[Senate Hearing 111-492]
[From the U.S. Government Publishing Office]
S. Hrg. 111-492
DEFAULT NATION: ARE 401(K) TARGET DATE FUNDS MISSING THE MARK?
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HEARING
before the
SPECIAL COMMITTEE ON AGING
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
__________
WASHINGTON, DC
__________
OCTOBER 28, 2009
__________
Serial No. 111-14
Printed for the use of the Special Committee on Aging
Available via the World Wide Web: http://www.gpoaccess.gov/congress/
index.html
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SPECIAL COMMITTEE ON AGING
HERB KOHL, Wisconsin, Chairman
RON WYDEN, Oregon BOB CORKER, Tennessee
BLANCHE L. LINCOLN, Arkansas RICHARD SHELBY, Alabama
EVAN BAYH, Indiana SUSAN COLLINS, Maine
BILL NELSON, Florida GEORGE LeMIEUX, FLORIDA
ROBERT P. CASEY, Jr., Pennsylvania ORRIN HATCH, Utah
CLAIRE McCASKILL, Missouri SAM BROWNBACK, Kansas
SHELDON WHITEHOUSE, Rhode Island LINDSEY GRAHAM, South Carolina
MARK UDALL, Colorado SAXBY CHAMBLISS, Georgia
KIRSTEN GILLIBRAND, New York
MICHAEL BENNET, Colorado
ARLEN SPECTER, Pennsylvania
AL FRANKEN, Minnesota
Debra Whitman, Majority Staff Director
Michael Bassett, Ranking Member Staff Director
(ii)
C O N T E N T S
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Page
Opening Statement of Senator Herb Kohl........................... 1
Opening Statement of Senator Bob Corker.......................... 2
Panel of Witnesses
Statement of Barbara Bovbjerg, Director, Education, Workforce and
Income Security, U.S. Government Accountability Office,
Washington, DC................................................. 3
Statement of Andrew J. Donohue, Director of Investment
Management, U.S. Securities and Exchange Commission,
Washington, DC................................................. 26
Statement of Phyllis C. Borzi, Assistant Secretary of Labor,
Employee Benefits Security Administration, U.S. Department of
Labor, Washington, DC.......................................... 39
Statement of John Rekenthaler, CFA, Vice President of Research,
Morningstar, Chicago, IL....................................... 53
Statement of Ralph Derbyshire, Senior Vice President and Deputy
General Counsel for FMR LLC, the Parent Company of Fidelity
Investments, Marlborough, MA................................... 61
Statement of Michael Case Smith, Senior Vice President,
Institutional Strategies, Avatar Associates, New York, NY...... 73
APPENDIX
Statement of Certified Financial Planner Board of Standards, Inc. 91
Letter from Kevin Keller, CEO, Certified Financial Planner Board
of Standards, Inc. with additional information................. 98
Testimony submitted by Securities and Exchange Commission and the
Department of Labor's Employee Benefits Security Administration
by Marilyn Capelli Dimitroff................................... 104
Statement from the Profit Sharing/401K Council of America (PSCA). 110
Statement from the National Association of Independent Retirement
Plan Advisors (``NAIRPA'')..................................... 114
Testimony submitted by Richard O. Michaud and Robert O. Michaud.. 119
Information from Investment Company Institute on Fees In Target
Date Funds..................................................... 129
(iii)
DEFAULT NATION: ARE 401(K) TARGET DATE FUNDS MISSING THE MARK?
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WEDNESDAY, OCTOBER 28, 2009
U.S. Senate,
Special Committee on Aging,
Washington, DC.
The Committee met, pursuant to notice at 2:02 p.m., in room
SD-562, Dirksen Senate Office Building, Hon. Herb Kohl
(chairman of the committee) presiding.
Present: Senators Kohl, Bennet, Corker, and LeMieux.
OPENING STATEMENT OF SENATOR HERB KOHL, CHAIRMAN
The Chairman. Good afternoon and thank you all for being
here.
Today we will be talking about the promise and the reality
of target date funds, which are an increasingly popular choice
for people saving for retirement. Target date funds were
developed for the average American worker who understands the
importance of saving but may not understand the complexity of
investing. Target date funds, which automatically adjust their
investment portfolios to become more conservative as the
participant gets close to retirement, come with the promise
from financial firms that investors can simply indicate when
they would like to retire, and the firm will handle the rest.
Many Americans think target date funds sound like a great
idea, and the U.S. Government agrees. In 2007, the Department
of Labor qualified target date funds to be a default investment
fund for millions of Americans who are automatically enrolled
in 401(k) funds by their employer. As of March 2009, Fidelity
reported that 96 percent of their plans with automatic
enrollment used target date funds as their default option.
Therefore, a conversation about target date funds is really a
conversation about the future of America's retire security.
In February, our committee raised some concerns about the
recent performance of target date funds. We found that the
composition of these funds varied widely across the industry,
and many contained an inappropriately high level of risk. Some
workers in funds with a 2010 retirement date lost as much as 41
percent of their 401(k) savings in 2008.
We discovered that there is no standard for what financial
firms label and advertise as target date funds and no
regulation of their composition. In response to our request,
the Securities and Exchange Commission and the Department of
Labor held a joint hearing in June on target date funds, and I
am hopeful that we will soon see greater oversight of this
product that is on track to become the No. 1 savings vehicle in
America.
The Aging Committee has also continued with our
investigation of target date funds, and the more we learn, the
more concerns we have. This afternoon we will discuss three key
problems. First, there is a lack of transparency and
consistency in the design of target date funds. Second, many
funds charge excessive fees, eroding the value of a worker's
assets over time. Third, fund managers have a conflict of
interest in constructing target date funds and must resist the
temptation to put their bottom line above the interests of the
participants. Today the committee is releasing a report
detailing each of these issues and their impact on retirement
savings.
This afternoon's hearing is the third in a series we have
held on strengthening the 401(k) system, which is steadily
replacing defined contribution plans throughout our country.
Previously we addressed the issue of hidden fees in 401(k)
plans, which can have a big impact on retirement savings over
several decades, and we have also examined the long-term
effects of 401(k) loans and withdrawals on workers' retirement
savings. We have introduced legislation with Senator Harkin to
require the disclosure of 401(k) fees and will soon introduce a
bill to implement GAO's recommendations to reduce the effects
of loans and withdrawals. After all, in our efforts to
encourage Americans to save for retirement, we must make sure
that they are also able to save smartly.
I would like to turn right now to the ranking member on
this committee, Senator Corker.
STATEMENT OF SENATOR BOB CORKER, RANKING MEMBER
Senator Corker. Mr. Chairman, thank you. I apologize. I
needed to introduce a panelist in another committee.
I want to welcome each of you as witnesses.
Mr. Chairman, thank you for calling this hearing. I think
we obviously want to encourage Americans to save for the
future. I think most of us are concerned about a calamity that
is coming down the pike with people not saving as much as they
should with retirement. At the same time, we want to make sure
that people have the opportunity to invest in ways that are
beneficial to them, and we do not want to discourage employers
who are good actors, who are trying to encourage their
employees to save, from doing so. So, Mr. Chairman, I thank you
for, again, having this hearing.
I look forward to the panelists. Without further ado, I
look forward to their testimony.
The Chairman. Thank you, Senator Corker.
Now we will be introducing our panel.
Our first witness on the panel will be Barbara Bovbjerg of
the U.S. Government Accountability Office. Ms. Bovbjerg is the
Director of the Education, Workforce and Income Security team
where she oversees studies on aging and retirement income
policy.
Next, we will be hearing from Andrew Donohue, the Director
of the Division of Investment Management at the U.S. Securities
and Exchange Commission. As Director, Mr. Donohue is
responsible for developing regulatory policy and administering
the Federal securities laws that apply to mutual funds and
investment advisors.
