choose the underlying funds. Instead, the investment managers invest in shares of the company’s other mutual funds.

Total assets in target-date funds are projected to grow to $2.6 trillion by 2018 and attract 80% of new and reallocated flows into defined-contribution plans for the next decade, according to a study titled “Target-Date Retirement Funds: the New Defined Contribution Battleground” released in November by Casey Quirk & Associates LLC. With that kind of inflow, how can plans be created that profit both investors and investment managers?

“Right now there’s a mismatch between what people expect from these funds and what has actually happened,” Alfred said. “Do the returns of the funds in the short-term take the pressure off the cries for regulation? Absolutely. But the underlying problems are just exacerbated as more and more money comes into these funds.”