[Senate Prints 111-34]
[From the U.S. Government Publishing Office]
111th Congress
1st Session COMMITTEE PRINT S. Prt.
111-34
TARGET DATE RETIREMENT FUNDS:
LACK OF CLARITY AMONG STRUCTURES AND FEES RAISES CONCERNS
__________
Summary of Committee Research
prepared by the
MAJORITY STAFF
of the
SPECIAL COMMITTEE ON AGING
UNITED STATES SENATE
ONE HUNDRED AND ELEVENTH CONGRESS
October 2009
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SPECIAL COMMITTEE ON AGING
HERB KOHL, Wisconsin, Chairman
RON WYDEN, Oregon BOB CORKER, Tennessee, Ranking
BLANCHE L. LINCOLN, Arkansas Member
EVAN BAYH, Indiana RICHARD SHELBY, Alabama
BILL NELSON, Florida SUSAN COLLINS, Maine
BOB CASEY, Pennsylvania ORRIN HATCH, Utah
CLAIRE McCASKILL, Missouri GEORGE LeMieux, Florida
SHELDON WHITEHOUSE, Rhode Island SAM BROWNBACK, Kansas
MARK UDALL, Colorado LINDSEY GRAHAM, South Carolina
MICHAEL BENNET, Colorado SAXBY CHAMBLISS, Georgia
KIRSTEN GILLIBRAND, New York
ARLEN SPECTER, Pennsylvania
AL FRANKEN, Minnesota
Debra Whitman, Staff Director
Jack Mitchell, Chief of Oversight and Investigations
Prepared By:
Jason Holsclaw, Majority Staff
Jeff Cruz, Majority Staff
Ashley Glacel, Majority Staff
(ii)
C O N T E N T S
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Page
Foreword......................................................... 1
Select Aging Committee Hearings.................................. 2
Aging Committee Majority Staff Information Paper................. 5
Executive Summary................................................ 5
Introduction..................................................... 6
Background....................................................... 7
Pension Protection Act of 2006 Encourages Automatic Enrollment
Policies....................................................... 8
Adoption of Automatic Enrollment Has Grown Considerably With
Plans Overwhelmingly Adopting Target date Funds as Default
Investment..................................................... 9
Although Popular Investment Tools, Design and Transparency of
Target date Funds Raise Concerns............................... 11
Agencies Taking Steps to Evaluate Target date Fund Concerns...... 18
Conclusion....................................................... 18
Acknowledgments.................................................. 20
FOREWORD
----------
The Special Committee on Aging (Aging Committee) has a long
history of examining various aspects of both the defined
benefit and defined contribution pension industry. Most
recently, the Aging Committee held hearings reviewing the
recession's effect on older American's retirement income,
including whether individuals have adequate pension benefits
and coverage as well as whether retirement-related federal
government programs--such as the Pension Benefit Guaranty
Corporation and the Social Security Administration--are
performing effectively.
Since the economic downturn, I have become increasingly
concerned that plan sponsors and participants may not be
receiving adequate information regarding the risk associated
with certain 401(k) products, such as target date retirement
funds--investment vehicles designed to automatically adjust to
more conservative investments as one approaches retirement.
Today, more and more companies are automatically enrolling
their workers into these types of plans due to Department of
Labor's ruling that these funds qualify for ``safe harbor''
relief from fiduciary liability. In fact, many have suggested
that these funds will be the retirement savings vehicle for the
vast majority of Americans in the future.
While well-constructed target date funds have great
potential for improving retirement income security, it is
currently unclear whether investment firms are prudently
designing these funds in the best interest of the plan sponsors
and their participants. In fact, an Aging Committee
investigation conducted in early 2009 found significant
differences in the asset allocations and equity holdings within
these funds, raising questions about whether plan sponsors and
participants understand the underlying assumptions and risk
associated with these products. Therefore, I requested that the
U.S. Department of Labor and the U.S. Securities and Exchange
Commission examine these funds, and I commend the agencies for
taking steps to do so.
The Aging Committee's hearing on October 28, 2009, together
with this staff information paper represent an attempt to
outline concerns related to target date funds. This staff
report summarizes the Aging Committee's actions to date and
presents findings from various sources, including Committee
hearings, government reports, and academic research.
My hope is that this paper will assist Members of Congress,
their staffs, and the general public in better understanding
the potential benefits and challenges associated with these
types of investment funds.
HERB KOHL, Chairman
SELECT AGING COMMITTEE HEARINGS
----------
Senate Special Committee on Aging hearings
On October 24, 2007, the Senate Special Committee on Aging
held a hearing on ``Hidden 401(k) Fees: How Disclosure Can
Increase Retirement Security,'' which examined the effect
hidden 401(k) fees can have on retirement savings and the need
for simple and clear disclosure. The Committee heard testimony
from: Barbara Bovbjerg, Director of Education, Workforce and
Income Security Issues, GAO; Bradford Campbell, Assistant
Secretary of Labor, the Employee Benefits Security
Administration; Jeff Love, Director of Research, AARP; Mercer
Bullard, assistant professor, University of Mississippi School
of Law; Michael Kiley, President, Plan Administrators, Inc.;
and Robert Chambers, Esq., Partner, Helms, Mulliss & Wicker LLC
and Chairman of the American Benefits Council.