Also joining us today is Phyllis Borzi, the Assistant
Secretary of the Employee Benefits Security Administration at
the Department of Labor where she oversees the administration,
regulation, and enforcement of title I of ERISA.
Next, we will be hearing from John Rekenthaler of
Morningstar, one of the leading providers of independent
investment research. Mr. Rekenthaler is Vice President of
Research and New Product Development.
The next witness will be Ralph Derbyshire, Senior Vice
President and Deputy General Counsel for Fidelity Investments,
the leading provider of target date funds.
Finally, we will be hearing from Michael Case Smith of
Avatar Associates, an independent investment manager based in
New York. Mr. Smith is Senior Vice President of Institutional
Strategies and Portfolio Manager of Target date funds for
Avatar.
Thank you all so much for being here. Ms. Bovbjerg, we will
take your testimony.
STATEMENT OF BARBARA BOVBJERG, DIRECTOR, EDUCATION, WORKFORCE
AND INCOME SECURITY, U.S. GOVERNMENT ACCOUNTABILITY OFFICE,
WASHINGTON, DC
Ms. Bovbjerg. Thank you, Mr. Chairman, Senator Corker.
I am pleased to be here today to set the stage for the
discussion of default investments in 401(k) savings plans.
Although in the past, 401(k)'s were supplemental to defined
benefit pension plans, 401(k)'s are increasingly the primary
source of workers' pension income today. As such, these
accounts will need to be sufficient to support workers through
decades of retirement.
My testimony today describes 401(k) saving and its
challenges and measures that may improve such saving. My
statement is based on reports we have issued over the last
several years on 401(k)'s, many of them for this committee.
First, saving and its challenges. Only about half the
workforce participates in a pension plan at all, and only about
a third of workers save in defined contribution plans, of which
401(k)'s are the most common. Significantly, only about 8
percent of those in the lowest earnings quintile participate in
one. The savings that result, of course, are insufficient.
According to the 2004 Survey of Consumer Finance, the
median account balance for DC plans overall was about $23,000
for workers with a DC plan and not quite $28,000 for
households. As you might expect, lower earners save much less.
Their median account balance was $6,400. Workers nearing
retirement age did better, but with median savings of about
$40,000, and that is still not enough.
These figures suggest that relatively few save, and even
those who do save, save too little to ensure a secure
retirement. These findings were developed from data collected
before the market meltdown, by the way, so account size has
likely fallen even lower today.
Leakage from existing 401(k) savings partly explains the
small account balances. Some 401(k) participants take actions
that reduce savings they have already accumulated, such as
borrowing from their account, taking hardship withdrawals,
simply closing the account and taking the money when they
change jobs. Although this so-called leakage affects a minority
of 401(k) accounts, participants who take these actions can
experience significant reductions of potential retirement
income, both from the loss of compound interest, as well as
from the financial penalties associated with the early
withdrawals.
In a recent report to this committee, we called for
measures to improve the information participants receive about
the disadvantages of early withdrawals and for statutory
changes in hardship withdrawal rules. Reducing leakage, which
is in fact self-inflicted savings reduction, would certainly
help maintain what little savings workers accumulate.
Fees can also reduce 401(k) savings, often without the
account owner's knowledge. We have reported that 401(k)
participants can be unaware that they pay any fees for their
accounts, and even when they know fees are being charged, few
participants know how much they are. Even small fees can add up
over a working lifetime and reduce retirement savings in a
significant way. Hidden service provider arrangements may also
drive fees higher than they need to be and thus cause plan
participants and fiduciaries to unknowingly pay more than they
should.
We have called for improved disclosure of fees to help
reduce excessive and unnecessary drains on 401(k) savings. I am
pleased to note that Labor is taking regulatory actions and
that, in fact, legislative remedies are also moving forward.
So let me turn now to some good news. As we reported to you
last week, provisions to encourage automatic enrollment appear
to be raising 401(k) participation, which means the prospects
for improved saving are rising. Plans using auto enrollment
have increased from 1 percent in 2004 to about 16 percent in
2009, with higher rates of adoption among larger plan sponsors.
Indeed, Fidelity Investments estimates that almost half of all
401(k) participants are in auto enroll plans and that
participation rates have risen accordingly. This is good news,
indeed.
However, there are still some areas for concern. In our
view, employers need to take action to increase saving, as well
as participation, and this means higher default contribution
rates and more adoption of automatic escalation.
We also note that the default investments are increasingly
target date funds, a focus of today's hearing. Such funds can
be advantageous to workers who do not want to rebalance their
investments regularly, but the variation in these funds
suggests that greater care should be given to their
transparency and to their cost.
In conclusion, American workers are increasingly being
asked to save for their own retirements and they are not saving
enough. Government action to enhance participation holds
promise, but measures to discourage leakage and the charging of
hidden fees must also receive priority. Also, it would be
shameful if the very act of encouraging participation through
automatic mechanisms also placed workers funds in default
investments that do not serve their needs. As workers are faced
with increasing responsibility for their own retirements, more
must be done by Government and employers to help them.
That concludes my statement.
[The prepared statement of Ms. Bovbjerg follows:]
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The Chairman. Thank you very much.
Mr. Donohue.
STATEMENT OF ANDREW J. DONOHUE, DIRECTOR OF INVESTMENT
MANAGEMENT, U.S. SECURITIES AND EXCHANGE COMMISSION,
WASHINGTON, DC
Mr. Donohue. Chairman Kohl, Ranking Member Corker, thank
you for the opportunity to testify before you today. My name is
Andrew Donohue and I am the Director of the Division of
Investment Management at the Securities and Exchange
Commission, and I am pleased to testify on behalf of the
commission about target date funds.
Today's hearing occurs against the backdrop of recent
turmoil in financial markets.
Today workers are increasingly dependent on participant-
directed vehicles such as 401(k) plans and responsible for
managing their own retirement portfolios.
Target date funds are designed to make it easier for
investors to hold a diversified portfolio of assets that is
rebalanced automatically among asset classes. Today assets of
target date funds registered with the commission total
approximately $227 billion. Target date funds have become more
prevalent in 401(k) plans as a result of the designation of
these funds as a qualified default investment alternative under
the Department of Labor pursuant to the Pension Protection Act
of 2006.
On June 18, 2009, the commission and the Department of
Labor held a joint hearing to explore issues relating to target
date funds. While some of the hearings spoke of the benefits of
target date funds, for example, as a means to permit investors
to diversity their holdings and prepare for retirement, a
number also raised concerns.
One concern that has been raised is the degree to which
communications to investors in target date funds have or have
not resulted in a thorough understanding by investors of those
funds and their associated risks. Losses in target date funds
incurred in 2008 raise questions about the extent to which
investors understand the risk of target date funds.
Recent variations in returns among target date funds with
the same target date also have raised questions about the
extent to which differences among target date funds have been
effectively communicated to investors.
Marketing materials for target date funds typically portray
the funds as offering a simple solution for investors'
retirement needs. The marketing materials frequently are less
nuanced than the disclosure found in the target date funds'
prospectuses. To the extent that an investor relies primarily
on a fund's marketing materials, the investor may develop
unreasonable expectations regarding target date funds and their
ability to provide for retirement.
Often target date funds contain a year, such as 2010, in
their name. These names provide a convenient mechanism by which
an investor may identify a fund that appears to meet his or her
retirement needs. However, investors may not understand from
the name the significance of the target date in the fund's
management or the nature of the fund's asset allocation to and
after that date. For example, investors may expect that at the
target date most, if not all, of the fund's assets will be
invested conservatively to provide a pool of assets for
retirement needs.
At Chairman Schapiro's request, the commission's Division
of Investment Management has undertaken a review of target date
funds with a view to recommending steps that the commission may
take to address concerns that have been raised. Because many
individuals invest in target date funds through 401(k) plans
and other defined contribution plans that are not regulated by
the commission, we have been cooperating closely with our
counterparts at the Department of Labor.
