Fees, Lawsuits, and the Fate of TDFs

Art by Marcellus Hall“Warren Buffett doesn’t pay retail, and neither should an employee of a company 401(k) plan,” argued Jerry Schlichter, an attorney for plan participants of California utility Edison International, in a class-action lawsuit in February. The Supreme Court case—Tibble v. Edison—probes into plan sponsors’ fiduciary duties and the brass tacks of running a 401(k) plan: Are plan sponsors prudently offering low-cost mutual funds? Are they reviewing the choices often enough? Are members privy to the same pricing as Warren Buffett? A Justice Department attorney argued that plan sponsors have an “ongoing monitoring duty” for performance and investment fees. “You can’t just set the funds and hold them and forget about it,” the government’s lawyer said.

Taking the court’s inquest one step further, do plan sponsors also have a responsibility to provide their participants with a cheaper target-date fund (TDF) option? Since glide path strategies often charge significantly higher investment fees than passive, off-the-shelf products, are litigation-shy plan sponsors turning away from TDFs in search of lower fees—and if not, should they?

“Fees should be reasonable, but plan sponsors should not simply choose the cheapest solution, especially if it isn’t reflective of their investment beliefs.” —Josh CohenMark Fortier, St. Louis-based NISA Investment Advisors’ director of defined contribution product design and implementation, argues the tide hasn’t turned just yet, especially when it comes to fees. “Understanding fees is definitely a critical issue,” he says. “But fees aren’t the objective. The bigger issue is for plan sponsors to understand what the plan is designed for and what the TDF is trying to achieve. Only then can fees be evaluated for reasonableness.”

Taking the judiciary’s fee focus too seriously could actually have an adverse impact on participants, adds Josh Cohen, Russell Investments’ head of institutional defined contribution. “It’s about value, not about the lowest absolute cost,” he says. “Fees should be reasonable, but plan sponsors should not simply choose the cheapest solution, especially if it isn’t reflective of their investment beliefs.”

But the industry is on the cusp of major change, says Robert Krebs, NISA’s co-head of defined contribution solutions. Plan sponsors, in turn, are feeling the need to alter their policies and TDF investment programs to align with this new reality. It’s a “natural evolution,” he says, “given the changing needs of sponsors and participants.” Today’s retirement landscape has vastly shifted since TDFs first arrived on the scene: An aging population nears retirement, and more and more corporate (and even some public) sponsors are freezing their defined benefit plans. “The objective of a plan 10 years ago was savings and accumulation,” Krebs continues. “Now, these funds are more retirement income-oriented.” Plan sponsors are also feeling the pressure to revisit their initial decisions about TDFs made in the mid-2000s. The definition and the source of risk will evolve with the demographics, he says, most likely shifting towards the risk associated with securing retirement income.

While plan sponsors may not be tossing the simplicity and efficacy of TDFs aside altogether, Fortier says they are beginning to question the “simple solution that assumes everyone retires at the same age.” Gone are the days when plan sponsors could blissfully rely on theoretical targets of risk and retirement dates.

Now they must roll up their sleeves and consider practical factors like income and actual retirement dates that better inform individual retirement strategies, says David O’Meara, a senior Towers Watson investment consultant. The market is now awash in TDFs for every taste—ranging from off-the-shelf passive to customized products—he adds. “The future is in customization,” Cohen of Russell believes. “As more participants rely on their TDFs as the main source of income in retirement, it will become more important to tailor their glide paths as much as possible…” Which could mean more fees.