Legislative Action:
Increasing the Transparency of Pension Fees. Under
ERISA, there are currently no requirements to clearly
disclose the record keeping and investment fees charged
for managing a 401(k) account. Yet, a small difference
in fees, when compounded annually, results in large
difference in final retirement savings. In the 111th
Congress, Rep. George Miller (D-CA, 7th Congressional
District) introduced H.R. 1984, the 401(k) Fair
Disclosure for Retirement Security Act, and Senators
Tom Harkin (D-IA) and Herb Kohl (D-WI) introduced S.
401, the Defined Contribution Fee Disclosure Act, to
amend ERISA to require the disclosure of fees to both
plan sponsors and participants. If passed, this
legislation could increase overall retirement security
without cost to the American taxpayers. The House bill
passed through the House Committee on Education and
Labor in June 2009.
On April 30, 2008, the Senate Special Committee on Aging
held a hearing entitled, ``Leading by Example: Making
Government a Role Model for Hiring and Retaining Older
Workers'' evaluating the federal government's efforts to hire
and retain older workers. The Committee heard testimony from:
Barbara Bovbjerg, Director, Education, Workforce and Income
Security Issues, US Government Accountability Office, Robert
Goldenkoff, Director, Strategic Issues, US Government
Accountability Office, Nancy Kichak, Associate Director,
Strategic Human Resources Policy, Office of Personnel
Management, Thomas Dowd, Administrator, Office of Policy
Development and Research, Employment and Training
Administration, US Department of Labor, Max Stier, President
and CEO, Partnership for Public Service, Chai Feldblum, Co-
Director, Workplace Flexibility 2010.
Legislative Action:
Remove the pension penalty for seniors to continue
working in a phased retirement: In the 111th Congress,
Senator Herb Kohl (D-WI) joined Senator George
Voinovich (R-OH), the ranking member of the Senate
Homeland Security and Governmental Affairs Committee's
Subcommittee on the Oversight of Government Management,
the Federal Workforce and the District of Columbia, in
introducing S. 469 the Incentives for Older Workers
Act, which includes a provision that removes the
penalty under defined benefit pension plans that
reduces the pension of full-time workers who take a
lower salary while reducing their hours in a phased
retirement. This penalty affects more than three
million Americans in private pension plans that are
calculated, in part, by their final year pay.
On July 16, 2008, the Senate Special Committee on Aging
held a hearing entitled ``Saving Smartly for Retirement: Are
Americans Being Encouraged to Break Open the Piggy Bank'' to
examine the reported increase in leakage and to explore ways to
protect American's retirement savings. The Committee heard
testimony from: Christian Weller, Senior Fellow, Center for
American Progress; Mark Iwry, Principal, Retirement Security
Project; David John, Principal, Retirement Security Project;
Gregory Long, Executive Director, Federal Retirement Thrift
Investment Board; John Gannon, Senior Vice President, Financial
Industry Regulatory Authority; Bruce Bent, Chairman, The
Reserve.
Legislative Action:
Reducing the ``Leakage'' of Pension Savings. In
conjunction with the July 2008 hearing, the Aging
Committee requested that the U.S. Government
Accountability Office (GAO) study the extent to which
Americans tap into their accrued retirement savings
prior to retirement. In August 2009, GAO issued 401(k)
Plans: Policy Changes Could Reduce Long-term Effects of
Leakage on Workers' Retirement Savings, which suggested
that Congress consider changing the requirement for the
six-month contribution suspension following a hardship
withdrawal, as well as recommended that the Secretary
of Labor promote greater participate education on the
importance of preserving retirement savings, and that
the Secretary of the Treasury clarify and enhance loan
exhaustion provisions to ensure that participants do
not initiate unnecessary leakage through hardship
withdrawals. In conjunction with the 2008 hearing,
Senators Charles Schumer (D-NY) and Herb Kohl (D-WI)
introduced S. 3278 in the 110th Congress, to limit the
number of 401(k) loans to three and prohibit the
widespread use of 401(k) debit cards.
On February 25, 2009, the Senate Special Committee on Aging
held a hearing entitled ``Boomer Bust? Securing Retirement in
Volatile Economy,'' which examined the economic downturn's
effect on retirement security, particularly for those on the
brink of retirement. The Committee heard testimony from:
Jeanine Cook, a Baby Boomer from Myrtle Beach, South Carolina;
Dallas L. Salisbury, President & CEO, Employee Benefits
Research Institute; Dean Baker, Co-Director, Center for
Economic and Policy Research; Ignacio Salazar, President & CEO,
SER--Jobs for Progress; Barbara B. Kennelly, President & CEO,
National Committee to Preserve Social Security and Medicare;
Deena Katz, CFP, Associate Professor, Texas Tech University,
and Chairman, Evensky & Katz.
On May 20, 2009, the Special Committee on Aging held a
hearing entitled ``No Guarantees: As Pension Plans Crumble, Can
PBGC Deliver,'' to consider whether the federal government's
Pension Benefit Guaranty Corporation (PBGC) has the capability
to fulfill its mission to insure the pensions of nearly 44
million Americans, at a time when several of the country's
largest automobile companies are teetering on the edge of
bankruptcy. The question of PBGC's governance came amidst
allegations of mismanagement by the agency's former director,
Charles E.F. Millard, who deviated from PBGC's conservative
investment strategy just before the market downturn. In
addition, the PBGC Inspector General alleged that Millard
improperly influenced the procurement process surrounding the
restructure of the Corporation's investments. The Committee
heard testimony from: Dallas L. Salisbury, President and CEO,
Employee Benefits Research Institute; Barbara Bovbjerg,
Director, Education, Workforce and Income Security, U.S.
