A Game-Changer for Government Retirement Markets?

The next-gen target-date funds for 457 plans have lower fees and consistent returns.
August 20, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  Finance Columnist
The finance columnist for Governing.

One of the nation's largest mutual fund companies has pre-announced a new product line that could shake up the governmental 457 and 403(b) deferred compensation markets: a series of "target-date" index funds. The original TD funds were all actively managed at relatively high fees and carried the risk that portfolio managers would underperform the index, as many have The new funds use index funds only and often have much lower fees and more predictable performance.

Although this is not the first company to offer such products, this 401(k) industry leader's entry could be a game-changer in that marketplace, so it's worth paying attention.

I first wrote about target-date funds two years ago in one of my earliest columns. TD funds are designed and managed to provide an age-appropriate asset allocation for investors who want a single fund that aligns well with the date they have targeted for retirement. The idea is to make it simple and to reduce the risks of investing in stocks as the worker ages and nears retirement. That was before the market crashed in 2007-09, and the industry discovered that many of the target date funds were too aggressively invested for many older workers who couldn't afford the losses they suffered in the bear market. Even now, with stocks rallying 50 percent since the March 2009 bottom, most holders of target-date funds are still underwater. As a result, the industry and the SEC are taking a hard second look at the asset allocations for investors near or in retirement.

Fortunately for most public workers, their 457 and 403(b) plans are supplemental savings, and their primary retirement benefits are pensions that guarantee a fixed income for life. These lucky folks have thus sidestepped the grave market losses that private-sector employees have suffered with their 401(k) plans.

What's notable about the new index-fund approach is that fees could be set at a relatively low level. After all, index funds simply hold a basket of securities that match the broader market indexes, and their managers don't try to outwit the markets. Thus, their performance is more predictable. There is no "mis-management" risk of a portfolio manager zigging when she should have zagged, and producing lower returns than a computer-assisted MBA can achieve with a pure index fund. This should appeal to risk-conscious and fee-conscious public employees -- and especially to their plan sponsors and oversight committees.

Yet to be seen is how the new market entrants structure their fees, and whether they will include a share class priced to provide compensation for recordkeepers who rely on a piece of the fee revenue to pay for participant education, sending out statements and the telephone and internet systems that support 457 and 403(b) plans. Low fees can sometimes mean low service: One fund family offers stripped-down no-frills index TD funds for 21 basis points -- that is, 0.21 percent of assets annually, but there is no compensation for recordkeepers. The dilemma here is that a low-fee index fund with no compensation for recordkeepers is a cheap deal for individual plan participants, but the costs of running and servicing the employer's plan are thereby shifted to other funds or other investors who thus subsidize the index fund investors.

Most plan administrators (recordkeepers) like to insert their own proprietary TD funds into the plan's investment menu, because they collect higher fees from actively-managed funds with high fee ratios. Often, this takes the annual cost of the fund to the level of 1 percent of assets (100 'basis points,' as it's called in the trade). For a pure index target-date fund with no "revenue sharing" for recordkeepers, the fees could easily be cut to a quarter of that. Even with a compensation provision for recordkeepers, the index funds should cut fees to half of the actively managed products'.

As these new products begin to infiltrate the public sector retirement world, plan sponsors will be well advised to revisit their investment menus. Many mutual funds have disappointed their investors in the past five years. This might be the right time to engage an independent expert to take a comprehensive look at the overall plan, weed out underperforming funds, seek lower fees and lower performance risks, and make things as easy as possible for nervous employees who are still terrified by the stock market. It's noteworthy that investors in target-date funds were among the few who actually increased their investments in stocks at the market bottom in March, as noted in my companion column this week.

Girard Miller's general market observations and institutional investment strategies are his own and not those of affiliated organizations, and should not be construed as investment advice or recommendations concerning specific securities.

Girard Miller
Girard Miller | Finance Columnist | millergirard@yahoo.com