Subject: File No. S7-12-10
From: Jane White
Affiliation: President, Retirement Solutions, LLC

August 20, 2010

The Only Thing Worse Than Not Telling 401(k) Participants How Much to Save to Hit the Retirement Bullseye is Offering Reckless Target Date Funds

The Pension Protection Act of 2006 permitted employers to default 401(k) participants into a category of mutual fund known as a target date fund, which gradually shifts the investment allocation away from stocks and into bond/fixed income funds as they near retirement, if the participants would prefer not to choose their own glidepath to retirement. As a result, the automation of asset allocation has eliminated the necessity for participants to be advised a) that they have to lower their concentration in stocks as they get closer to retirement and b) remember to continue to make this shift on a regular basis.

As a result, the growth in assets in target-date funds has been exponential as of 2008, 75% of 401(k) plans offer these funds as an investment option, according to TD Ameritrade. According to the Vanguard Group, one of the three largest providers of these funds, the percentage of 401(k) plans it manages that use these funds as the default investment option mushroomed from 42% of them in 2005 to 87% in 2008.

While in theory the target date concept is a sound one, many of these funds have suffered negative returns in recent years. This is happening largely because their managers have recklessly overloaded these funds with stocks and/or junk bonds even for those investors with a short investment time horizon. As a result, the SEC is proposing tougher disclosure rules for target-date funds, which would be forced to disclose the types of investments they contain as a tag line next to the funds name. For example, a fund with a 2020 target date might carry a tag line stating: 40% equity, 50% fixed income, 10% cash in 2020.

Why has there been no Pension Adequacy Act? Target date funds wont get 401(k) participants on target because employee/employer contribution rate matters more than asset allocation. However, the biggest problem with target date funds is that they mislead 401(k) participants into thinking that the most important component of retirement adequacy is the investments you choose when its the actually the size of the contribution to retirement savings relative to income along with the investment time horizon. While the Pension Protection Act changed the rules on giving advice about where 401(k) participants should invest, it didnt enact the most crucial requirement, which is to make a 401(k) plan into an actual pension plan instead of only a supplement to one, as was the modest intent when it was created 30 years ago. While a 401(k) plan is considered a defined contribution plan, not only is the necessary employee contribution rate rarely, if ever, defined, but the employer contribution rate of 3% will enable few Americans to achieve a nest egg equivalent to at least 10 times final pay, the actuarial rule of thumb for account adequacy.

In order to be able to afford to retire someone in their 60s with an annual salary of $65,000, the median income for that age group, should have accumulated at least $650,000 in retirement savings, which includes their current accounts, rollover accounts and account balances at previous employers. Unfortunately few, if any, Americans in the private sector are on target to retire: A 2005 study of nearly 2,000 employers showed a median balance for participants 65 and over of only about $55,000. And while some participants may have significant assets in other accounts, most of them wont. Whats more, most of them wont be receiving benefits from a defined benefit pension since the percentage of Americans covered by a DB plan has shrunk from 44% of the workforce in 1974 to 17% of it in 2004, according to the Employee Benefit Research Institute.

While account adequacy is beyond the focus of this paper, it is vital to reiterate that the most important reform to 401(k) plans not only has not occurred but appears not to be on the Obama Administrations radar screen.


While target-date funds are theoretically a good way to automate the asset allocation shift participants need to make as they get closer to retirement, there are major flaws that are preventing these funds from accomplishing their goals. In summary, participants are not educated to shift all of their qualified account assets into these funds and the funds themselves are often not prudently managed in a fashion that would enable participants to achieve maximum investment returns with limited risk as their time horizon shrinks, while paying low costs.


a) Most participants arent using a single fund to manage all of their assets. A study by AllianceBernstein showed that nearly 70% of 401(k) participants who invest in target date funds chose dont use them as one-stop savings sources but instead invest in additional funds. Whats more, 20% of participants in another survey owned multiple lifecycle funds, thus defeating their purpose. While the decision to own multiple lifecycle funds might be a justified caution about trusting all their assets to one allocation strategy, not putting all of your investments in target date funds makes no sense. Not only do you risk having too much of your savings in a fund with an irresponsible allocation strategy but youre paying fees to multiple fund managers for the wrong strategy. Solution: Participants should be advised to move all of their account assets into a single target-date fund once they have received adequate information/disclosure on its performance history and investment approach.