The Division of Investment Management is focusing on two
areas where enhanced regulation of target date funds may be
appropriate: funds' names and on funds' sales material.
Section 35(d) of the Investment Company Act makes it
unlawful for any mutual fund to adopt, as part of its name, any
word or words that the commission finds are materially
deceptive or misleading. One approach that we are examining
closely is whether there are circumstances where the use of a
date in a fund's name should be restricted in any way or
prohibited.
The division also is considering whether we should
recommend that the commission amend its rules governing mutual
funds sales materials to address issues raised by target date
funds.
The division is concerned that target date marketing
messages be balanced and they not suggest uniformity or
simplicity of target date funds where they are not present.
Finally, together with the commission's Office of Investor
Education and Advocacy, the division is developing outreach
efforts to investors that could help address potential
misconceptions about target date funds. This is an area where
we are hopeful that we can leverage our partnership with the
Department of Labor to enhance the effectiveness of our
efforts.
Thank you for this opportunity to appear before the Special
Committee, and I would be pleased to answer any questions you
may have.
[The prepared statement of Mr. Donohue follows:]
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The Chairman. Thank you very much.
Ms. Borzi.
STATEMENT OF PHYLLIS C. BORZI, ASSISTANT SECRETARY OF LABOR,
EMPLOYEE BENEFITS SECURITY ADMINISTRATION, U.S. DEPARTMENT OF
LABOR, WASHINGTON, DC
Ms. Borzi. Good afternoon, Mr. Chairman and Ranking Member
Corker. Thank you so much for inviting me to discuss target
date funds and the Department of Labor's activities in
connection with these funds and retirement plans.
I am Phyllis Borzi, the Assistant Secretary of Labor for
the Employee Benefits Security Administration, also called
EBSA. EBSA's mission is to protect the security of retirement,
health, and other employee benefit plans for America's workers
and to support the growth of employer-sponsored benefits.
Mr. Chairman, as you have already noted, the growth of
target date funds as an investment option in participant-
directed individual account plans over the past few years has
been really significant. At the end of 2008, an estimated 75
percent of 401(k) plans offered target date funds as an
investment option.
Target date funds are designed to simplify the burden that
workers have in 401(k) plans to finance their own investments,
their own retirements with little or no investment expertise.
These funds, however, have been under scrutiny for the past few
years for exposing investors and plan participants to
unexpectedly large losses, particularly in 2008. Funds with the
same target retirement date have investment allocations that
differ significantly and thus produce different results. These
differences in target date funds and the associated differences
in their investment performance have prompted questions about
whether plan fiduciaries and workers adequately understand
these funds, how they operate and what their benefits, risks,
and costs are.
The Department shares the committee's interest in examining
whether target date funds provide workers with a secure
retirement. As you know, in June we held a joint hearing with
the SEC on target date funds. The hearing consisted of nine
panels testifying on a variety of issues. Many panelists
discussed the importance of disclosure and the challenges that
exist with regard to clear communication about the sometimes
complicated aspects of these funds.
Since the June hearing, the Department has been reviewing
the testimony, the additional submissions, and any other data
that we have received on target date funds, and we have also
been working with our colleagues at the SEC to explore what we
can do together or what each individual agency can do to
improve the understanding by both ERISA fiduciaries and
participants of how target date funds operate.
The remainder of my statement will focus on the
Department's outreach and oversight role related to target date
funds. I want the committee to understand that these are an
important priority of mine and a priority of the Secretary. We
think the issues and concerns that you raised are very
important and we take them very seriously and we are working
diligently to carry out this investigation.
So let me tell you a little bit about the Department of
Labor's oversight. EBSA is responsible for administering and
enforcing the fiduciary, reporting and disclosure provisions of
title I of ERISA. ERISA protects participants and beneficiaries
by holding plan fiduciaries accountable for prudently selecting
the service providers and the plan investments. In carrying out
this responsibility, plan fiduciaries must follow a prudent
process, and they have to take into account all relevant
information. But most importantly, they must act solely in the
interest of plan participants and beneficiaries.
In 2006, Congress included in the Pension Protection Act
provisions that were designed to promote the broader use of
automatic enrollment in 401(k) plans. The new law provided
statutory fiduciary relief for investments in certain types of
default alternatives in the absence of participant direction.
In 2007, the Department published a final regulation that
described the types of investments that constituted qualified
default investment alternatives, or QDIAs, and target date
funds were included as a QDIA. Importantly, however, under the
final regulation, even though target date funds are an
acceptable form of QDIA, the fiduciary continues to have the
obligation to prudently select, evaluate, and monitor any of
these investment alternatives, including the target date funds.
So the QDIA reg does not give the fiduciary a pass from the
basic fiduciary responsibility to prudently select, evaluate,
and monitor these funds.
EBSA assists plan fiduciaries and others in understanding
their obligations under ERISA through comprehensive education
and outreach and our regulatory programs. Of course, we also
provide oversight through our enforcement program. Under ERISA,
plan fiduciaries are personally liable for losses if they acted
imprudently in selecting and monitoring the investment choices
they offer to their participants. So when EBSA investigators
review the fiduciary selection of investments, rather than
focus on how the asset performed, they are going to focus on
the procedures used by the fiduciary to select and monitor the
performance of the investment.
To help educate plan fiduciaries about their obligations
under ERISA, our education and outreach program provides
information on specific topics such as selecting and monitoring
service providers and investment options and automatic
enrollment. We have numerous publications on our website, and
we have also sponsored seminars and webcasts to help plan
fiduciaries understand the law. Similarly, we have publications
that help participants understand the choices that are offered
through their plans.
The Department is considering a number of additional
initiatives to further assist plan fiduciaries and participants
in understanding the benefits, the risks and the costs of plan
investment options, including, of course, target date funds.
One of our current regulatory initiatives involves
transparency--improving disclosure to plan participants
concerning their investment options and the fees that are
charged.
In addition, we are specifically considering what kind of
disclosures need to specifically be made about target date
funds. At the same time, we are evaluating our QDIA regulation
to see whether additional types of meaningful disclosure might
be necessary when a target date fund is selected as a QDIA.
We are also considering whether the Department can assist
plan fiduciaries by providing more specific guidelines as to
how they should go about selecting and monitoring target date
funds for their plans regardless of whether the target date
fund is a default investment or simply one of the investment
options that are offered by the plan.
Similarly, we have a regulatory initiative on investment
advice. That was, as you probably remember, a pretty
controversial regulation issued by the last administration. The
Department intends to withdraw the final rule and the
accompanying class exemption, and issue a new proposed rule
that will support affordable and unbiased investment advice.
This will help participants in choosing the investments,
including target date funds.
Finally, we do share the committee's concern about the fee
levels associated with some target date funds. As part of our
regulatory project dealing with the disclosures of fees to plan
sponsors and participants, we are working through the issues as
they relate to target date funds and paying particular
attention to them. I look forward to working with you on this
and many other issues.
Finally, thank you so much for the opportunity to testify
at this important hearing. We remain committed to protecting
plan participants and assuring the growth of retirement
benefits and adequate security for America's workers, retirees,
and their families. I will be happy to answer any questions
later on.
[The prepared statement of Ms. Borzi follows:]
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The Chairman. Thank you.
Mr. Rekenthaler.
STATEMENT OF JOHN REKENTHALER, CFA, VICE PRESIDENT OF RESEARCH,
MORNINGSTAR, CHICAGO, IL
Mr. Rekenthaler. Hello. My name is John Rekenthaler. I am
Vice President of Research for Morningstar. Thank you for
inviting me to talk to the committee today.
Morningstar is a leading provider of independent investment
research and is the largest mutual fund research firm in the
United States.
