A recently released study investigates whether target date funds are managed in the best interests of investors. There is a substantial vein of research in the financial literature on what are referred to as ‘agency problems.’ Fund managers act as ‘agents’ for investors: they invest on behalf of the people who invest in a fund. In theory, fund managers should want to generate the highest returns for their investors, but there are some inherent conflicts of interest—and the author of this study explains why these problems may be especially egregious with target date funds.
Because target date funds are the most commonly selected Qualified Default Investment Alternative (QDIA) in 401(k) plans, employers can automatically direct investors into these funds. The selection as a QDIA will tend to generate flows into these funds for investors who may lack the interest or knowledge to make a critical selection. Furthermore, because 401(k) plans tend to offer only a single fund company’s target date funds, investors who want a target date fund have only one choice. These factors mean that target date investors will be relatively indiscriminate to under-performance, whether this is generated by high expenses or by poor investment choices on the part of the fund manager. With only one option, Target Date fund investors can’t choose between funds. This study documents that target date fund flows are, in fact, not sensitive to performance.
The study separates target date funds on the basis of three useful criteria:
- Single funds (SFs): funds that invest directly in stocks and bonds
- Internal Fund-of-Funds: funds that invest in only their own fund family’s funds
- External Fund-of-Funds: funds that invest in other firms’ funds
SF target date funds invest in stocks and bonds directly, while Fund-of-Funds (FoFs) invest in other mutual funds. There is significant potential for agency problems with Internal FoFs. A FoF target date fund can obviously generate higher income for its fund family if the FoF is invested entirely in its own funds. Further, there is additional incentive to invest in funds with higher expense ratios.
The study examines the extent to which the results we might expect from these agency problems show up in fund performance—and they show up in force. Target date funds that only invest in funds from their own fund families tend to under-perform those that invest in funds from other fund families by between 0.8% and 1% per year (compensating for differences in risk levels, etc.).
A reduction in performance on the order of 1% per year due to agency problems has an enormous impact over a working lifetime. The Department of Labor estimates that a 1% reduction in return over a 35-year career will result in a 28% reduction in the amount of retirement savings accumulated. Losing almost 28% of a retirement plan’s likely value directly translates into a 28% reduction in retirement income. Given the challenges that Americans face with respect to retirement savings via 401(k) plans and other defined contribution plans, we must actively seek to avoid the potential for expensive agency issues.