b) Most participants probably dont shift assets from rollover accounts or accounts at previous employers into target-date funds. Whats more, 401(k) participants are not advised to shift all of their retirement savings into these funds, only account balances at the current employer, which doesnt make sense if the average American works for seven to 10 different employers during a lifetime. Solution: participants should be urged to move assets at previous employers and in rollover accounts into a target-date fund.

c) The age group in the workforce that would benefit the most from investing in target date funds--those nearing retirement--is the least likely to use them. While 43% of retirement-plan participants in their 20s owned target-date funds in 2008, up from 29% in 2007, only 22% of savers in their 60s did. This is not surprising because the age cohort that is more likely to be auto-enrolled in target date funds are those entering the workforce, as opposed to long-service employees who made their investment choices years ago and probably only shift a portion of their 401(k) investments to a target date fund--or more likely, put new contributions in one. Solution: communicate directly with participants in this age cohort--whether via email or seminars--regarding the vital role that asset allocation plays in managing retirement assets.

PART II: Reckless and Costly Management of Target Date Funds

a) As the SEC and the Department of Labor have both observed, too many managers of target-date funds are attempting to goose returns with irresponsible use of stocks, junk bonds, etc. However, disclosure doesnt go far enough in protecting 401(k) savers from paying high fees for dangerously inferior performance.

Unfortunately, even if the previous proposals were adopted and participants were convinced to made prudent decisions to shift all of their retirement savings into one well-managed target date fund, too many mutual fund companies are loading up target date funds with stocks, even when participants are close to retirement. This practice totally contradicts the time-honored rule that your glidepath in these funds should feature a shrinking stock allocation as your investment time horizon shrinks.

As a result of these risky investment bets, in 2008 the average return of the four largest target funds--holding 87% of all assets--aimed at people expecting to retire in 2010 was minus 25.8%, almost as bad as the overall market slump for the SP 500 that year of minus 37%. The problem with this investment approach is that while investment losses in stocks can be recovered if investors are in their 20s and therefore have an investment time horizon lasting many decades, investors in their 60s have a shorter time horizon, and therefore a greater risk that these losses wont be recouped.

Why? While stocks have never lost money over multi-decade holding periods, the shorter the time horizon the bigger the risk of loss. Of the 70 10-year holding periods since 1926 recorded by the annual report on investment performance, Morningstars Stock Bonds, Bill and Inflation, there have been nine periods when investors in the SP 500 lost money returns for the five-year periods just since 1998 have been negative in five out of the seven periods.

It is very likely this irresponsible practice occurs because the fund managers are aiming to get a four-star ranking from Morningstar for a one-year performance when essentially their performance has been boosted by the financial equivalent of steroids--not a prudent investment policy. Whats more, its never a wise policy to measure performance on a short-term basis because a four-star ranking can come about as a result of luck--e.g. a booming stock market performance that lifts all ships. In the same fashion you dont judge a track stars talents on one seasons performance, its unwise to gauge an investment on short-term results.
Amazingly, not only is T Rowe Price Groups 2010 target date fund nearly 60% in stocks, its investment strategy is to keep retirees in stocks until death, with a 20% stock allocation at age 85. The time horizon is not (defined as) retirement, its life expectancy, Jerome Clark of T. Rowe told Kiplingers Personal Finance. Pension actuary James Turpin disagrees. For someone 70 years old or older more than 5% to 10% (invested) in equities represents too much risk for someone who is likely to only live another 10 to 12 years, he says.