I would like to state up front that Morningstar is
generally supportive of target date funds. Throughout its
history, Morningstar has frequently criticized entire
categories of funds for being gimmicky or overpriced. We are
considerably more positive about target date funds. We regard
target date funds as being a sound invention that meets a true
investor need. By offering broadly diversified portfolios that
change over time, target date funds are a suitable choice for
those who wish to delegate their investment decisions. They
also are well suited for inactive owners who will not be making
trades as they grow older and their situations change.
That said, there are certain concerns, given the
extraordinary position that target date funds now occupy as the
default investment choice for America's new retirement model.
One concern lies with fees. Overall, annual expense ratios
for target date funds mutual funds compare favorably with the
expense ratios charged by other types of mutual funds. For
example, on an asset-weighted basis--that is, with the larger
funds counting proportionately more in the calculation than the
smaller funds--target date funds have an average annual expense
ratio of 0.69 percent. This is lower than the 0.82 percent
figure for so-called allocation funds, which are a competitor
to target date funds that also invest in a broad mix of stocks
and bonds.
However, that average conceals a very wide range among the
48 target date fund families we track. On the low end, one
target date family has an expense ratio of only 0.19 percent.
On the high end, another has an expense ratio of 1.82 percent,
more than nine times higher than the first family. The issue of
expenses is particularly important with target date funds
because of their very long time horizons. Several fund families
today offer funds with a 2055 date, 46 years into the future.
As the committee well knows, the power of compounding greatly
magnifies small differences over such a long time period.
For example, let us assume two target date funds that
invest in identical underlying assets, returning 7 percent
annually. One fund boasts the industry's low expense ratio of
0.19 percent and, one, the industry's high expense ratio of
1.82 percent. Over the 46-year time horizon mentioned above, an
initial investment made in a low-expense fund would become
worth more than twice as much as the one made in the high-
expense fund. Few employees who are defaulted in target date
funds through their 401(k) plans will be aware of either the
expense differences or their powerful implications.
Another concern is the tendency of target date funds to
invest solely in their company's underlying funds. No reputable
institutional investor would hand over his or her entire
portfolio to a single asset management firm. Instead, the
institutional investor sifts among many investment managers
seeking to purchase the best and lowest-cost options for
various slices of the portfolio. One firm gets a portion of the
portfolio's large-company stocks, another manages its short-
term Treasuries, and so forth. The institutional investor would
not expect a single firm to excel at all types of investing.
Yet, that is implicitly the position taken by most fund
families in running their target date funds. It is difficult to
square such a practice as being the best outcome for an
investor, although of course from a business perspective, it is
understandable that a target date fund family would like to
keep all of the assets collected in-house.
Third, we are worried by the low level of conviction placed
by the industry's target date investment managers in the funds
that they run. Morningstar tracks how much money a target date
manager or any mutual fund manager invests in his or her own
funds, as this is an item listed in each fund's Statement of
Additional Information. After all, target date funds would seem
to be the ideal way for a fund manager to eat his own cooking
or her own cooking, as they saying goes, given that target date
funds are openly marketed as being suitable for every possible
type of investor. Yet, only 2 out of 58 target date managers
whom we track list $500,000 or more invested in their own
funds. Even more strikingly, 33 of the managers, or 57 percent,
show no investment at all.
Overall in the fund industry, managers who invest heavily
in their own funds tend to out-perform those who invest less.
We would like to see target date fund managers embrace their
funds more enthusiastically.
In summary, target date funds are a useful and productive
addition to the fund industry and a clear benefit to employees
who own 401(k) plans. They must improve, however, if they are
to fully earn their position of being at the heart of America's
retirement future.
Thank you.
[The prepared statement of Mr. Rekenthaler follows:]
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The Chairman. Thank you.
Mr. Derbyshire.
STATEMENT OF RALPH DERBYSHIRE, SENIOR VICE PRESIDENT AND DEPUTY
GENERAL COUNSEL FOR FMR LLC, THE PARENT COMPANY OF FIDELITY
INVESTMENTS, MARLBOROUGH, MA
Mr. Derbyshire. Chairman Kohl, Ranking Member Corker, thank
you for the opportunity to testify before you today. My name is
Ralph Derbyshire. I am Senior Vice President and Deputy General
Counsel for Fidelity Investments.
Since the advent of the 401(k) plan in the early 1980's,
Fidelity has been a leading provider of investment and
administrative solutions for plan sponsors and participants.
Today, Fidelity record keeps 19,000 workplace retirement plans
with more than 14 million plan participants. We are also the
leading provider of target date funds with more than $93
billion in target date assets.
My testimony will focus on three areas: first, how target
date funds help investors address improper asset allocation;
second, how automatic enrollment plans and target date funds
have helped increase retirement savings; and third, some
suggested improvements to increase understanding of target date
funds.
Target date funds were created to address one of the
biggest problems with defined contribution investing: improper
asset allocation. Across all age groups, the majority of plan
participants hold equity allocations that do not align with the
amounts that most investment professionals recommend. You can
see in figure 1--and these figures are in the appendix to my
written testimony--that as participants approach retirement
age, there is almost an even split, with approximately 40
percent invested too aggressively and 40 percent invested too
conservatively. That means that less than one-quarter of the
retirement age participants are in an appropriate allocation.
In 1996, Fidelity introduced the Freedom Funds as one of
the first mutual fund target date investment offerings to help
address this asset allocation problem. As with most target date
funds, Freedom Funds have an asset allocation mix that is more
aggressive when the investor is younger and becomes more
conservative as the investor grows older. The funds' managers
set the target asset allocation mix and achieve that mix by
investing in as many as 24 underlying Fidelity mutual funds. We
employ a rigorous process of selecting those underlying funds
based on an analysis of performance, risk, style consistency,
and how well the funds complement each other. This provides
sophisticated, long-term asset allocation in a simplified,
straightforward investment vehicle for participants.
It is also important to note that for the Freedom Funds the
target date is the date when the individual plans to retire and
not when they plan to liquidate their holdings in the fund. Our
target date funds are designed to last well into an investor's
distribution phase, which for the typical investor will extend
for at least 20 years beyond retirement. Figure 2 shows the
asset allocation or the ``glide path'' of Freedom Funds over
this entire life cycle.
As has been noted, target date funds have increased in
popularity in recent years, due in large part to changes made
to the automatic plan features in the Pension Protection Act of
2006. The percentage of plans at Fidelity that use a target
date fund as the default option has increased from 38 percent
before the effective date of PPA to 64 percent in 2009. Among
plans at Fidelity that offer automatic enrollment, over 95
percent use a target date fund as the default option.
Our data also shows that the PPA automatic programs have
had a dramatic effect on employee participation in retirement
plans, particularly among lower compensated and younger
workers. Figure 3 demonstrates how automatic enrollment impacts
employee behavior. Overall, 76 percent of eligible employees
are automatically enrolled into the plan with an additional 19
percent of employees opting affirmatively to enroll in the
plan. Counting those few who then opt out at a later date, the
overall participation rate for these plans is 89 percent, which
compares very favorably to participation rates of 50 to 60
percent in plans without automatic enrollment. So this
combination of a large number of participants coming into plans
with automatic enrollment, combined with a default into the
target date fund has had a powerful impact on participant asset
allocation. That is demonstrated in figure 4.
There has been a lot of discussion about how target date
funds have performed during last year's market downturn, and in
this difficult environment, many individuals take dramatic
action with their portfolios, often selling at depressed levels
only to buy back later at a higher price when the market
rebounds. But if an investor stuck with their target date fund
investments, they would be well on their way to recovering
their losses from last year.
For example, while the Fidelity Freedom 2010 fund was down
about 25 percent for the 2008 calendar year, it is back up
about 22 percent year to date in 2009. While that is not a
complete recovery, these funds are designed for investing
throughout retirement, again an additional 20-plus years, and
over the long term, the 2010 fund has produced a greater than 6
percent average annual return since it was launched in 1996.
