Target Date Funds Pose Potential Fiduciary Risks

Target date funds (TDFs) currently hold about $3 trillion in defined contribution plan assets.  However, according to a recent article penned by Ron Surz in 401kSpecialist, the TDF gamble may meet a perilous end.  That is if and when an inevitable stock market crash occurs.  Mr. Surz is the President of Target Date Solutions and CFO of GlidePath Wealth Management.

Mr. Surz asserts that $3 trillion in TDF assets could become less than $1.5 trillion if market losses are as severe as predicted.  TDFs have served as popular qualified default investment alternatives (QDIAs) in many DC plans since the Pension Protection Act was passed in 2006.  However, questions have come up recently about the risks TDFs bring to retirement outcomes. Many participants who were defaulted into TDF QDIAs have no idea of the risk that may exist.  Participants may stand to lose a significant portion of their life savings, Mr. Surz opined.

According to Mr. Surz:

The average TDF is invested 50% in equities (stocks, real estate, etc.) and 35% in risky long-term bonds at the target date, so 85% in risky assets.  This allocation is expected to have excessive losses in three years out of 20, where “excessive” is defined as a loss greater than 10%.

But the past 13 recovery years from the 2008 crash were extraordinary.  There’s a 10% chance of avoiding an excessive loss over a 13-year period with this allocation, and here we are with no excessive losses in TDFs—we’ve been incredibly lucky.  The stock market has returned a fantastic 600% over the past 13 years, leading many to expect a correction in this decade.

This is not the first time we have seen this phenomenon.  The financial crisis of 2008 hit TDFs hard.  Many experienced substantial losses.  However, back then, TDFs were in a relative infancy, with only $200 billion in assets.  Mr. Surz noted that the probability of a similar market correction in the near term is high simply because it’s long overdue.  And, he wrote: “The imminent market crash could be a doozy that irreparably harms participants who are near retirement.”

Congress has even expressed concern over the risk, sending a letter to the Government Accountability Office (GAO) to review TDFs and their risks to retirement savers.  According to Mr. Surz, there are two types of TDFs:  risky and safe.  By and large, plan fiduciaries have chosen the risky type, “…and therein lies the bad gamble,” he wrote.  In addition, he noted, “Fiduciaries should have opted to protect defaulted participants, as exemplified by the Federal Thrift Savings Plan (TSP), the largest savings plan in the world. The TSP TDF ends less than 30% in risky assets at the target, whereas the typical TDF ends 85% in risky assets.”

The irony is that most fiduciaries chose the most popular TDFs due to their perceived protection from lawsuits.  For their part, TDF participants want, and believe they have, protection from losses as they approach retirement.  Some even believe TDFs guarantee they won’t experience investment losses (which obviously, is not the case).  According to Mr. Surz, “The conflict of interest exists when popular TDFs do not serve the interests of participants and expose them to significant risk.”

There is no telling when the stock market will undergo a correction.  We can only assume that it will at some point.  TDF participants could be at tremendous risk to lose a substantial portion of their retirement savings.  It is important for retirement plan sponsors and committees to understand the risks and the resulting potential fiduciary consequences.  Sadly, it may be too late to correct the probable devastation.

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