Investors Need to be Careful with Target-Date Mutual Funds


Target-Date mutual funds are not always what they appear to be, reports Leslie Wayne in her June 25, 2009 article in the New York Times entitled “Target-Date Mutual Funds May Miss Their Mark.” Target-Date mutual funds are supposed increase the allocation of bonds over time in order to reduce volatility as an investor approaches retirement. Stocks are generally more volatile than bonds, and investors generally increase the percentage of bonds to add the stability to a portfolio of investments.

The funds are marketed as a simple and easy way to automatically lower the risk in your portfolio as you get older. It sounds good in principle, but the Fidelity Freedom 2010 Fund contained 50% stocks and lost 25% of its value, and the AllianceBernstein 2010 fund had 57% stocks and lost 33% of its value, according to the article. Some of target-date funds fared even worse – losing 40% to 50% of their value ? more than the S&P 500 (100% stock) index, which fell 38.5%.

How is that possible? “Funds with the same target date in their names can be structured, and thus perform, very differently,” says Mary Shapiro, Chairperson of the Securities and Exchange Commission. Target-Date funds have been fond to vary wildly in their allocations of stocks and bonds. The percentage of stocks in funds called Target 2010, which are aimed at people hoping to retire in the year 2010, ranged from a relatively conservative 21% to a much higher-risk 79%, according Ms. Shapiro. The average 2010 fund had more than 45% of its holdings in stocks in 2008.

Why is this a big problem? In 2006, Congress passed legislation that enabled employers to route employees who did not specify their investments into target-date funds. Consequently, money flowed into such funds in unprecedented amounts. Before that, the default choice was generally a money market or “stable value” fund. The SEC is considering whether putting a date in a fund’s name should be prohibited, as well as whether the risks have been adequately disclosed and whether the funds were properly structured.

Representative Rob Andrews, Democrat from New Jersey, is concerned that mutual fund companies are not making adequate disclosures or offering other choices to 401(k) plans, such as low-cost index funds. Mutual fund companies often create target-date funds by bundling existing funds, which enables the fund companies to collect more fees than investors understand they are paying. “I’m not saying that pensions are being pillaged by greedy mutual fund companies,” said Representative Andrews, “but I am saying that that people should know how much they are paying and that investment advice should be in the best interest of the investor, not the advisor.”

If regulators do not act, Congress says it will. Senator Herb Kohl, Democrat from Wisconsin and Chairman of the Special Committee on Aging, has criticized aspects of target-date retirement funds. “At the end of the day, consumers need to know what they’re getting into,” Senator Kohl said. “We’d like to see regulation, whether it’s a standardization of target-date composition, or increased clarification of information made available about the plans.”

Trustees and other fiduciaries of plans established under The Employment Retirement Income Security Act of 1974 (ERISA), such as 401(k) plans, must protect plan assets “with the care, skill, prudence, and diligence ‘ that a prudent man acting in a like capacity and familiar with such matters would use’.” In other words, ERISA fiduciaries must not merely act like prudent person, but instead like prudent experts. This applies to smaller ERISA plans as well as larger ones. If ERISA trustees do not possess the requisite expertise, it behooves them to retain experts to advise them.

When a plan suffers a significant loss (realized or unrealized), ERISA trustees must weight the potential benefits and burdens of various possible courses of action, and make informed decisions. Once a loss is identified, the need to make such decisions is ongoing, and the number and complexity of such decisions can be overwhelming. Among the many decisions that confront ERISA trustees are:

  • Whether the plan has a viable cause of action to recover a loss;
  • Identification of the potential defendants and likelihood of recovery from each;
  • Whether to participate in an already-filed lawsuit or initiate a lawsuit;
  • Whether opt out of in a securities class action and seek a larger recovery in a separate direct action or actions;
  • Whether to apply to be lead plaintiff in a securities class action;
  • Whether to remain a passive class member in a securities class action; and
  • Whether to object to a settlement negotiated by a lead plaintiff in a securities class action.

In order to protect the Plan and themselves, ERISA trustees should retain an experienced securities litigation law firm to monitor the plan’s portfolio, identify losses that resulted from possible securities law violations, and evaluate potential claims. While general counsel could serve as monitoring and evaluation counsel, the better practice is to engage a firm with the proper experience and credentials. Once retained, monitoring and evaluation counsel can coordinate with the trustees, custodian, and investment managers to ensure that needed actions are taken.

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing institutional and individual investors in securities-related litigation and arbitration. Page Perry partners also have an active practice representing ERISA plans and beneficiaries, including monitoring plan portfolios and evaluating potential claims. For further information, please contact us.