While we feel that target date funds are an important and
valuable investment tool, we agree that improvements can be
made to help enhance investor understanding. The Investment
Company Institute earlier this year released a set of
principles aimed at improving the disclosure, communications,
and education around target date funds. Among the suggested
recommendations include the clear and concise disclosure of the
relevance of the target date when it is used in a fund name,
the funds' assumptions about the investor's withdrawal
intentions, the targeted age group and an explanation of the
funds' glide path. These disclosures can enhance understanding
by investors which will help assure that the funds are being
used appropriately, and we fully support those recommendations.
I thank you for the opportunity to address this important
topic, and I would be pleased to take your questions.
[The prepared statement of Mr. Derbyshire follows:]
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The Chairman. Thank you.
Mr. Smith.
STATEMENT OF MICHAEL CASE SMITH, SENIOR VICE PRESIDENT,
INSTITUTIONAL STRATEGIES, AVATAR ASSOCIATES, NEW YORK, NY
Mr. Smith. Good afternoon, Chairman Kohl, Ranking Member
Corker.
My name is Michael Case Smith and I am not a lawyer. I am a
target date fund manager. I am with Avatar Associates. Avatar
was founded in 1970.
We have target date funds to 401(k) plans and profit
sharing plans. Avatar willingly accepts and acknowledges it is
a fiduciary for the allocation of the variable fee funds that
we use to construct our target date funds. We can do this
because we have limited the ability to self-deal and the
conflicts of interest by constructing the target date funds
with exchange-traded funds with which we have no economic
interest. I will note that according to an article earlier this
week, about 2 percent of the target date funds follow that non-
conflicted model.
I have been asked today to talk about conflicts of interest
in target date funds, primarily proprietary target date funds.
These are mutual funds that are constructed with shares of
other mutual funds, typically mutual funds from the same
company. We believe, our clients believe that target date funds
allocated in this manner embed conflicts of interest. This is
because the fund company determines its own mix of mutual
funds. Since each underlying fund has its own fee structure,
controlling their allocation may directly or indirectly affect
the company's compensation.
Fund companies take the position that since target date
allocations occur within the mutual fund, ERISA laws against
self-dealing do not apply, and since ERISA does not apply, they
are not fiduciaries. Since they are not fiduciaries, they are
perfectly free to self-deal and put in their portfolio things
like new funds that do not have long track records that would
attract investment as a standalone option on the fund roster,
poor-performing funds that, again, perhaps would not attract
assets as a stand alone fund on a 401(k) roster or funds with a
higher fee structure such as equities compared to bonds.
But for the Department of Labor's interpretation that
shares of an underlying mutual fund do not constitute plan
assets, such self-dealing within a target date fund would
clearly constitute a prohibited transaction under ERISA. We do
not believe that the exemption was meant to apply to
proprietary asset allocation in mutual funds because such
investment structures either did not exist at the time of the
designing of ERISA or virtually unheard of, therefore certainly
not contemplated by Congress.
The committee is aware of Avatar's request to the
Department of Labor to answer a simple question: Should this
exemption to rules against self-dealing apply to target date
funds? If not, shares of the underlying proprietary funds and
the target date fund of funds will be seen as what they are
when they are offered as a stand alone option: plan assets
under ERISA. If they are found to be plan assets under ERISA,
fund companies would be prohibited from self-dealing and have
to put the interest of the participants and beneficiaries ahead
of their own. This is something many plan sponsors and
participants frankly would be surprised to learn that fund
companies are not required now to do when they select, monitor,
and allocate their own variable-fee funds.
ERISA section 3(21) and 401(b) provide that under most
scenarios assets underlying a mutual fund do not constitute
plan assets. But these provisions carried qualifications back
in 1974 such as ``shall not by itself'' or not ``solely by
reason of.'' The wording of these statutory provisions shows us
that the exception applicable to the underlying assets of a
mutual fund--that is, the underlying fund of funds--is not
absolute.
An interesting piece of legislative history shows that the
Department of Labor's ERISA exemption on this matter was
premised on the applicability of protections against self-
dealing, self-interested transactions that are part of the
Securities and Exchange Commission's Investment Company Act.
As Senator Long stated in a 1973 Committee on Finance
report--and I will quote--``Mutual funds are currently subject
to substantial restrictions on transactions with affiliated
persons under the Investment Company Act of 1940.'' This would
argue against the extension of the exemption to tiered asset
allocation of mutual funds from ERISA rules against self-
dealing.
Now is the perfect time for Congress to clarify that such
conflicts of interest are prohibited and in that way protect
plan participants and our Nation's private pension system. Once
this conflict is eliminated, target date funds that have
embedded conflicts of interest have a number of easy ways to
comply.
One way of doing so would be to simply adopt the
protections for the exemption of investment advice, one-on-one
advice, that Assistant Secretary Borzi spoke of that Congress
already passed in the Pension Protection Act. I am glad to hear
that she is looking to upgrade those protections and they will
be unbiased and affordable. In that example, an algorithm would
be used from a non-conflicted third party to review the in-
house glide path and allocations of the fund company.
Another way that a company can comply is turn over the
allocation to an independent third party, something I would
note that fund companies already do in their managed account
options under Sun America Advisory.
I would like to conclude by saying that Avatar's goal in
being here is to encourage and support a robust and equitable
target date market by having asset allocation determined in a
non-conflicted manner. Our goal to be here is to encourage
Congress to clarify what respectfully probably seems like
common sense to 435,000 plan sponsors and 70 million Americans:
Parties-in-interest should be prohibited from self-dealing in
target date funds.
Thank you for your time. I welcome any questions.
[The prepared statement of Mr. Smith follows:]
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The Chairman. Thank you, Mr. Smith.
Questions from the panel? Senator Corker.
Senator Corker. Thank you, Mr. Chairman. I appreciate the
courtesy of that, and I certainly appreciate all of your
testimony. I find this to be a pretty fascinating hearing.
I want to start by saying I hope that we will not get into
the mode of trying to legislate returns. My guess is one of the
main reasons we are having this hearing is we have had a
downturn in the market, and all of a sudden, people's
expectations were not met. I doubt many of the people on this
dias up here had their expectations met. I doubt many people in
the country did.
So I will just set the stage from my own point of view to
say that I realize that there have been lots of tragedies, lots
of disappointments, lots of people who reached retirement age
who have not met their expectations. Again, I do not think we
can legislate returns, and I am sure that is not what the
Department of Labor is hoping to do.
I would ask this question. Why would we not have as a
default investment something like Treasury bonds or something
like that and allow people to opt into more risky investments
down the road if they choose to do that? The Labor Department.
Ms. Borzi. Unfortunately, I was not around a couple of
years ago when the qualified default investment regulation was
passed, but I am sure that those kinds of safe investments were
considered as part of the default investment approach.
I think at the time people certainly thought that a target
date fund was a relatively easy way for a participant to be
able to get the diversification and not have to deal with the
constant rebalancing in asset----
Senator Corker. Well, that is what it is.
Ms. Borzi. But I think your point is very well taken.
Senator Corker. But it is that. Right?
Ms. Borzi. We are going to be looking back at the qualified
default investment alternative regulation in the context of
target date funds, and maybe that is an issue we need to look
at.
Senator Corker. I am not necessarily in any way saying that
is a good idea. I am just asking the question.
John?
Mr. Rekenthaler. Well, if I may, a few years back stable
value funds I believe, which were a form of a cash fund and a
more conservative investment, were the primary default--when
defaults were used. They came under quite a bit of academic
criticism from the academic community and others, the main
point being that people who were defaulted into 401(k) plans
through automatic enrollment plans tended not to move. They
tended to be inactive and inert, and therefore, they were stuck
in cash, the lowest-performing investment. Well, at least that
was the theory, that cash was the lowest-performing investment
a few years back.