Government Accountability Office; Rebecca Anne Batts, Inspector
General, Pension Benefit Guaranty Corporation; Vincent
Snowbarger, Acting Director, Pension Benefit Guaranty
Corporation; and Charles E.F. Millard, Former Director, Pension
Benefit Guaranty Corporation.
Legislative Action:
Strengthening the Pension Benefit Guaranty
Corporation's Governance Structure. In May 2009, PBGC
reported an accumulated deficit of about $33.5 billion.
Moreover, the hearing revealed that the PBGC Board of
Directors had not met since February 2008 despite the
economic downturn, and that PBGC lacked certain
procurement safeguards. On the basis of the Committee's
findings, Senators Herb Kohl (D-WI), Russ Feingold (D-
WI), Claire McCaskill (D-MO), and Michael Bennet (D-CO)
introduced S.1544, which expands and strengthens PBGC
governance and oversight, in part, by expanding the
PBGC's board of directors, redefining the Inspector
General's reporting structure, and adding additional
procurement safeguards.
AGING COMMITTEE MAJORITY STAFF INFORMATION PAPER
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Executive Summary
Target date retirement funds--also referred to as lifecycle
funds--are a type of mutual fund that automatically rebalances
to a more conservative asset allocation as the participant
approaches their retirement target date. These funds offer
investors certain advantages generally not offered by other
types of investment vehicles by purporting to offer
participants a beneficial long-term asset allocation strategy,
while lowering financial risk as participants approach
retirement. Since the Department of Labor designated target
date funds as an appropriate investment default option in
response to the enactment of the Pension Protection Act of
2006, more than $140 billion in net monies have entered into
target date funds, and 96 percent of plans that offer automatic
enrollment policies are using target date funds.
Although target date funds have proved popular with
participants and have won the approval of many investment
professionals, the losses suffered by target date funds during
the economic downturn raised concerns about the design and
transparency of these funds. For example, an Aging Committee
investigation found that the allocation of assets among stocks,
bonds, cash-equivalents varied greatly among target date funds
with the same target retirement date, with select firms' 2010
target date funds' equity holdings ranging anywhere from 24 to
68 percent. It was also unclear to what extent plan sponsors
educate their participants on these funds, as well as how
fiduciary standards would be enforced.
In response to the Aging Committee's concerns, officials
from the Department of Labor's Employee Benefit Security
Administration (EBSA) and the Securities and Exchange
Commission (SEC) held a joint hearing on June 18, 2009, to hear
testimony on the investment of 401(k) and other retirement
plans in target date type plans in an effort to determine the
need for additional guidance. Witnesses at the hearing
addressed how target date fund managers determine asset
allocations and changes to asset allocation; how they select
and monitor underlying investments; the extent to which the
foregoing, and related risks, are disclosed to investors and
the adequacy of that disclosure; and the approaches or factors
to compare and evaluate target date funds. At the time of this
writing, EBSA and SEC were continuing to coordinate and
evaluate what steps should be taken to address target date
funds, specifically for those funds used as default options and
directed at a less financially-sophisticated participant.
Introduction
Since they were first introduced several decades ago,
401(k) plans have become the principal retirement savings
vehicle for millions of U.S. workers. According to the Bureau
of Labor Statistics, 51 percent of workers in the private
sector participated in an employer-sponsored retirement plan of
some kind in 2007.\1\ Only 20 percent of all private-sector
workers were covered by traditional pensions--also called
defined benefit or ``DB'' plans--whereas 43 percent
participated in 401(k) plans and other defined contribution
plans (DC).\2\ Twelve percent of workers participated in both
types of plans.\3\
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\1\ Patrick Purcell and John Topoleski, 401(k) Plans and Retirement
Savings: Issues for Congress, R40707, Congressional Research Service,
July 14, 2009.
\2\ Employers may sponsor defined benefit (DB) or defined
contribution (DC) plans for their employees. DB plans promise to
provide a benefit that is generally based on an employee's years of
service and salary. (See 29 U.S.C. 1002(35).) DB plans use a formula
to determine the ultimate pension benefit participants are entitled to
receive. Moreover, an employer bears the investment risk, and must
ensure that the pension plan has sufficient assets to pay the benefits
promised to workers and their surviving dependents. Under a DC plan,
such as a 401(k) plan, employees have individual accounts to which the
employee, employer, or both make contributions, and benefits are based
on contributions, along with investment returns (gains and losses) on
the accounts. (See U.S.C. 1002(34).) Not all DC plans are 401(k)
plans, but 401(k) plans hold about 67 percent of DC plan assets. Other
DC plans include 403(b) plans for non-profit employers, 457 plans for
state and local governments, and miscellaneous other DC plans.
Increasingly, 403(b) plans and 457 plans operate similarly to 401(k)
plans. In this report the terms ``401(k)'' plan and ``defined
contribution'' plan are used interchangeably unless a distinction is
noted in the text.
\3\ U.S. Department of Labor, Bureau of Labor Statistics, National
Compensation Survey: Employee Benefits in Private Industry in the
United States, March 2007, Summary 07-05, August 2007. The sample
represented 108 million workers.
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Unlike employees with more traditional defined benefit
pensions, most employees with defined contribution plans--such
as 401(k) plans--choose to participate in their employer's
plans and generally decide the amount they want to contribute
and how to invest it. Thus, they bear the responsibility for
funding and managing their investments in a way that seeks to
achieve sufficient benefits in retirement. The worker's account
balance at retirement will depend on how much the individual
contributed to the plan over the years and on the performance
of the assets in which the plan is invested.
