From lawsuits for high fees to regulatory probes into the way funds are sold, the US asset management industry has been attacked on multiple fronts in recent years.
But one area that has largely escaped unscathed up until now is the $1.7tn target-date fund market, which has experienced runaway growth and is a central plank of the US defined contribution retirement system.
Target-date funds — retirement portfolios that rebalance automatically according to the investor’s age and target retirement date — account for almost a third of assets held in US employee retirement plans, according to Callan Associates, a consultancy.
Yet critics fear target-date funds could be an accident waiting to happen, warning that concentration and competition issues are putting investors at risk.
“Target-date funds have very much been under the radar,” says Chris Brown, founder and principal of Sway Research, a consultancy focused on fund distribution within 401(k) plans. “This has allowed the big captive providers to get bigger and bigger.”
The target-date market is controlled by a small number of asset managers. The top three providers — Vanguard, Fidelity Investments and T Rowe Price — manage 63 per cent of the total asset pool, according to Sway Research. In addition, the vast majority of target-date managers exclusively invest in their own in-house funds, with just one provider in the top 10 — Principal — outsourcing the portfolios to external managers.
One reason for the closed nature of the market is downward pressure on management fees. The average fee for target-date funds fell to an all-time low of 0.62 per cent in 2018, down from 1.03 per cent in 2009, according to Morningstar. The squeeze has forced target-date providers to prioritise in-house funds over external managers to save money.
“Ten years ago if you had a well-constructed ‘best of breed’ multi-manager fund, you had an advantage,” says Jim McCaughan, former chief executive of Principal Global Investors. “Now that’s less the case because of the intense focus on price.”
The conflicts of interest inherent in this model are rising up the US Securities and Exchange Commission’s agenda. The agency’s compliance inspections and examinations unit this month issued a rare warning following a one-off review of target-date funds, criticising managers for failing to properly disclose conflicts resulting from the use of in-house funds.
This issue has taken on particular urgency given the increasing proportion of US workers being channelled into target-date funds as default investment choices. Since the landmark Pension Protection Act was introduced in 2006, US employees are automatically enrolled in 401(k) plans if they are available. The rise of target-date funds was sparked by the change of legislation, as the products responded to a need for default investment options.
“The stamp of approval that came with the Pension Protection Act really opened the floodgates for target-date funds,” says Jeff Holt, director of multi-asset and alternative strategies for Morningstar.
Morningstar’s research shows that target-date funds have more than quintupled their assets under management over the past decade, during which they have regularly recorded double-digit annual growth. “The fact that so many retirement investors are relying on them is what has brought them to the SEC’s attention,” says Mr Holt .
Investors’ hands-off approach to target-date funds — designed as simple, “set it and forget it” investments — gives specific impetus to investor protection concerns.
“The assumption is that those investors don’t dig into portfolios or look at what they are invested in,” says Mr Holt. “Because of that, it is much more important that investors aren’t misled as to what they’re getting.”
Chief among the questions regulators will be asking about target-date funds is whether they deliver good investor outcomes. William Beggs, assistant professor of finance at the University of San Diego School of Business, says that the use of in-house funds as underlying investments can compromise performance, pointing out that target-funds providers who fill their target-date funds with their own investment strategies have little incentive to fire the underlying manager if returns tail off.
Research by Mr Beggs found that the presence of conflicts of interest in the management of retirement assets materially impacts performance. Target-date funds run by managers who also provide investment consulting services to 401(k) plans underperformed conflict-free funds by 40 to 50 basis points per year.
In recent years, financial services groups such as Prudential, American Century, BlackRock, Goldman Sachs and Putnam Investments have been hit by lawsuits from employees over the mismanagement of their internal 401(k) plans. In several cases, plaintiffs alleged their employers packed retirement plans with higher-cost, underperforming affiliated funds when better options from competitors were available.
Yet litigation in this area is in its infancy. Apart from employee-led lawsuits, most cases against retirement plan administrators have focused on fees. “People have not yet gone after a single-manager investment strategy in a target-date wrapper,” says Mr Brown. “At some point, we could see that.”
The SEC’s recent warning stopped short of proposing a clampdown on the use of in-house investments within target-date funds, focusing instead on the need for managers to disclose conflicts of interest. But Mr Beggs questions whether disclosure will be enough to make investors aware of the conflicts and how this may affect their investments.
Advocates of target-date funds argue the in-house model works well for investors. “[Using in-house funds] is standard practice,” says Daniel Uquillas, senior analyst at Cerulli Associates. “Most investors are not surprised that if they buy a target-date fund from a company it is invested in the funds of that company.”
Mr Uquillas points out the simplicity of target-date funds benefits US retirement savers. “They were a big step in providing an age-appropriate strategy to average retirement investors who lack asset management expertise,” he says. Moreover, target-date funds’ increasingly low price is another bonus for investors and plan sponsors.
Yet Mr McCaughan adds: “Regulators and market operators are worried that the industry has moved towards a fully affiliated model. Low fees are good for investors but there is a balance to be sought.”
Mr Brown, who forecasts that target-date funds will make up 45 per cent of the 401(k) market by 2023, notes that the real test for the funds will be how they fare during a prolonged market downturn. Many target-date products suffered during the 2008 crash, prompting congressional hearings and calls for greater regulation. However, this was later quelled by the subsequent rebound enjoyed by target-date funds and no regulatory action was taken.
“When the next correction hits, and target-date funds get clobbered, people might lose a big chunk of their retirement savings,” says Mr Brown. “At this point, I would expect the SEC to take a serious look at underlying investments and potentially recommend changes, including more non-proprietary investments.”