I mean, the main concern was that people who were defaulted
into an overly conservative investment would miss participating
in a market growth over the years and would not make the change
because they tended to be the least active of investors. I
think target date funds were intended as a middle ground.
Senator Corker. Of course, that is what we have done with
Social Security. Right? We put people in the lowest-performing
asset for life.
But, Mr. Derbyshire, let me ask you this. There is a whole
lot being made of fees, and I am in some investments where we
pay huge fees. They happen to be, by the way, the greatest
returns also. I wonder if you would like to talk a little bit
about the focus on fees. In essence, should we not be looking
at the overall return of the portfolio in relation to other
investments? Is there some concern that if we focus only on
fees--I mean, the fact is you could have some very poor
performers, people who really do not do much work who charge a
very little fee, but in essence, their performance is not
particularly good. I wonder if you might enlighten us in that
regard.
Mr. Derbyshire. Well, I think at the end of the day,
obviously, performance net of fees is the single most important
criteria for evaluating whether a fund has performed well.
In looking at target date funds, I think what Morningstar
would tell you about fees is that there are some outliers, but
for the most part, the fees within target date funds are
actually well within the mainstream of mutual funds as a whole.
So I am not sure that there is a particular problem overall
with the level of fees in target date funds. After all, most of
these funds are themselves made up of other mutual funds that
have an existing fee structure in them. So I do not think for
most target date funds there is a special issue regarding fees.
Senator Corker. Do you have any idea how your portfolio has
performed as opposed to Mr. Smith's which just invests in
indexes? Has there been a marked difference? I mean, obviously,
Mr. Smith is touting--and by the way, I think it is a very good
point--not having a conflict of interest. Obviously, you think
your funds are the very best funds there are, and that is why
you invest in them. You all create them. Has there been a
marked difference in return between the two?
Mr. Derbyshire. I am not familiar with Mr. Smith's product
and its returns, so I really could not comment on that.
Senator Corker. But at the end of the day, I guess the
question is we are trying to--I worry a little bit about the
involvement that we are considering putting ourselves into here
as it relates to what we are going to be telling people to
invest in and not invest in. I understand the conflicts issue.
But again, at the end of the day, what we are hoping to happen
is that people will save and that they will invest in funds
that give them the greatest return. Sometimes that can be done
through the exchange route. Sometimes that is done
proprietarily. I hope that we will not over-involve ourselves.
Mr. Derbyshire. Well, I would just comment I think Mr.
Smith's remarks were mostly directed at the conflict of
interest issue as opposed to the aggregate, overall fee level.
I would be happy to speak to the conflict issue, if that is
your question.
Senator Corker. That would be great.
Mr. Derbyshire. Sure.
So the point that is being made essentially involves two
propositions. One is that because of the fee structure in these
funds, the fiduciaries that are managing these funds are going
to make different and worse investment decisions. In other
words, the managers will invest in higher-paying funds in order
to pay more revenue to themselves or to prop up an under-
performing fund with additional assets. The second proposition
is that we should use ERISA rules to regulate that conduct. I
would dispute both of those propositions.
The first one about the investment advisor's conduct, Mr.
Smith said the investment advisor is not a fiduciary. Well, he
is correct that it is not a fiduciary under ERISA, but it is a
fiduciary under the Investment Advisors Act. So that fiduciary
has to manage the fund in the best interests of the
shareholders, and it would be a clear breach of that duty to
invest in a fund solely to generate more revenue for the
advisor itself.
The second point I would make is that mutual funds, because
of the Investment Company Act of 1940, are regulated by a board
of directors and that board has to include independent
directors. In fact, in the case of Fidelity's Freedom Funds, 75
percent of the directors on the target date board are
independent. The board provides oversight over the activities
of the investment advisor, which is an additional protection.
In terms of the second proposition about using ERISA's
fiduciary rules to provide some layer of additional protection,
what I would say is it is not an accident of history that ERISA
was not imposed on mutual fund managers and the mutual fund
assets. It was a purposeful decision made by Congress in 1974,
and it was precisely for the reasons I cited, which is that
there are two securities laws enacted in the 1940's that were
specifically designed to govern mutual fund conduct. To
introduce ERISA into that framework would result in both
duplication and potential inconsistencies.
An important point here is that mutual funds include many
different investors. They are not all employee benefit plan
investors. What is the rationale for imposing ERISA, which is
an employee benefit plan statute, into an investment vehicle
that includes non-retirement plan investors?
So I think both of the propositions are false, and the
evidence I think bears out that these funds are not being used
in the way Mr. Smith would allege.
Senator Corker. Thank you, Mr. Chairman.
The Chairman. Thank you, Senator Corker.
Senator Bennet.
Senator Bennett. Thank you, Mr. Chairman.
Thank you very much, all of you, for your testimony. I was
watching it before I came over. I just wanted to ask a couple
of questions, one along the lines of Senator Corker's question
about these two funds.
Can somebody speak to the overall return in this downturn
that we had of target date funds versus other kinds of mutual
funds? I mean, was the performance the same, worse, better?
Mr. Rekenthaler. I guess that is my job.
Broadly speaking, target date funds performed as a somewhat
more aggressive version of balanced funds. So, in other words,
they performed somewhat better than pure stock funds,
definitely a lot worse than conservative, fixed-income
Treasury-type portfolios. The prototypical balanced fund is 60
percent stock, 65 percent stock. A lot of the target date funds
with the assets being in the longer-dated funds were a little
bit heavier in stock than that and did a little bit worse. Just
as an example, the stock market was down 37 percent, and I
think the typical target date fund was down in the upper 20's.
It depended upon age, the longer-dated funds. But they
certainly were mortal. No question about that.
Senator Bennett. Everything was.
Mr. Rekenthaler. Yes.
Senator Bennett. One of the things that just was so
striking to me when I was starting to have town hall meetings
in January and February and March is that everyone was deeply
concerned about where the economy was. I think the people most
concerned about it in my view actually were young folks coming
out of school who felt like they were going to be the last
people hired into this economy. They still continue to worry
about it. People in their 70's who had seen, in many cases,
half their net worth vanish at Dow 6500. It looks a little
better at 10,000.
I also agree with Senator Corker that we need to be very
careful about how we legislate these kinds of things. We cannot
legislate returns.
I was really struck, as I read some of the written
testimony and also heard some of the earlier testimony by
Chairwoman Schapiro about how huge the variation was in
balancing in these funds. I think some of the funds have 21
percent equities. Some have 79 percent equities, and then there
are a lot in between. If you were right on the cusp of your
retirement and free to choose, obviously, to have 100 percent
in equities, but if these funds are meant for retirement and
people are not moving in or moving out of them very much, it
just worried me to see that huge a distribution. I wonder if
anybody has got thoughts about that.
Mr. Rekenthaler. I would like to address that a little bit.
One is that the variation among the target date funds is really
pronounced in the near-dated funds near retirement. Actually
the longer-dated funds all look, broadly speaking, the same. A
2040 fund and a 2050 fund are pretty much--the 2040 funds range
from 80 percent stock to 95 percent stock. They are stock
funds. They tend to perform similarly. The 2010 funds are where
you have the range from 26 percent in equity on the low end to
72 percent in equity on the high end.
There really is not an investment consensus--and I would
say this is clearly an investment issue--among the fund
families as to how you should be positioned. If you emphasize,
as many do, that a 65-year-old married couple--you know, the
odds are that somebody is going to live 25 years or so more, at
least one party in the marriage--and you think about longevity
risk and protection against inflation and so forth, you
emphasize equities. There has been a whole lot of research done
on that in financial planning journals and everything else
saying that that is reasonable and sound and not--at least from
published and reasonable journals saying that this is a fair
approach. It is not somebody just inventing something.
On the other hand, there are those who take a more
conservative approach, concerned about market risk. A lot of it
depends upon the assumptions of the withdrawal rate of the
investor which we do not know what the withdrawal rate of the
investor is.