The majority of assets held in DC plans are invested in
stocks and stock mutual funds, and as a result, the decline in
the major stock market indices in 2008 greatly reduced the
value of many families' retirement savings.\4\ According to the
Federal Reserve Board, assets held in DC plans fell from $3.73
trillion at year-end 2007 to $2.66 trillion at year-end 2008, a
decline of 28.7 percent.\5\ The decline would have been even
greater if not for ongoing contributions to the plans by
workers and employers. Furthermore, the rise in unemployment
resulting from the downturn has had a detrimental impact on
retirement savings, due to participants' need to use their
accrued retirement savings. The removal of retirement savings
prior to retirement--a phenomenon referred to as leakage--can
affect a participants ultimate preparedness for retirement,
especially when the funds are removed and not replaced.
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\4\ On October 11, 2007, the Standard & Poor's 500 Index of common
stocks reached an intra-day high of 1,576, an all time record for the
index. On March 6, 2009, the S&P 500 fell to an intra-day low of 667, a
decline of 57.7 percent from its all-time high. Over the next three
months, stock prices climbed 41 percent. The S&P 500 closed at a value
of 943 on June 1, 2009. This was 40 percent lower than the index's
highest level in October 2007. By July 7, the S&P 500 had fallen to
881.
\5\ Board of Governors of the Federal Reserve System, Flow of Funds
Accounts of the United States: Flows and Outstandings, Fourth Quarter
2008, March 12, 2009, p. 113.
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The economic downturn has shed light on concerns affecting
the retirement system in the United States. This report
highlights issues specifically related to the composition and
use of target date retirement funds. The following information
presented in this report is based on an Aging Committee
investigation, government reports, literature reviews,
interviews with financial experts and government officials, and
industry analyses. As part of this review, the Aging Committee
also collected and reviewed information on EBSA's enforcement
practices to determine the extent to which EBSA focuses on
target date funds' composition and transparency. The Aging
Committee also reviewed information highlighting the Securities
and Exchange Commission compliance and enforcement efforts
related to target date funds.
Background
Private-sector pension plans are generally classified
either as defined benefit or as defined contribution plans.
Defined benefit plans generally offer a fixed level of monthly
retirement income based upon a participant's salary, years of
service, and age at retirement, regardless of how the plan's
investments perform. In contrast, defined contribution plans,
such as 401(k) plans, benefit levels depend on the
contributions made to the plan and the performance of the
investments in individual accounts, which may fluctuate in
value. Named after section 401(k) of the Internal Revenue Code,
traditional 401(k) plans allow workers to save for retirement
by diverting a portion of their pretax income into an
investment account that can grow tax-free and be withdrawn
without penalty after age 59\1/2\.\6\
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\6\ The Internal Revenue Code, as amended, exempts certain early
distributions from the penalty if the distributions are made to a
beneficiary or estate on or after death; made on account of total and
permanent disability; made as part of a series of substantially equal
periodic payments over the life expectancy of the owner or life
expectancies of the owner and the beneficiary; equal to or less than
deductible medical expenses (7.5 percent of adjusted gross income);
made due to an IRS levy of the plan; made to individuals called to
active duty after September 11, 2001, and before December 31, 2007;
made to a participant after separated from service with an employer in
or after the year that he or she reaches age 55; made to an alternate
payee under a qualified domestic relations order; dividends from
employee stock ownership plans; or made to an individual whose main
home was located in a designated hurricane disaster area and who
sustained an economic loss by reason of the hurricane. Additionally,
some plan sponsors offer Roth 401(k) plans that allow plan participants
to make elective after-tax contributions through payroll deduction.
403(b) plans are similar to 401(k) plans, in that they typically permit
both sponsors and participants to make pre-tax contributions, but are
designed for public education entities and tax-exempt organizations
that operate under I.R.C. 501(c)(3). Participants in these plans are
generally limited to investing in annuity contracts issued by insurance
companies and custodial accounts invested in mututal funds.
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Employers and employees may make pretax contributions, up
to certain limits, to individual participant accounts. In 2009,
participants may contribute up to $16,500 per year. The 401(k)
account balance is a function of both the contributions made to
the accounts over a career as well as the investment
performance of the account. About one-half of all U.S. workers
participate in some form of employer-sponsored retirement plan.
Participation in 401(k) plans rose steadily from fewer than 8
million participants in the mid-1980s to over 70 million
participants in 2006--the most recent year for which data were
available. The assets in 401(k) plans also increased
significantly over the same time period, from less than $100
billion to over $3 trillion.\7\ Current law limits participant
access to their retirement savings in their employer-sponsored
retirement plans so that the favorable tax treatment for
retirement savings is limited to savings that are, in fact,
used to provide retirement income. Only under certain
circumstances do federal regulations allow 401(k) plan sponsors
to provide participants with access to their tax-deferred
retirement savings before retirement.
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\7\ For 2006 estimates, see Investment Company Institute, ``The
U.S. Retirement Market, 2007,'' Research Fundamentals, vol. 17, no. 3
(2008).