Solution: The SECs proposal to require target-date funds to merely disclose the types of investments they contain as a tag line next to the funds name is tantamount to a label on a wine bottle that reveals the alcohol content without disclosing that alcohol can be hazardous to your health. This disclosure should communicate that too high a stock allocation for those close to retirement can be hazardous to your wealth, offering specific examples from Stocks, Bonds, Bills and Inflation, as outlined on page 4. Even better, the SEC should reach out to the actuarial community to develop Best Practices for a prudent glidepath that all fund companies servicing 401(k) plans would adhere to in order for the funds to be allowed in the plans. Rather than simply disclosing that an investment approach is harmful, we should protect 401(k) investors from harm.

b) Whether they are investing in target-date or other mutual funds, most 401(k) participants do not have access to passively managed, or index, mutual funds--forcing them to pay higher fees for similar or worse investment performance

Rep. George Miller of California has proposed requiring all 401(k) plans to include index funds. Having an index fund is a win-win: your fund is guaranteed to meet the benchmark because it IS the benchmark and youre paying less in fees because youre not paying an fund manager to underperform the SP 500. Unfortunately, only about 10% of employers offer them.

The inconvenient truth about mutual funds is that the low-cost generic version of a fund is also a better performer than its managed counterpart. Vanguard Group founder John Bogle has shown that between 1980 and 2005, an SP 500 index fund returned 12.3% a year, compared to 7.3% for the average mutual fund investor.

The obvious reason why its virtually impossible for a fund manager to beat the market is that nobody can predict whether todays corporate superstar will be driven out of business by tomorrows uber-superstar. But a less-discussed reason is that most mutual fund managers dont take a buy-and-hold approach and hang onto companies that are likely to be winners several decades from now. Half a century ago funds held stocks for an average of five years, today its 11 months.

You not only cant predict tomorrows winners but you can predict when the markets on a roll because double-digit returns only occur during a tiny percentage of the time. Investors who were out of the market during the best 90 days out of the 30-year period from 1962 to 1992 would have lost 95% of market gains. To put it another way, a dollar would have been worth $24 for the buy-and-hold investor but only $2.10 for the investor who timed it wrong.

In summary, most of the 8,000-plus mutual funds managing the assets of 95 million investors underperform the generic version of a managed mutual fund. If the majority of car manufacturers produced autos that broke down in a few years they would be out of business. Unfortunately, too many poor performers in the mutual fund industry survive due to a combination of name recognition, a lack of disclosure of their long-term track record, and questionable pay to play practices.

Because of a counterintuitive, but required practice known as benchmarking, a typical employer will get rid of a fund due to poor performance as frequently as once a year. According to the Deloittes 2005/2006 Benchmarking Survey (the most recent available), 57% of employers surveyed had changed funds within two years.

How do inferior funds get chosen for 401(k) plans, given that sponsors have a fiduciary duty to pick well-managed plans AND its a no-brainer to find the funds track records by accessing Morningstars ratings. Back-room dealings play a significant role. In 2004 the SEC asked 20 mutual fund companies to provide information on payments made to employers to induce them to pick funds, a practice known as pay to play. Along with employers there are intermediaries known as consultants who receive revenue-sharing payments. In essence the participants are paying high fees to have access to poorly performing funds that employers are required to dump--in which case they will likely be replaced by lousy funds.

c) 401(k) participants should be advised to choose target date funds that contain international stocks, reflecting an investment strategy that reflects the fact that The World is Flat when it comes to investing, not as a currency hedge.

While there is no doubt that the first decade of this century has been the worst on record for the U.S. stock market, the best fix for 401(k) accounts is not to switch to safe investments, as some have proposed, but to have more international exposure, given that two thirds of the worlds largest publicly held companies are based overseas. Whats more, mutual funds that invest in companies in emerging markets such as Brazil, India, Russia and China have delivered greater than 10% annual returns for the past decade. The good news is that target-date funds are more likely to have more international holdings--estimates range from 17% to 30% of assets. Whats yet to be determined is whether the fund managers are choosing the investments because of their vital role in the global economy or as a currency hedge, which means they are likely to dump these funds if they just happen to have a bad year or if currency values head in the wrong direction.

Conclusion: In the same fashion that Americans have been victimized by irresponsible mortgage lending and credit card practices they have been ill-served by too many irresponsible managers of mutual funds who view short-term performance measures as a way to increase assets under management over long-term performance that deliver value for its customers. The SEC along with the Department of Labor should take a more prominent role in overseeing 401(k) plans--not just acting as a potential source of financial literacy but as a steward of 401(k) assets.