FIXING FAILED US PENSIONS SCHEME / THE FINANCIAL TIMES ( RECOMMENDED READING )

Fixing a failed US pensions scheme

By John Keefe

Published: January 24 2010 10:24

Although US workers and investment managers have had more than 20 years to get the hang of saving and investing through defined contribution plans, the system has not worked very well, even before the market downturn in 2008.

According to Fidelity Investments, asset allocations in 40 per cent of its DC account population were too timid in light of the worker’s age, and another 40 per cent too aggressive. And DC account assets had built up to just $28,000 (£17,000, €19,400) for the median household, and $40,000 for people nearing retirement, says the government accountability office.

These poor marks made employers eager to adopt the industry’s latest solutions – defaults to automatic enrolment of participants and higher contributions, as well as target date retirement funds. On paper, the target date design takes asset allocation decisions away from employees, and invests their accounts in a diversified, prudently managed manner, with appropriate exposure to investment risks over a worker’s entire career.

But the markets’ responses to the global financial crisis revealed flaws in target date funds, both in theory and practice, so like the bankers and brokers before them, representatives of the mutual fund industry were called to dark-panelled chambers in Washington.

As the US stock market sold off 37 per cent during 2008, investors in target date funds of vintage year 2010 expected to retire in a couple of years with their capital more or less intact. Instead, “ . . . the reality of target date funds was quite surprising to many investors last year”, said Mary Schapiro, head of the Securities and Exchange Commission, in a June 2009 public hearing.

She added: “The average loss in 2008 among 31 funds with a 2010 target date was almost 25 per cent, but perhaps even more surprising were their widely varying performance results – returns of 2010 target date funds during 2008 range from minus 3.6 per cent to minus 41 per cent.”

That was cause to consider whether regulatory changes, industry reforms or other revisions were needed, Ms Schapiro said.

The SEC, which regulates mutual funds, and the Department of Labor, the overseer of retirement plans, are considering fairly tame corrective measures: revising disclosure to investors, in particular sales literature, and limiting the names managers can apply to their funds.

In hearings, concerns have also been raised about fee levels and the potential conflicts of interest inherent in target date funds built solely from a manager’s proprietary offerings. So far, however, the two agencies have not indicated an interest in regulating asset management, such as prescribing investment allocations.

More than half (58 per cent) of US DC plans offer target date funds, according to research by the Profit Sharing Council of America, an industry trade group. The SEC reports target date fund assets at $227bn.

“A lot of the concern about 2008’s returns relates to investors’ confusion over what target date funds are,” notes Mark Warshawsky, director of retirement research with consultant Towers Watson. “Some investors have expected guarantees on assets or income when they retired.

“There were also misunderstandings on different funds’ strategies,” he adds.

“Some are intended to become conservative near retirement and end at retirement date, and others are less conservative and continue into retirement.

“Those are two different needs and call for different products. The question is how well that was understood by the participants.”

When the value proposition for target date funds is minimal involvement in investment decision making, it seems illogical to expect those same disengaged participants to pore over the small print.

“Here [is] what respondents think target date funds promise,” reported Jodi DiCenzo, of Behavioral Research Associates, testifying at the SEC/DOL hearings in June, quoting from a survey her firm had conducted: “‘Funds at the time of retirement; secure investment with minimal risks; it’s like a guaranteed return on investment even when the market bottoms out; a comfortable retirement’.

“Alarmingly, more than 60 per cent of employees [believe] they will be able to retire on the target date . . . and 30 per cent of workers think they can save less money and still meet their retirement goals if they invest in a target date fund.”

Beyond the SEC and DOL’s efforts towards greater disclosure, Senator Herb Kohl, a Democrat from Wisconsin who heads the Senate special committee on ageing, is planning to introduce legislation in February with considerably more teeth, to amend Erisa, the legislation that governs pension plans, to confer fiduciary responsibility on fund managers.

“It is often hard for financial experts, let alone consumers, to know what investments are included in their target date fund,” Mr Kohl’s staff told FTfm. “We have seen troubling reports that many of these funds expose investors on the brink of retirement to excessive risk. It is particularly important to provide fiduciary protections to the millions of Americans who are defaulted into target date funds as their primary retirement investment.”

Without disclosing details, Mr Kohl’s staff add that the proposed regulation would likely not prescribe asset allocation guidelines, but instead link fiduciary responsibility and fund performance.

Ralph Derbyshire, deputy general counsel for Fidelity Investments, says: “We’re eager to work with the SEC and DOL on communicating more effectively with target date fund shareholders.

“But mutual funds are already well regulated and have fiduciary obligations to investors under both the Investment Company Act and Investment Adviser Act. Adding another layer of regulation under Erisa is unnecessary and inefficient, and in the end might increase the costs retirement investors have to bear.”

Copyright The Financial Times Limited 2010.