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The Internal Revenue Service (IRS), within the Department
of the Treasury, and EBSA are primarily responsible for
enforcing laws that govern defined contribution plans. IRS
interprets and enforces provisions of the Internal Revenue Code
that apply to tax-qualified pension plans. EBSA enforces the
Employee Retirement Income Security Act of 1974's (ERISA)
reporting and disclosure provisions and fiduciary
responsibility which, among other things, concern the type and
extent of information provided to plan participants. In
addition, the SEC is responsible under federal securities laws
for regulating and examining entities registered with SEC, such
as investment advisors, managers, and investment companies that
often provide services to pension plans. While the SEC does not
draw authority from ERISA, the SEC coordinates with EBSA for
consultation and exchange of information as directed by a
Memorandum of Understanding signed in July 2008.\8\
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\8\ Department of Labor and the U.S. Securities and Exchange
Commission. Memorandum of Understanding Concerning Cooperation between
the U.S. Securities and Exchange Commission and the U.S. Department of
Labor, July 29, 2008.
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Pension Protection Act of 2006 Encourages Automatic Enrollment Policies
To encourage retirement savings, Congress enacted the
Pension Protection Act of 2006 (PPA), which, in part, removed
impediments to employers adopting automatic enrollment
policies, including exemptions from legal liability for market
fluctuations. In encouraging employers to adopt automatic
enrollment, PPA directed the Department of Labor to assist
employers in selecting ``default investments'' that best serve
the retirement needs of workers who do not direct their own
investments.
DOL's final regulation provided safe harbor relief from
fiduciary liability for investment outcomes if employers met
certain criteria, one of which being that assets must be
invested in a ``qualified default investment alternative''
(QDIA) as defined in the regulation.\9\ However, it does not
identify specific investment products. Rather, the regulation
describes mechanisms for investing participant contributions.
DOL noted that the intent is to ensure that an investment
qualifying as a QDIA is appropriate as a single investment
capable of meeting a worker's long-term retirement savings
needs. The regulation also states that a QDIA must be managed
by either an investment manager, plan trustee, plan sponsor or
a committee comprised primarily of employees of the plan
sponsor that is a named fiduciary, or be an investment company
registered under the Investment Company Act of 1940.
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\9\ 29 CFR Part 2550; RIN 1210-AB10; Default Investment
Alternatives under Participant Directed Individual Account Plans,
Federal Register / Vol. 73, No. 84 / Wednesday, April 30, 2008. The
final regulation provides for four types of QDIAs: 1) a product with a
mix of investments that takes into account the individual's age or
retirement date (an example of such a product could be a lifecycle or
targeted-retirement-date fund); 2) an investment service that allocates
contributions among existing plan options to provide an asset mix that
takes into account the individual's age or retirement date (an example
of such a service could be a professionally-managed account); 3) a
product with a mix of investments that takes into account the
characteristics of the group of employees as a whole, rather than each
individual (an example of such a product could be a balanced fund); and
4) a capital preservation product for only the first 120 days of
participation (an option for plan sponsors wishing to simplify
administration if workers opt-out of participation before incurring an
additional tax). A QDIA generally may not invest participant
contributions in employer securities.
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One of the product mechanisms DOL elected as a QDIA was the
target date fund--also referred to as lifecycle funds--a type
of mutual fund that automatically rebalances its asset
allocation following a predetermined pattern over time to a
more conservative asset allocation as the participant's target
date for retirement approaches. As the participant nears
retirement age, the investment allocation is shifted away from
higher-risk investments, such as stocks, and moved toward
lower-risk investments, such as bonds and cash equivalents. The
asset allocation path that changes over time is known as the
glide path, which is based on the number of years to and beyond
the target date. A target date fund is a lifecycle fund
designed to achieve a particular (generally conservative) mix
of assets at a specific date in the future, which is usually
the year when the participant expects to retire. These funds
are named accordingly (e.g. 2010 Target date Fund).
Automatic Enrollment Has Grown Considerably With Plans Overwhelmingly
Adopting Target date Funds as Default Investment
According to the U.S. Government Accountability Office
(GAO), defined contribution plan sponsors are increasingly
adopting automatic enrollment policy plans (in which workers
``opt-out'' of plan participation rather than ``opt-in'') to
encourage their employees to save for retirement.\10\ Available
data indicate that plans with automatic enrollment policies are
overwhelmingly adopting target date funds as their default
investment. For example, 87 percent of Vanguard group plans
with automatic enrollment had target date funds as a default
investment at the end of 2008, compared to 42 percent in
2005.\11\ (See table 1.)
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\10\ Automatic enrollment is a practice where an employer enrolls
eligible employees in a plan and begins participant deferrals without
requiring the employees to submit a salary deferral request.
\11\ GAO, RETIREMENT SAVINGS: Automatic Enrollment Shows Promise
for Some Workers, but Proposals to Broaden Retirement Savings for Other
Workers Could Face Challenges, GAO-10-31. (Washington, D.C.: October
2009).
[GRAPHIC] [TIFF OMITTED] T3067.001
Conversely, the use of balanced funds, money market funds,
and stable value funds default investments have declined
significantly.\12\ GAO stated that this trend toward target
date funds as a default investment vehicle is corroborated by
data from Fidelity investments, which showed that, as of March
2009, 96 percent of plans with an automatic enrollment policy
used target date funds, up from 57 percent at the end of 2005.
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\12\ Both money market and stable value funds were often used as
default investment before PPA because employers were concerned about
legal liability investments they had chosen declined in value as a
result of market fluctuations. As a as result, they invested workers'
contribution in such low risk, low-return default investments.