So there are a lot of assumptions built into this, and it
is tricky on the retirement age. I would say--I think we all
feel--that this is about the top of the first inning almost in
terms of thinking about how funds behave during retirement, and
if you are going to take somebody through retirement in a
target date fund or another kind of investment, how should that
be structured. We are much later in the game in that than we
are in the accumulation phase where there has been much more of
a consensus.
Senator Corker. Phyllis.
Ms. Borzi. I want to echo that, Senator. One of the things
that we are so concerned about at the Department of Labor is
that not only do participants not understand the choices in
front of them when they have target date funds, but oftentimes
it appears the fiduciaries do not understand, when they select
these funds, the variation.
Why is that? Well, I think in part it has to do with the
fact that many of the employers who choose a target date fund
as part of their investment platform do so because they think
they are doing the right thing for their employees. They
understand that one of the biggest mistakes that people make is
in allocation, and that it is the most difficult decision that
the participant has to make when faced with how to allocate his
or her own portfolio. So the target date fund is an attractive
option.
One of the things that we are trying to do--and we are
working with our colleagues at the SEC about this--is to try to
figure out how we can structure better disclosure so that
fiduciaries, particularly small- and medium-sized employers,
have the information that they need to make more intelligent
decisions. I have to commend my co-panelist from Fidelity. Many
of the mutual fund companies themselves have been working very
hard to try to focus on this disclosure issue. It is a concern
that we all have. Unfortunately, one of the other things that
we know is we can have the best disclosure in the world, but
that will not make people read it. So I do not know how we are
going to overcome that problem of participant understanding.
But our first job is to educate the fiduciary so that as
they select these funds, they are in a better position to be
able to evaluate the relative risks and rewards and then try to
help communicate these choices to the actual participants.
Senator Bennett. Do you have a view?
Mr. Derbyshire. Well, Ms. Borzi actually picked up on what
I was going to say, which is that even if we cannot educate all
the participants, we can certainly educate fiduciaries around
the assumptions that go into building a target date fund.
As Mr. Rekenthaler mentioned, I think the most critical
assumption around these near-retirement date funds is the
withdrawal assumption that goes into the funds. That probably
accounts for most of the variation in the asset allocation.
Part of the ICI's recommendations are to make sure that that
information is available to both plan sponsors and participants
so they can make an appropriate decision around the funds.
Senator Bennett. Thank you. Thanks to the panel and thank
you, Mr. Chairman, for holding this hearing.
The Chairman. Thank you, Senator Bennet.
Ms. Borzi, some have suggested that the regulations be
changed to require the investment manager of target date funds
to assume fiduciary responsibility in order to qualify as a
default investment. Do you think this is a good idea? Can it be
done within the Department or we must we do it legislatively?
Ms. Borzi. If you are specifically asking about the
question that Mr. Smith raised as to whether or not the mutual
funds need to take fiduciary responsibility for how they
structure the underlying investment option, I think that is a
difficult question to answer. As he pointed out and as Mr.
Derbyshire pointed out, we are constrained by the statute. What
we regulate is conflicts of interest and issues related to the
fiduciaries, not the underlying investment asset. I know that a
number of witnesses at our hearing suggested that we need to
look into this question and maybe make some changes.
I would just be cautious about this. I am not ruling it out
or ruling it in. I am just saying at this point I think it is a
little too early to make that decision. I think it has
ramifications. It does involve our colleagues at the SEC who
typically regulate the mutual fund itself. We regulate the
fiduciaries. But I think that there are a lot of short-and
long-term effects that have to be evaluated in order for me to
answer that in a straightforward manner.
The Chairman. OK.
Mr. Smith. If I may?
The Chairman. Yes, sir, Mr. Smith.
Mr. Smith. Mr. Derbyshire laid out an argument that as long
as we are doing the allocation of shares that are recognized as
plan assets, it is perfectly OK. It sort of begs two questions.
No. 1, the fiduciary relief he points to was exactly the
loophole I was speaking of, pointing to another area of
fiduciary relief. The question it begs is, if it is perfectly
OK to do it within the life cycle fund, why did they not do it
for the previous 25 years when those shares of their mutual
funds, which are plan assets, were standing alone on the
investment roster? Did they not because it is against the rules
for a party-in-interest to self-deal and take discretion over
participant assets and skew them to portfolios of which they
receive variable fees.
But if it is the case, I would challenge Assistant
Secretary Borzi. What is the point of upgrading the investment
advice rules under the Pension Protection Act if those are
meant to remove conflicts of interest from somebody giving
advice to a participant in a one-on-one setting? Do not bother
if it is OK in an embedded mutual fund. But those are two very
different things.
Ms. Borzi. They are two very different things. The point of
the investment advice rule is to be sure that people get
accurate, straightforward advice regarding their investment
choices. Again, part of the problem here is that we have a
statutory provision. Our regulation is supposed to be
consistent with the statutory provision.
As you probably know, this issue, the issue of what kind of
investment advice could be given, was the last issue that
Congress addressed in the context of its discussion of the
Pension Protection Act. There was a fundamental policy
disagreement as to whether or not any form of conflicted advice
was permissible or whether there were sufficient safeguards
that could be crafted so that in a potential conflict-of-
interest situation, participants can be protected.
Unfortunately for the point of view that you are
expressing, Congress made a different policy choice, and the
policy choice Congress made was to craft an exemption from
ERISA that allowed, under certain narrow circumstances, advice
to be given by an entity that was already a service provider
with respect to a plan. The reason that we are rethinking the
investment advice regulation is because we want it to be much
closer to the intent expressed by Congress to make sure that
the safeguards are there.
As I pointed out a minute ago, the underlying statutory
authority for the Department is pretty clear. I think the
statute is clear that we have the ability to regulate the
fiduciaries but that we do not have the ability to regulate the
mutual funds in creating these investment options.
Congress could, of course, as the chairman pointed out
before, always change the law, and all I am suggesting is I
think that there are a lot of things you need to think about
before we move forward in that direction.
Mr. Smith. My only point, and the last one, is the
statutory language gives what we will call wiggle room, and
they use words like ``not solely of'' and what have you.
Ms. Borzi. My lawyers disagree. While I am a lawyer myself,
the one thing I learned in private law practice is that clients
are better off listening to their lawyers than going off on
their own. So that is the legal advice I am getting from my
lawyer.
Mr. Smith. Fair enough. But on the one-on-one advice side,
you pulled it from the previous administration. Let us assume
it was to make it a higher level of safety for the plan
sponsor. The words you use, Assistant Secretary, were
``unbiased,'' and that is all we are asking. That is all we are
saying. If it is unbiased in one-on-one advice, it should be
unbiased in the mutual fund----
Ms. Borzi. I am using ``unbiased'' in the context of the
statutory provision that we are charged with interpreting.
The Chairman. Mr. Donohue.
Mr. Donohue. I hesitate to jump in here but I will.
I just would like to make the point that for investment
companies, it is a comprehensive regulatory regime, that
independent directors in particular put in place to help
oversee conflicts that exist that advisors have in any number
of areas, and this may be one. So boards have responsibilities.
Investment advisors are fiduciaries to the fund. Board of
directors are fiduciaries. They have responsibilities not just
to the fund but also to the fund shareholders which would
include investors and do include all investors into those
funds.
Among other things that the board will wind up approving,
the board will wind up approving the overall fees that are
being received by the manager for what they are performing.
They have obligations to do that under section 15. The manager
has obligations to provide to the board all information that
has been requested or is relevant to that determination of
whether or not the fees are appropriate. Then there are
remedies available under 36(b) for either the SEC or individual
investors to sue where they think that the fees may be
inappropriate.
So if the concern is that there may be conflicts in terms
of moving assets into certain underlying funds because of
higher fees, there is a regulatory regime that is in place that
should be overseeing that and should be doing that effectively.
