In recent years, target retirement date funds (TDFs) have become a very popular investment option on participant-directed defined contribution plan investment lineups. But, as discussed in this LawFlash, as TDFs have grown in popularity, there are signs of increasing scrutiny around TDFs used in participant-directed defined contribution ERISA plan investment lineups. This increasing scrutiny is expected to raise new regulatory initiatives generating new questions and may favor increased process review by ERISA plan fiduciaries.
A TDF is an investment fund (usually part of a family or series of investment funds) that is managed in accordance with a dynamic asset allocation “glidepath” with the intention of achieving an appropriate risk and performance level over time corresponding to a specific targeted retirement date (e.g., a 2020, 2030, 2040, 2050 TDF). Traditionally, for TDFs in the series with a later target retirement date (for example, a 2050 TDF), the TDF focuses more on growth of capital through a larger equity allocation. By comparison, for TDFs in the series with a closer target retirement date, the TDF’s asset allocation moves down the glidepath to become more conservative (in an effort to protect capital) through a larger fixed income allocation.
The increasing popularity of TDFs is illustrated by the sharp increase over the past two decades in the number of plans offering TDFs as investment options, in particular as the “QDIA” or the “default” investment option in most plans, and the flood of plan assets (AUM) being allocated or mapped into TDFs. Even when not serving as a plan’s default investment option, TDFs can be popular investment elections among plan participants because TDFs permit plan participants to choose a TDF and “set it and forget it.” Plan participants can enjoy a “professionally managed” approach to their asset allocations without the burden of monitoring their portfolio to adjust their asset allocation over time. This can be particularly appealing for plan participants that are less sophisticated with regard to retirement investing. As the demand for TDFs has grown, a robust marketplace has created TDFs highlighting different strategies, including in many instances, variations in asset types and glidepath allocations, in an effort to create best in class strategies for participants, gain a competitive edge in the TDF market, and attract AUM.
As TDFs have grown in popularity, and emphasis in plan investment lineups, there are signs of heightened scrutiny of TDFs. As discussed in this LawFlash, this scrutiny is challenging plan fiduciary TDF decision making from three angles—from Congress, from regulatory agencies and from plaintiffs attorneys. With TDFs in the spotlight, plan fiduciaries may want to consider reviewing and adjusting their process for selecting and monitoring TDFs.
As a result of the growing popularity of TDFs and the rapid proliferation of TDF offerings to retail/individual investors, lawmakers are starting to ask more questions to better understand the potential risks and downsides of TDFs for ERISA plan participants. In a recent joint letter (the Murray-Scott Letter) to the US Government Accountability Office (GAO), Senator Patty Murray, Chair of the Senate Committee on Health, Education, Labor & Pensions; and Representative Robert “Bobby” Scott, Chairman of the House Committee on Education & Labor called for the GAO to review TDFs because “[t]he millions of families who trust their financial futures to target-date funds, need to know these programs are working as advertised and providing the retirement security promised.”
The Murray-Scott Letter presents two key concerns. First, it alleges that the evolving market for TDFs has resulted in a universe of available TDFs for which “expenses and risk allocations vary considerably.” The letter appears particularly focused on how TDFs are marketed as “set it and forget it” investments, plan participants may be trusting the glidepath of the TDF available under their plan without understanding if the fund offers the appropriate (for their particular financial circumstances) time horizon and risk tolerance. The Murray-Scott Letter cites studies indicating that TDFs may in fact be too heavily weighted toward equities as the targeted retirement date draws near, resulting in an overexposure of risk to the plan participant.
The Murray-Scott Letter also questions the appropriateness of the use of “potentially higher risk and more lightly-regulated ‘alternative’ assets, such as private equity” to populate TDF asset allocations. The lawmakers refer to Information Letter 06-03-2020 (the Information Letter) issued by the Trump administration’s Department of Labor (DOL), which they assert “paved the way” for the use of alternative assets such as private equity investments TDFs.
In a call to action for the GAO, the Murray-Scott Letter sets forth several questions spanning the following TDF-related topics:
At the same time, there are also signs of increasing federal regulatory interest around TDFs. The interest of regulators in TDFs can be reviewed from the DOL’s issuance of its final rule providing fiduciaries relief for defaulting plan investments in qualified default investment alternatives (the QDIA Regulations) in response to a call to action by Congress in its enactment of the Pension Protection Act of 2006. In the QDIA Regulations, reference was made specifically to investment alternatives with asset allocations based on the participant’s “target retirement date” as one of only four types of investment alternatives that meet the definition of a “qualified default investment alternative” or “QDIA,” therefore qualifying for fiduciary relief.
In May 2010, the DOL and the Securities and Exchange Commission (SEC) published a joint Investor Bulletin regarding Target Date Retirement Funds, which addressed the nuts and bolts of the operation of a TDF and considerations in evaluating TDFs. Later in 2010, the SEC and DOL each issued proposed rules relating to TDF disclosures, including calling for advanced disclosures concerning TDF asset allocations and glidepaths. Later in February 2013, the DOL issued guidance titled “Target Date Retirement Funds–Tips for ERISA Plan Fiduciaries,” which detailed several best practices for plan fiduciaries to consider when selecting and implementing TDFs as investment options under participant-directed defined contribution plans (DOL TDF Tips).
More recently, SEC interest in TDFs resurfaced in 2019 when it issued a risk alert identifying that TDF examination initiatives had uncovered potential disclosure and operating policy and procedure issues.
In addition, the DOL has recently focused on issues related to TDFs. This focus has included an interest in the use environmental, social, and governance, or ESG factors in QDIAs. Another example is in May 2021, DOL Acting Assistant Secretary Ali Khawar indicated that the DOL is reconsidering the Information Letter issued under the Trump DOL, which provided some support for the use of alternative assets such as private equity investment in participant-directed defined contribution plans. In recent statements, Mr. Khawar stated that the DOL was reevaluating the risks of the use of alternative investments in such plans, and especially in TDFs used in smaller plans.
The third area of interest is in the courts as there have been recent legal claims challenging TDF offerings. As a result, court cases are also focusing on the prudence of different TDFs in ERISA plans and fiduciary decision making in selecting and monitoring TDFs. Some of these lawsuits challenge TDFs based on the all-too-familiar “excessive fees” claims. Others include claims of imprudent management and oversight. Recent claims have alleged the plan fiduciary inappropriately permitted expensive alternative investments to be used in the plan’s TDF asset allocation (echoing the concerns raised in the Murray-Scott Letter). Another suit included claims that the plan fiduciary imprudently hired a TDF investment manager with too limited experience and track record to manage the plan’s TDFs.
In light of the congressional and federal regulatory agency interest and continuing deluge of plaintiffs’ class action claims involving TDFs, we note these observations:
While these inquiries are not mandatory, they reflect the concerns raised in the Murray-Scott Letter, the DOL’s statements and recent legal claims, and could be considered as part of a fiduciary evaluation of TDFs.
If you have questions about how to navigate the use of TDFs, including questions about possible risks related to the use of TDFs, please reach out to the authors, your Morgan Lewis contact, or any of the following lawyers:
Lisa H. Barton
Craig A. Bitman