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In addition, the Employee Benefit Research Institute (EBRI)
reported in March 2009 that workers who were considered to be
automatically enrolled in a 401(k) plan were more likely to
invest all their assets in a target date fund. The study
indicated that except for participants in the largest plans
(more than 10,000 participants), more than 90 percent of those
automatically enrolled into target date funds had all of their
allocation in target date funds.\13\ Most recently, EBRI
reported that for year-end 2008, nearly seven percent of 401(k)
assets in plans they reviewed were invested in lifecycle
funds.\14\ Moreover, EBRI reported that almost 44 percent of
participants under age 30 had assets in a target date fund.\15\
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\13\ Craig Copeland, Use of Target date Funds in 401(k) Plans,
2007, Issue Brief 327, Employee Benefit Research Institute,
(Washington, D.C.: March 2009). EBRI's analysis was based on
information maintained by the Employee Research Institute/Investment
Company Institute database.
\14\ Jack VanDerhei, EBRI; Sarah Holden, ICI; and Luis Alonso,
EBRI; 401(k) Plans Asset Allocation, Account Balances, and Loan
Activity in 2008, Issue Brief No. 335, Employee Benefit Research
Institute, (Washington, D.C.: October 2009).
\15\ EBRI, Issue Brief 327.
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The research firm Morningstar, Inc. also noted in September
2009 that the popularity of target date funds remained
relatively unaffected by the recent economic downturn. They
suggest that cash flows were on track to set a record,
accumulating at an annualized rate of $60 billion over the
first seven months of the year. In total, more than $140
billion in net monies have entered into the target date funds
since the start of 2007, according to the firm.\16\
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\16\ Morningstar, Inc. Target date Series Research Paper: 2009
Industry Survey. September 9, 2009.
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Although Popular Investment Tools, Design and Transparency of Target
date Funds Raise Concerns
Although target date funds have proved popular with
participants and have won the approval of many investment
professionals, the losses suffered by target date funds during
the economic downturn raised concerns about the design and
transparency of these funds. In early 2009, the Aging Committee
conducted an investigation of these funds, which revealed that
the date in the name of the target date fund was not consistent
with the design of the fund, making these funds difficult for
investors to evaluate and compare. In fact, the Aging Committee
found that allocation of assets among stocks, bonds, cash-
equivalents varies greatly among target date funds with the
same target retirement date, with firms' 2010 target date
funds' equity holdings ranging anywhere from 24 to 68 percent.
(The Aging Committee's review of select, large 2010 target date
funds found that many funds had equities exposure at or well
over 50 percent.) Since that time, a study by the investment
research firm, Morningstar, Inc., corroborated the Aging
Committee's findings, noting that among target date 2010 funds,
stock allocations ranged from 26 percent of assets to 72
percent of assets.\17\ As a comparison, in January, 2009, the
Thrift Savings Plan's ``L2010 Fund'' for federal employees who
plan to retire in 2010 held 70 percent of its assets in bonds
and 30 percent in stocks.\18\ Similarly, the Dow Jones Target
Date Indexes propose that a fund's asset class allocation
should have an equities exposure of approximately 28 percent at
the target date.\19\ In December 2008, the average 2010 fund
had more than 45 percent of its assets invested in stocks.\20\
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\17\ Morningstar, Inc. Target date Series Research Paper: 2009
Industry Survey. September 9, 2009.
\18\ CRS, R40707.
\19\ According to Dow Jones over the life of each target index the
relative risk of the index will range from a more aggressive portfolio
that incurs approximately 90 percent of the risk of the composite stock
market index (Stock CMAC) in the beginning to a conservative portfolio
that incurs approximately 20 percent of the risk of the stock CMAC 10
years after the index reaches its ``target date''. The Dow Jones
``Today'' Index aims to hold risk constant at 20 percent of the risk of
the stock CMAC and is a benchmark for a conservative, balanced
portfolio an investor might hold 10 years after reaching retirement.
\20\ Patrick Purcell and John Topoleski, 401(k) Plans and
Retirement Savings: Issues for Congress, R40707, Congressional Research
Service, July 14, 2009.
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Fund performance also varied greatly during the bear market
of 2008. The S&P Target date 2010 Index Fund, a benchmark of
fund performance, fell 17 percent in 2008. The fund holds 60
percent of its assets in bonds and other fixed-income
securities and 40 percent in equities. The Deutsche Bank DWS
Target 2010 Fund fell just 4 percent in 2008, whereas
Oppenheimer's Transition 2010 fund fell 41 percent. For the
federal Thrift Savings Plans, shares of the ``L2010 Fund'' fell
10.5 percent in 2008.
Because of the losses resulting from the financial
downturn, industry experts have raised concerns about
investors' understating of the construction of the glide path
and its effect on the funds asset allocation. There are varying
opinions on whether a target date fund is designed to terminate
at the time of retirement or is intended to account for a
participant's post-retirement needs. Documentation provided to
the Aging Committee by select firms indicated that many of
these funds were designed to take into account and mitigate (1)
market risk, (2) longevity risk, and (3) inflation risk.\21\
Many of the firms' materials suggested that these funds were
not intended for a participant to cash out their retirement
savings at the projected retirement date. Instead, the funds
were designed to provide income for the years during retirement
as well. However, it is unclear whether participants were aware
of this plan design.
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\21\ Market risk is the risk of adverse market movements. Longevity
risk is the risk of outliving one's savings. Inflation risk is the risk
that inflation can eat away at the purchasing power of accumulated
savings possibly very rapidly.