So I think that is one aspect of it.
The second thing is having been set up as fund of funds,
these funds hopefully are taking advantage of economies of
scale that are occurring at the underlying funds. You could set
up a target date fund where you invest directly in the
underlying assets without going through another fund, and doing
that in that manner would not raise any of the concerns that
were raised by Mr. Smith because that is what mutual funds do.
So in doing that, the statutory regime for fund of funds
actually has a preference for in-house funds because of some of
the conflicts that arose prior to 1940 where funds were
investing in unaffiliated funds and could put a certain amount
of pressure on the non-affiliated funds to do certain things
for them. So there is a preference that is built into the
statute, into the regulation for investing in underlying funds
in excess of what would have been permitted otherwise under the
1940 act.
So without getting into the issues relating to the
application of ERISA, which I am not an expert in, I would say
that I do think there is a comprehensive scheme that is in
place.
The Chairman. Thank you.
Senator Corker.
Senator Corker. Yes, sir, thank you. I think Mr. Derbyshire
wanted to respond to your question.
Mr. Derbyshire. Well, I just wanted to add one final point
about the overall notion that there is somehow a deep conflict
in Fidelity or some other provider choosing its own funds, and
that is the fact that when an investor chooses a Fidelity
target date fund, they are asking us to manage their assets for
them. It would almost be contrary to common sense to say,
``Well, we should be required to invest in someone else's
funds.'' As Mr. Donohue noted, we could manage these funds as a
total pool of assets without having a fund of funds structure,
and if they have asked us to do that, it should be OK for us to
invest in our underlying funds if that in fact results in
economies of scale and better investment results for the
participants.
Senator Corker. Just to follow on that thinking, I suppose
that--and I know this is not something that we in essence
regulate, but you potentially feel a greater obligation to the
people investing to ensure that your funds perform than you
would if you were just getting a fee, if you will, for putting
it in a fund you were unrelated to. I would assume that would
be the case.
Mr. Derbyshire. Yes, well, I think that would be fair. We
want to understand what we are buying and what we are investing
in and we certainly would know more about our own funds than we
would about anyone else's.
Senator Corker. Then if you want to give a counter point,
Mr. Smith.
Mr. Smith. I do. Here is what the industry has done on this
point. They have said let us disclose this. The problem is we
deal with small business owners and small businesses. Small
businesses do not do a 401(k) plan based on the life cycle
fund. They do it on the platform and the services and what have
you. So the question for the small business owner is, if I do
what the industry tells me to do, and I do my evaluation, and I
say specifically, if I may, I am in a Fidelity plan and I say I
want to fund X life cycle fund, I frankly do not have the
choice. So we talk a lot about all the options out there, but
when I am employee at a small business, which represents the
vast number of the 401(k) plans out there, I do not have choice
on my platform. Right?
Mr. Derbyshire. I would say that we are an open-
architecture shop where we will allow people to put whatever
investments we can administratively operate on our platform.
There may be economic consequences to that because, of course,
we rely on the revenue from our funds to run our business. But
we are an open shop and if plan aduciaries want to put
different assets on our platform, we will do that if we can
accommodate them.
Senator Corker. Go ahead, John.
Mr. Rekenthaler. If I may speak to this without touching on
any of the legal issues, if that is possible, because I am
apparently the only non-lawyer here or there is a well-versed
non-lawyer there. But I am definitely not a well-versed non-
lawyer.
I guess our view--and I discussed these proprietary funds.
Just step back and looking from a high level is that when
401(k) plans began, they tended to be so-called closed
architecture where the organization, the record keeper would
bring in only its own funds, and the large plans fought against
this and made them be open and unbundled. Those same large
plans now are--you know, it is quite in vogue to create so-
called custom target date funds where target date funds at a
large plan are constructed for a low cost using a variety of
funds from a variety of providers in an open-architecture
setting.
So my view is large plans have generally led the way
because they are large institutions that are well informed and
have buying power and they have pushed for open architecture
and they have pushed for low costs. It seems to me that is
where the target date industry overall needs to be doing and
not just for employees in large plans but for employees in
companies across the country of all sizes.
Senator Corker. A response, Mr. Derbyshire?
Mr. Derbyshire. Well, I would certainly agree that large
plans have led the way, and I think that is normally the case
in most developments. There is nothing different about target
date funds in this vein. Large plans have, obviously, more
economic power to negotiate the deals that they want and they
are very, very demanding at every level. What I would say is
that the entire 401(k) industry, small and large employers as
well, benefit from those developments. So the extent that these
large employers are negotiating better arrangements for target
date funds in their plans, those get extended to the rest of
the market as well. It takes time but I think everyone
benefits.
Senator Corker. So, Mr. Chairman, I am going to be 100
percent honest and say that I do not know that I understand all
the arcane issues of ERISA. I know our staff and I are going to
talk more fully about this after the hearing.
I think this has been, though, really enlightening, and it
seems to me that what Labor has said is that we need to make
sure that employers are far more educating employees. I
absolutely agree. I know, having been an employer, making these
decisions is excruciating, and you want to make sure that your
employees 20 years later who have invested in these funds and
you have invested funds for them have a retirement. I think
there is a tremendous lack of education in that regard. I know
that we had seminars each year to sort of let our employees
know. But that needs to happen. It needs to happen a lot more.
I applaud your efforts in trying to make sure that that occurs.
I think from the standpoint of employers, I think some of
them may decide to go with the funds that they feel like have
no conflicts and they may, on the other hand, decide to go with
funds that they just have faith in because of a track record.
At the end of the day, you want to make sure that those returns
are there.
I think the other issue I would take from this or the other
point is this target date fund--making sure people understand
what that means. If they plan to withdraw all of the money when
they are 65, that means one thing, and if they plan to live off
of it, they hope they have good genes and they are going to be
around for another 20 years after that, that means something
totally different. It seems to me that that is another piece.
Obviously, the strategies vary widely in that case when you
have to go on another generation versus ending at a date.
So I think this has been a great hearing, Mr. Chairman. I
appreciate you raising this issue. I hope, on the other hand,
we do not overreact to a tremendous downturn in the market and
try to do some things that over time might hurt the very people
that we would all like to see retire with greater savings in
hand.
So thank you all for your testimony, and I think each of
you have provided a lot of information.
The Chairman. Thank you, Senator Corker.
Senator LeMieux.
Senator LeMieux. Mr. Chairman, I apologize for being a
little delayed. I was at another committee meeting. I do not
have a lot to add because I, unfortunately, did not get to hear
the presentations.
But certainly the 401(k) programs are tremendously
important for the people of this country, and as Senator Corker
just said, a lot of downturn in the economy has caused a lot of
consternation among people who were about to retire
specifically, people who were a few years away and thought that
they were on a specific path and may not have had the
information they needed to make sure that they were investing
in more stable investments as they got to the end of their
retirement.
So I have read over the materials and the information about
transparency and making sure there is enough information for
people who are in these plans. Like Senator Corker, I too was
an employer prior to coming to the Senate in charge of a law
firm where we had about 300 employees, and these programs are
tremendously important. We did our best every year to try to
give information to all the folks so that they knew that they
had in their options and knew the different plans. It is very
difficult for the average employee, no matter how well
educated, to go through these issues. They are very cumbersome.
Usually someone comes into your board room and says, OK, here
are three plans. This one does this. This one does that. You
kind of check a box and maybe you go with it.
So I just appreciate the chairman for having this meeting.
I hope to listen and learn more about it. I thank all the
witnesses for their testimony.
The Chairman. Thank you very much. This has been a great
hearing on a very important topic. Your coming here to bring
your experience and your perspective has made this very
informative. Thank you very much.
[Whereupon, at 3:20 p.m., the hearing was adjourned.]
A P P E N D I X
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