Senate to address conflicts in proprietary target funds

Insiders say that the Senate Special Committee on Aging hearings Wednesday will focus on the potential for conflict of interest within proprietary target date funds. As of Sept. 30, 98% of target date fund assets were in proprietary funds, according to Strategic Insight/ Simfund. Ninety-one percent of target date funds are proprietary. Specifically, the committee wants to get a better understanding of the fiduciary role of investment managers who oversee these funds, said an aide to Sen. Herb Kohl, D-Wis., chairman of the committee. “There seems to be a sense out there that there are often low-quality funds put within target date funds,” said the aide, who asked not to be identified. Mr. Kohl wants to examine if fiduciary standards are working for target date funds and, if not, whether the Department of Labor and Congress should consider changes to the rules. For the past few months, Mr. Kohl has been leading the charge on Capitol Hill to focus on target date funds. In June, he put together a joint hearing by the Securities and Exchange Commission and the Labor Department, but that meeting focused more on why the glide paths, or asset allocation, of funds with nearing retirement dates were so aggressive. Experts, however, said that the glide path controversy is directly related to the potential conflict-of-interest questions on which the hearings will focus this week. “The glide path issue is almost a side issue,” said Marcia Wagner, founder and principal of The Wagner Law Group LLC. “The real issue is: "Why was everything so heavily weighted in equities?' I think that's a direct result of parties' creating funds of funds to skew the asset allocation to be more profitable.” In 2007, the year after the Pension Protection Act of 2006 made target date funds a qualified-default-investment alternative for 401(k) plans, the equity asset allocation for the more aggressive target date funds was 94%, up from 80% in 2004, according to Hewitt Associates LLC. “One question the committee might ask is: "Did the math really change that much or did these funds start investing in equities and more esoteric things to be more profitable?'” said Michael Case Smith, head of institutional strategies at Avatar Associates LLC, an independent investment manager. Mr. Smith testified at the June 18 hearing with the SEC and the Labor Department. The committee is also examining the expenses of the underlying portfolios within target date funds. A few weeks ago, the committee asked BrightScope Inc., a 401(k) ratings and analytics firm, for data on how much target date funds cost, compared with other investment options within 401(k) plans. “We ran those numbers across the 15,000 plans in our database, and it came up that target date funds were 10% to 25% more expensive than other funds in the core menu,” said Ryan Alfred, co-founder and president of BrightScope. But the fact that target date funds, which are funds of funds, are more expensive than single mutual funds isn't a surprise, given that they have overlay fees and often encompass several funds, industry experts said. “The question, though, is: "Why are they higher?'” Mr. Alfred said. “If they are higher just because of the overlay fees and broader diversification, that's one thing. But if they are higher because fiduciaries aren't being prudent or they lack the ability to choose an alternative, that's another thing.” Another issue that the Special Committee on Aging may examine is excessive trading among target date funds with both proprietary and non-proprietary portfolios, said Matthew D. Hutcheson, an independent fiduciary. “It appears to me that the underlying subadvisers are doing their own things, and perhaps they are trading excessively to generate transaction fees for the firm running the fund,” he said. For plan participants, it's impossible to know whether this is happening, Mr. Hutcheson said. “My biggest fear is that these funds are just financial fast food,” he said.
The mutual fund providers dispute these claims. Jeffrey R. Carney, senior managing director of global marketing and products at Putnam Investments, said it's advantageous for Putnam to appoint the same manager, Jeffrey Knight, to oversee all of the funds within its target date funds. Mr. Knight is head of global asset allocation. “It allows us to know what's going on with each fund,” Mr. Carney said. “In a lot of firms, one fund might be buying IBM [Corp.], while the other might be selling.” The increased scrutiny of conflict-of-interest issues within target date funds is already causing some smaller 401(k) plan sponsors to look for customized portfolios.

"GREAT OPPORTUNITY'

Customized portfolios, or collective trusts, are common in the large-plan market, but now smaller plans are asking for them, experts said. “Those advisers that are real investment managers are going to have a great opportunity to do well and get more business,” Mr. Hutcheson said. “Target date funds are going to have competition from investment fiduciaries who can create these portfolios more transparently and in a way where there are no conflicts of interest.” AllianceBernstein LP, which offers proprietary target date funds to all plan sponsors, as well as customizable target date portfolios to large-plan sponsors, is seeing increased interest in customized portfolios among smaller 401(k) plan sponsors, said Richard A. Davies, head of product strategy for AllianceBernstein's defined-contribution unit. The company is developing this capability for the smaller-plan market, he said. With the increased scrutiny of target date funds, Mr. Davies said, more companies will want advisers to offer customized portfolios. “Plans could easily have 60% to 70% of their assets in these portfolios, and who would ever give 60% to 70% of their assets to one manager?” he said. E-mail Jessica Toonkel Marquez at jmarquez@investmentnews.com.