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While there are valid arguments to support different
approaches to constructing a glide path, individuals' behavior
at retirement may minimize certain financial risks. According
to recent research, it is common for an individual to take a
lump-sum distribution of their assets at the time of
retirement. For example, a study by the Vanguard Center for
Retirement Research estimated in that 2008 about half of
retired households between the ages of 55 to 75 tapped into
their long-term accounts, typically as a large, one-time
withdrawal generally to address living expenses. Only two out
of ten households spent down their accounts on some type of
systematic or regular income payment program.\22\ Moreover, a
survey conducted by Investment Company Institute found that 54
percent of respondents took some or all of their balance as a
lump-sum distribution, and of those respondents, 86 percent
rolled over some or all of the balance to an Individual
Retirement Account or otherwise reinvested the assets. The
remaining 14 percent spent all the proceeds of the
distribution.\23\ Because many participants take such
withdrawals, the need for a more aggressive asset allocation to
manage for risks like longevity may be minimized, because
participants' often do not maintain their assets in their
target date fund throughout their retirement. Therefore,
participants--especially those who are less sophisticated and
defaulted into these funds--may lock in large losses such as
those experienced in 2008.
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\22\ Gary R. Mottola and Stephen P. Utkus, Vanguard Center for
Retirement Research, Spending the Nest Egg: Retirement Income decisions
among older investors, Volume 35, October 2008. The results in this
report are based on a national online panel survey of older Americans,
age 55-75, with $50,000 or more of accumulated financial assets. A
total of 1,478 respondents participated in the survey, which was
conducted in May 2008.
\23\ Investment Company Institute. 2009 Investment Company Fact
Book: A Review of Trends and Activity in the Investment Company
Industry, 49th Edition, 2009.
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In addition to potential design weaknesses and participant
misunderstandings, the fees associated with target date funds--
as well as all 401(k) plans--can have a significant impact on
the amount of income saved for retirement. For example, a 1-
percentage point difference in fees can signicantly reduce the
amount of money saved for retirement. Assume an employee of 45
years of age with 20 years until retirement changes employers
and leaves $20,000 in a 401(k) account until retirement. If the
average annual net return is 6.5 percent--a 7 percent
investment return minus a 0.5 percent charge for fees--the
$20,000 will grow to about $70,500 at retirement. However, if
fees are instead 1.5 percent annually, the average net return
is reduced to 5.5 percent, and the $20,000 will grow to only
about $58,400. The additional 1 percent annual charge for fees
would reduce the account balance at retirement by about 17
percent.
According to a September 2009 report by Morningstar, Inc.,
the average expense ratios vary widely,\24\ ranging from 0.19
percent to 1.82 percent, a difference of 163 basis points.\25\
(See table 2.) The research firm noted that more than half the
target date fund industry has annual expense ratios exceeding 1
percent.\26\ However, Morningstar indicated that target date
fund expense ratios will more than likely decline in the coming
years, in part, due to the wide price gap between funds.
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\24\ Expense ratios are fees and expenses incurred by mutual fund
investors, such as the management fee (the amount the fund's investment
adviser charges for managing the fund), the fund's other operating
expenses (such as fund accounting or mailing expenses).
\25\ A basis point is a unit that is equal to 1/100th of 1 percent,
and is used to denote the change in a financial instrument. For
example, 1 percent change = 100 basis points, and 0.01 percent = 1
basis point. The basis point is commonly used for calculating changes
in interest rates, equity indexes and the yield of a fixed-income
security.
\26\ Morningstar, Inc. Target date Series Research Paper: 2009
Industry Survey. September 9, 2009.
[GRAPHIC] [TIFF OMITTED] T3067.002
BrightScope, Inc. also found that target date funds have
higher expense ratios than the rest of the core portfolio in
401(k) plans. Their data assessment suggest that target date
funds have internal fees that are between 10 to 25 percent more
expensive than other funds on the core menu, which they suggest
may be partially explained by management overlay fees--
management fees layered on top of the underlying funds' expense
ratio.\27\ (See fig. 1.)
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\27\ BrightScope, Inc. is an independent provider of 401(k) ratings
and financial intelligence to plan sponsors, advisors, and participants
in all 50 states. BrightScope's data is based on investment menus for
6,978 small plans, 4,201 mid-sized plans and 1,667 large plans.
[GRAPHIC] [TIFF OMITTED] T3067.003
In addition to varying expense ratios within target date
funds, pension plan service providers or the various outside
companies may also charge fees which are deducted from an
individual's savings. These fees for services are either
``bundled'' or ``unbundled.'' Bundled providers are typically
large financial services companies whose primary business is
selling investments. They bundle their proprietary investment
products with affiliate-provided plan services into a package
that is sold to plan sponsors. In contrast, unbundled or
independent providers are primarily in the business of offering
administrative services with a ``universe'' of unaffiliated,
non-proprietary investment options. Bundled providers disclose
the cost of the investments to the plan sponsor, but do not
disaggregate the costs of the administrative services, whereas
unbundled providers disclose both since the costs are paid to
different providers. According to a House Committee on
Education and Labor report, many participants do not have a
clear understanding of fees and expenses charged by service
providers.\28\ In fact, some of the fees are not even known to
the plan sponsor because they are directly paid by service
providers.\29\
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\28\ 401(k) Fair Disclosure and Pension Security Act of 2009, Mr.
George Miller of California, from the Committee on Education and Labor,
U.S. House of Representatives, Report together with Minority Views [To
accompany H.R. 2989] Report 111-244, Part 1. July 31, 2009.
\29\ In an effort to increase fee transparency, Sens. Tom Harkin
(D-IA) and Herb Kohl (D-WI) in the 11th Congress, introduced S. 401,
the Defined Contribution Fee Disclosure Act, to amend ERISA to require
the disclosure of fees to both plan sponsors and participants. In
addition, Rep. George Miller (D-CA, 7th Congressional District)
introduced H.R. 1984, the 401(k) Fair Disclosure for Retirement
Security Act.
