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Target-Date Funds - The Next Wave of Litigation?

By Thomas B. Bastin, JD, LLM, AIF, CEBS


The financial services industry really loves complicated products and theories. Perhaps they create an aura of intelligence or superiority. Regardless of the goal there is one recent phenomena that may come back to haunt those who relied upon them. I am talking about target-date funds. Those pre-packaged fund of fund offerings are given nice neat little titles that a fifth grader could understand (retiring this year pick the 2010 fund). However, they come with fine print that only a trial lawyer could love.

So far the industry has been able to avoid the hard questions that come with these products. The gravy train has continued to move at break neck speed. The problem with high speed trains though is once they derail the results can be catastrophic to those trapped in the wreckage.

Modern Portfolio Theory - Flawed or Fabulous?

A key issue with target-date funds is the majority follow what is called Modern Portfolio Theory (MPT). In the spirit of simplicity I turned to Wikipedia for the following definition of MPT:

"The fundamental concept behind MPT is that the assets in an investment portfolio cannot be selected individually, each on their own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price. Investing is a tradeoff between risk and return. In general, assets with higher returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible return. Or, for a given return, per Harry Markowitz MPT explains how to select a portfolio with the lowest possible risk (the desired return cannot be more than the highest-returning available security, of course.).MPT is therefore a form of diversification. Under certain assumptions and for specific quantitative definitions of risk and return, MPT explains how to find the best possible diversification strategy. MPT also assumes that investors are rational and markets are efficient".

There are three important statements you can take from this definition: (1) diversification is important, (2) investors are rational and (3) markets are efficient. All three of these statements must be true for MPT to be correct. One must look no farther than the market events of the past 10 years to see that in fact markets are not efficient. Following a rational approach in which you believe known information does not allow one to successfully outperform the market has neither been the case in 2008 nor 2009. In addition, external events during the entire first decade of this century disproved any correlation between asset classes. Finally, who can argue after 2008 that investors are rational? I guess one would have to completely ignore the massive market liquidation that took effect over a four week period in the fall of 2008. Thus, in my opinion MPT is flawed and thus target-date funds relying upon it are exposing investors to unwanted risk.

The Hidden Problems

Target-date funds cloak themselves under the necessity of "diversification." This is successful because that is the one required aspect of MPT that is in fact true. Numerous charts can be displayed to participants highlighting asset class performance and the value of diversification to an investment portfolio. The sales pitch is supported by a logical and easy to explain concept. One stop shopping makes the target-date fund attractive to many investors lacking the desire to create their own diversified strategy. It is no mystery why holdings in these funds have exploded over the past five years.

Issue 1 - Isn't this Advice?

Participants are sold on diversification and told the easiest way to achieve that goal is simply to select a target-date fund that automatically adjusts their diversification via an "age appropriate" portfolio. For instance, the fund name often includes the year of retirement (2010, 2015 or 2020). As an Advisor if I were to direct a participant's investments in this fashion I would be giving advice and committing a fiduciary act. Yet somehow target-date funds do the same thing with none of the liability. How long before the trial bar questions this? Congress is already looking into it. What would it mean to the plan sponsor if the target-date fund was ruled to be providing advice? I can envision numerous claims for prohibited transactions as this newly designated fiduciary explains their conflicted compensation, "proprietary" fund selection process and failure to adhere to the plan sponsors own investment policy.

Issue 2 - Violation of Investment Policy Statement

Have you ever taken a hard look at the underlying holdings in target-date funds? I have and recently compared one big name fund family's offerings to the criteria listed in a plan sponsors own investment policy statement. You would probably be as surprised to learn as they were that 20 of the 24 underlying funds in the 2030 target-date fund failed to meet their own criteria. Just little issues like 10 did not have the requisite manager tenure (junior has to get experience somehow) and six failed enough criteria to warrant immediate replacement (right - they are going to fire their own lousy managers). The good news was four funds had no issues at all (yea - I guess they should feel blessed!!!).

By the way the same 2030 target-date fund also included 4 asset classes not authorized by the IPS. To make matters worse they were specialty asset classes which pose substantial risk the plan sponsor had no idea were even utilized. There is an old saying when practicing law that the only thing worse than failing to put something in writing is to actually do so and then to ignore it. I suspect upon closer look many plan sponsors would discover the target-date funds they use violate their own investment policy statement. I could be wrong but it is probably not a good move for one's career to wait and discover this during depositions.

Issue 3 - Debt to Equity Ratio

In my mind the biggest issue with target-date funds is they mislead investors. I do not believe it is done intentionally but rather a result of relying upon MPT. The real issue under this theory is investments are skewed heavily towards stock. Examining the same big name fund family I illustrated this point via their 2010 fund. Slightly over 50% of assets are invested in equity funds. We are talking about a person retiring this year and half of their money will be in the stock market. In my opinion this would be considered a moderate approach.

There is nothing wrong with taking a moderate approach provided that is your expectation and you will remain a "rationale" investor (one that will not liquidate during a downturn and lock in losses). However, I have found many retirees in the same situation preferred a more conservative allocation with far less equity holdings. My concern has always been that the conservative person does not realize exactly what they are buying and thus purchases the target-date fund under a false impression of the holdings. This is why we have always taken the approach of creating risk based asset allocation models with stated and static debt to equity ratios so a person could elect their own appropriate level of risk. Our conservator investor would be selecting a fund with 90% in cash/fixed income and only 10% in stocks. That represents a significant difference from the 2010 model which resembles our Moderate allocation (50-50). Arguably this is a moral issue rather than a legal one. I'm sure that a trial attorney can make the misleading argument but my real concern is the harm that can come to an unsuspecting investor.


I could go on and discuss issues such as excessive pricing but I believe the point has been made. Plan sponsors are free to offer any investment options they deem appropriate. However, if you utilize target-date funds do not stick your head in the sand and ignore the realities just outlined. Do your homework, understand what you are getting and then make a prudent decision as to what is best for your participants. Of course your plan broker or advisor should have already done this research for you!!!

Thomas B. Bastin, J.D., LL.M., AIF®, CEBS® is the President & General Counsel of ERISA Fiduciary Advisors, Inc., an independent Registered Investment Advisory Firm. As both a former practicing ERISA attorney and owner of a third party administration firm, he brings a unique background, knowledge & set of experiences to his clients. Mr. Bastin can be reached via email (tom@efadvisor.com) or telephone (866.606.4015). This article is protected by copyright laws © 2010.


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