PHOENIX -- The mutual fund industry has been wracking its brains to come up with a suitable solution that provides investors with a guaranteed income component in retirement, but has so far failed to achieve this goal.
Industry leaders warn that time is running out for a Holy Grail solution, and say that anxious legislators and regulators may be about to mandate their own version that would likely require an annuity component.
"If our industry doesn't overload the [Department of Labor] and the [Internal Revenue Service] with comment letters, and instead just sits idly by, we will be faced with some kind of mandate," said Geoffrey Bobroff, principal of Bobroff Consulting, at the Investment Company Institute's Mutual Funds and Investment Management Conference last week.
"The DOL and the [Securities and Exchange Commission] are working jointly and will issue a joint investor alert [warning investors about target-date funds] soon," said Bradford Campbell, of counsel for the law firm Schiff Hardin LLC and former DOL assistant secretary of labor for employee benefits. "If you don't offer comments, the government will move forward. Now is the time to comment, before the proposal, not after."
The deadline to submit comments is May 3.
Shift to Auto-Enroll
The gradual shift from pension-style retirement plans to 401(k)-style plans has concerned regulators and lawmakers that workers may be headed for a serious retirement savings gap.
Most workers don't know where or how much to save, and often end up doing whatever the default option is, even if that means saving nothing at all.
The DOL's decision in late 2007 to make target-date funds a qualified default investment alternative (QDIA) allowed employers to automatically enroll new participants into age-appropriate target-date funds.
Since they became a default option, participation rates have exceeded 90%, Campbell said. Participants have the ability to opt-out of these plans, but few choose to do so, or to make any changes to their asset allocations whatsoever.
"This is a segment of the industry that has experienced explosive growth in the last decade," said SEC Commissioner Luis Aguilar. "At the end of the 1990s, the assets in these funds totaled $10 billion. By July 2009, four separate target-date fund series were larger than the entire industry had been a decade before. In fact, by the end of 2009, assets in target date funds registered with the Commission totaled approximately $240 billion."
The booming popularity of target-date funds has placed them directly in the crosshairs, particularly after many 2010 target-date funds experienced steep losses in the recent recession.
Aguilar said the average short-dated target-date fund lost 25%-30% during the financial crisis of 2008, shocking investors and calling into question the reliability of these funds as the primary investment vehicle for some savers.
Kohl's Mission
As chairman of the Senate Special Committee on Aging, Sen. Herb Kohl (D-Wis.) has taken this issue head-on, holding numerous hearings on the funds to determine how they can be improved and whether the funds should have a guaranteed-income component.
"Target-date products operate under less-stringent fiduciary responsibility guidelines" than other investment products, Kohl said recently. "Many target-date funds are composed of hidden underlying funds that can have high fees, low performance, or excessive risk."
A recent advisory opinion from the Department of Labor found that the fiduciary responsibility of target-date funds currently resides with the employer. Many employers are unaware of the underlying investments of these funds, as they are determined by a fund manager. Increasing the fiduciary liability of employers could result in their decision to drop auto-enrollment options, thereby reducing the retirement security of workers, the DOL said.
Kohl is proposing that target-date fund managers take on this fiduciary responsibility in order for their funds to be eligible for the QDIA designation, by increasing their jurisdiction under the Employee Retirement Income Security Act of 1974 (ERISA), which typically governs pension plans.
According to the ICI, when target-date funds are used in retirement plans, plan fiduciaries must comply with ERISA's fiduciary obligations in selecting and monitoring target-date funds as investment options.
"A plan's fiduciary-usually a representative of the employer-selects and monitors target-date funds for use in the plan's investment lineup," the ICI said. "In doing so, the fiduciary must comply with a comprehensive set of ERISA obligations that require it to act with prudence and for the exclusive benefit of the plan and its participants. These regulations prohibit self-dealing and restrict conflicts of interest, among other practices."
As target-date funds often operate as funds-of-funds, they must also meet additional requirements under the Investment Company Act of 1940, the ICI said.
"With more than 90% of employers choosing off-the-shelf target-date funds as their employee's standard option, there is no question that we need greater regulation and transparency of these products," Kohl said. "People who are defaulted into target-date funds are the ones who need someone looking out for their financial interests the most. We need to ensure that automatic enrollees benefit from the same fiduciary protections as other investors."
Campbell said making fund managers comply with ERISA attempts to merge dual regulatory regimes.
"Merging these regulations would run the risk of new obligations and duties that don't mesh with existing duties," further increasing the potential to run into prohibited transactions, Campbell said. "The concern with target-date funds is over disclosure, but ERISA is based on personal liability."
"We've attempted to come up with products that offer some type of immediate annuity, but none of them have a guarantee," Bobroff said. "The DOL believes we have to give people an annuity, but the average account size in 401(k) plans (when you eliminate the big accounts) is quite small. You can't create a plan that mimics Social Security out of a $50,000 balance in a 401(k) plan."
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