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While target date funds that are mutual funds include
several layers of investor safeguards--such as regulatory and
disclosure requirements under the federal securities laws--
mutual fund companies that offer target date funds are not
subject to the fiduciary requirements of ERISA. Rather, a
plan's fiduciary--usually the employer who sponsors the plan--
selects and monitors target date funds for use in the plan's
investment lineup. However, plans sponsors generally do not
have a choice in selecting the underlying funds, and instead
must choose from a portfolio of propriety funds typically
constructed by the firm. In fact, nearly 92 percent of
companies offering target date funds used a packaged product,
according to a survey from the Profit Sharing/401(k) Council of
America. As a result, some investment firms may include low
performing funds in their portfolio in an effort to garner more
assets.
Under ERISA, mutual fund companies are generally not
subject to fiduciary rules since mutual funds are regulated by
the Investment Company Act of 1940. However, in March 2009,
Avatar Associates, an investment manager, suggested in a letter
to the Department of Labor that mutual funds that offer a
target date fund should be subject to ERISA. In its request for
an advisory opinion, Avatar argued that ERISA never expressly
addressed whether mutual fund companies that use proprietary
funds to create target date funds and other fund-to-funds
accounts should be exempt from ERISA's fiduciary obligation.
Moreover, Avatar suggested that there is an embedded conflict
of interest when mutual funds include their own proprietary
funds in their target date funds, noting concerns of self-
dealing.\30\ At the time of this writing, DOL was reviewing the
merits of Avatar's request.
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\30\ Self-dealing is a form of conflict of interest that involves
the conduct of a trustee, an attorney, or other fiduciary that takes
advantage of his or her position in a transaction and acting for his or
her own interests rather than for the interests of the beneficiaries of
the trust or the interests of his or her clients.
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Agencies Taking Steps to Evaluate Target date Fund Concerns
On the basis of the Aging Committee's findings, Chairman
Kohl requested that Secretary of Labor Hilda Solis and
Chairwoman Mary Schapiro of the Securities and Exchange
Commission direct their agencies to take action to review the
design, composition, and disclosures associated with target
date funds.\31\ In response to the Aging Committee's concerns,
EBSA and SEC held a joint hearing on June 18, 2009, to hear
testimony on the investment of 401(k) and other retirement
plans in target date type plans to determine the need for
additional guidance. Witnesses at the hearing addressed how
target date fund managers determine asset allocations and
changes to asset allocation; how they select and monitor
underlying investments; the extent to which the related risks
are disclosed to investors and the adequacy of that disclosure;
and the approaches or factors to compare and evaluate target
date funds.
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\31\ U.S. Senate Special Committee on Aging. See http://
aging.senate.gov/letters/targetdatedol.pdf and http://aging.senate.gov/
letters/targetdatesec.pdf.
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Prior to the June 2009 hearing, the ERISA Advisory Council
studied the issues related to target date funds and concluded
that the Department of Labor should provide more specific
guidance as to the complex nature of target date funds and the
methodology necessary for plan fiduciaries who are responsible
for selecting and monitoring these funds as a prudent
investment alternative in a defined contribution plan. The
Council also recommended that DOL should develop participant
education materials and illustrations to enhance awareness of
the value and the risks associated with these funds.
At the time of this writing, EBSA and SEC were continuing
to coordinate and evaluate what steps should be taken to
address the differences and risks associated with target date
funds, specifically for those funds used as default options and
directed at a less financially sophisticated participant.
Conclusion
Automatic enrollment of workers in 401(k) plans has proven
to be an effective means of increasing plan participation
rates. Because such policies are being increasingly adopted by
defined contribution plan sponsors in the wake of the Pension
Protection Act of 2006, many additional workers will be brought
into plans that might not otherwise have participated, and will
be defaulted into target date retirement funds. Despite the
potential for increasing savings, several of the concerns with
target date funds mentioned in this report--including plan
design and transparency--have led plan sponsors and
participants to misunderstand these products, and in some cases
suffer large losses. Moreover, it is vital that action be taken
to ensure that the fees associated with certain target date
funds are disclosed, as well as steps to clarify the fiduciary
responsibility of not only plan sponsors, but also those
companies that construct these funds.
As the Aging Committee explores ways to strengthen target
date funds, additional questions should be explored to
determine the merits of qualified default investment
alternatives. Therefore, in August 2009, Chairman Kohl
requested that the GAO review the appropriateness of the funds
classified as QDIAs, including target date funds and suggest
measures to increase transparency.
The Aging Committee anticipates GAO will release a report
addressing these questions in the fall of 2010.
ACKNOWLEDGMENTS
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The Aging Committee would like to thank the following
individuals for their research and technical assistance:
Ryan Alfred, BrightScope, Inc.
Mike Alfred, BrightScope, Inc.
Michael Hartnett, Senior Analyst, U.S. Government
Accountability Office
David Lehrer, Assistant Director, U.S. Government
Accountability Office
Jonathan McMurray, Senior Analyst, U.S. Government
Accountability Office
Patrick Purcell, Specialist in Income Security,
Congressional Research Service
John Rekenthaler, Vice President of Research, Morningstar,
Inc.
Dallas Salisbury, Chief Executive Officer, Employee Benefit
Retirement Institute
John J. Topoleski, Analyst in Income Security,
Congressional Research Service