[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? 

=======================================================================

                                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

                              ----------                              
                                                                   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?

                              ----------                              


                      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:]

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
    
    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:]

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
    
    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:]

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
    
    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.]















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