401(k) Specialist Issue 1 - 2023 - 30

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Target Date Funds (TDFs) for retirement savings
plans were launched in 2007, following the passage
of the Pension Protection Act of 2006 that
approved TDFs as one of three Qualified Default
Investment Alternatives (QDIAs).
A serious design flaw became quickly obvious
in 2008 when those near retirement in TDFs lost
more than 30%. The flaw is that TDFs are too risky
at the target date. But this flaw was ignored, mainly
because there was only $200 billion invested at that
time, so too new and too small to worry about.
Subsequent to 2008, high risk was rewarded for the next 13 years as stock and bond markets
flourished. Those 2008 losses were recovered, and all was well again, except for the participants
who retired in or around 2008 and cashed in their savings at a loss.
Then 2022 once again shocked participants with the realization that most TDFs are way too
risky at the target date. This time more than $3.5 trillion is at risk-the stakes are extremely high.
And the flaw has become even worse as TDFs increased risk, enticed by the remarkable run in
stock and bond markets.
In the 16-year history of TDFs, a couple of innovations were evolving that went almost
unnoticed. A couple pioneers launched TDFs that are actually safe at their target date. And
recognizing that safety deep into retirement might be suboptimal, one of those pioneers
introduced a U-shaped glidepath that is very safe at the target date but then re-risks in retirement
to extend the life of assets.
This article examines the evolution of TDFs that is not yet complete and explains what it
will take to complete the revolution. (Hint: expect lawsuits)
Definition of a TDF and its Glidepath
A target date fund is an investment plan designed to deliver " safe " money on an event
date, the target date. When the event is in the distant future, the TDF is aggressive, but then it
becomes progressively safer as the target date approaches. This planned change in risk is called
a " glidepath; " yes, like the landing of an airplane. It's risk management on cruise control.
TDFs were originally used for college savings plans, where the target date is the year the
student plans to start college. Then in the late 2000s, TDFs began to be used for 401(k) pension
plans, following the passage of the Pension Protection Act of 2006.
Companies that provide TDFs create glidepaths. There is little disagreement about how
much risk to take when the horizon to target date is long. Most TDFs are heavily weighted in
equities (stocks, real estate, etc.) when the target date is distant. But there is a lot of disagreement
about how much risk is appropriate when the participant retires.
These disagreements don't matter much because just three firms manage most of the assets,
and their glidepaths are quite similar. Vanguard, Fidelity and T. Rowe Price manage 65% of
the $3.5 trillion in TDFs, with Vanguard alone managing 40%. A market structure where a
handful of firms control the majority is called an " oligopoly. "
ISSUE 1 2023 | 401kSpecialist.com
The Oligopoly
The Big 3 oligopoly evolved from a preference
of plan sponsors and their advisors
to hire their bundled service providers to
manage TDFs because of familiarity and
a belief that any QDIA will do because-
hey-it's " Qualified. " But throwing darts at
the QDIA dartboard breaches the fiduciary
Duty of Care. More on this in the section
that follows on " Sequence of Return Risk. "
As the oligopoly grows, fiduciaries increasingly
rely on procedural prudence to
protect them from lawsuits, despite the existence
of a handful of safe TDFs. Vetting is a
mere handwave. " Hire the Big 3 " is an unofficial
mandate because there is confidence
in popularity and the dictates of procedural
prudence-no documentation needed.
You can't be sued if everyone is doing the
same thing, unless everyone is wrong, as was
the case with excessive fees. The next wave
should be lawsuits for taking excessive risk
at the target date.
An Inauspicious Beginning
Subsequent to the PPA, target date fund
assets in 401(k) plans grew from nothing to
about $200 billion in just two short years.
This set the stage for serious disappointment
in 2008 when the typical 2010 fund lost
more than 30%. The market crash of 2008
exposed the fact that far too much risk was
being taken, especially near the target date.
Note that the 2010 fund is designed for
those retiring between 2005 and 2015.
Participants who defaulted their investment
decision to their employers believed
they were protected, especially near retirement,
so they were devastated and shocked.
As a consequence of this shocking loss,
the U.S. Securities and Exchange Commission
(SEC) and the Department of Labor
(DOL) held joint hearings in 2009. See the
discussion on " Federal Oversight " below.
Today the $3.5 trillion in TDFs is 45%
of all 401(k) assets, and the 37 million
participants represent more than 60% of all
participants. TDFs are extremely popular
and important.

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401(k) Specialist Issue 1 - 2023

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