Target-date fund fee decline likely to continue

Target-date fund fees have been declining year by year and basis point by basis point, and more cuts seem likely.

A proliferation of fund offerings, increased competition among providers and a greater willingness by defined contribution plan executives to shop around are some of the reasons behind the fee reductions.

Also aiding the downward trend are strategic changes, such as moves by DC plans — especially the largest ones — to collective investment trusts, separate accounts and customized funds. Plan officials also are looking to index-based target-date funds, whose fees typically are lower than actively managed funds, to cut costs.

And, experts say, target-date fund fees could be lower in the future if plans reduce their use of revenue sharing. In addition, fees could be reduced as plans demand more choices other than those offered by record keepers with closed architecture.

In addition, two sets of fee disclosure regulations expected from the Labor Department could play a role in stimulating sponsors' fee-reduction zeal.

“If there ever was a time when plan sponsors are fee-sensitive, the time is now,” said Ryan Alfred, president of BrightScope Inc., a San Diego firm that rates 401(k) plans and 403(b) plans. In a recent study of institutional share classes among target-date fund families, BrightScope said the average fee in 2011 was 0.75%, down from 0.8% in 2008 when his firm conducted a similar review.

“There's room for some more downward pressure, but I don't think we'll see as aggressive cutting (in the future),” said Joshua Charlson, senior mutual fund analyst at Chicago-based Morningstar Inc. “We'll see some reductions, but we won't see the magnitude of the last five years in (the fee cuts of) the next five years.”

Average expense ratios for open-end, target-date mutual funds have been dropping since 2006, according to Morningstar's review of 38 target-date fund families. At year-end 2006, the average net expense ratio was 1.29%. By Sept. 30 of this year, the average was 1.12%.

Overall, target-date fund fees likely are lower than those calculated by BrightScope and Morningstar. Both use prospectuses as the source for their analyses, but both exclude collective trusts, separate accounts and custom funds.

Some of the future fee pressure will be based on the growing role of target-date funds.

A recent survey by the Plan Sponsor Council of America, Chicago, found that 13% of DC plan assets were invested in target-date funds in 2011, up from 2.6% in 2006. The percentage of plans offering target-date funds was 63.6% this year vs. 33.4% in 2006.

A recent report from Casey Quirk & Associates LLC, Darien, Conn., predicted target-date funds would account for 48% of all U.S. defined contribution assets by 2020compared to the 12.5% they represented in 2010.

Target-date funds got a huge boost from the Pension Protection Act of 2006, which designated them as a qualified default investment alternative. An analysis by investment consultant NEPC, Cambridge, Mass., found more than half of the target-date fund series available in 2010 were created in 2006 or later.

Pressure on fees has been spurred by more DC plan executives considering the use of custom target-date funds, passive target-date funds and non-mutual fund vehicles, said Ross Bremen, an NEPC partner.

Another source of fee pressure is efforts by plan officials to choose target-date funds that aren't proprietary to their record keepers. “The migration from proprietary products has been gradual as plan sponsors focus on providing the most appropriate QDIA,” Mr. Bremen said.

An NEPC survey earlier this year of approximately 100 clients found that half offer non-proprietary target-date funds.

“In an era when market returns were high, they (sponsors) didn't care if the fee was 80 basis points or 120 basis points,” said Mendel Melzer, chief investment officer of The Newport Group, Heathrow, Fla., a retirement services and asset management firm. “We're in a lower return environment where there's a greater focus on expenses in 401(k) plans in general and target-date funds in particular.”

Pamela Hess, director of retirement research at Aon Hewitt, Lincolnshire, Ill., agreed, saying: “Overall, sponsors are paying more attention to fees.

“Target-date funds are hard to benchmark, but target-date fees are the one thing they can benchmark.”

As a result, service providers have become more fee-sensitive. “Competition is fierce (among providers) because everyone wants those assets,” Ms. Hess said. “This is the future of defined contribution assets.”

Ms. Hess said she had seen a slowly evolving trend toward open architecture affecting both core funds and target-date funds, adding that a continuation of this trend could put pressure on fees.

“Previously, bundled providers often required the target-date funds to be proprietary,” she explained. “As employers demand more flexibility, and fees are less tied to plan assets, employers can increasingly leverage a broad array of target-date portfolios. And fees play a large role in fund selection.”

Lori Lucas, executive vice president and DC practice leader for Callan Associates Inc., San Francisco, said fee pressure has resulted from shifts to institutional share classes, collective trusts and passively managed funds.

“If a client likes a target date series, but doesn't like the price of the institutional share class, they may ask if there is a collective trust version,” Ms. Lucas said. “Custom target date funds are another way to possibly get to a lower cost target-date fund series.”

She forecasts a “slight” downward trend in fees for the future. She noted some trends — such as the adoption of more alternative investment components within a target-date fund lineup — could add to expenses, or at least reduce the overall rate in the decline of fees.

But Ms. Lucas added: “If there is a strong trend away from revenue sharing, there could be a significant downward trend.” She said revenue sharing — in which all or most of a record keeper's costs for providing services are offset by a plan's investments — can add as much as 35 basis points to target-date fund expenses.

Plus, the Labor Department's forthcoming disclosure regulation could pressure providers to cut fees.

Newport Group's Mr. Melzer predicted the DOL regulations governing fee disclosure from sponsors to participants, which take effect next May, could lead to a “populist movement” among participants who will question the fees and especially the use of revenue sharing.

Ms. Lucas doubted the sponsor-participant rules will have much effect on fees. But she added that the pending rules on fee disclosure between providers and sponsors might have a stronger impact. “Sponsors will be armed with more knowledge and information,” said Ms. Lucas. The DOL hasn't issued the final regulations yet, but it has said the rules will take effect in April.

Expense ratios for individual target-date fund families still vary widely, according to a Morningstar report in April that analyzed target-date funds using an asset-weighted expense ratio. Based on 2010 data, the report showed the Vanguard Target Retirement series had the lowest expense ratio — 0.18% — while the Oppenheimer LifeCycle series had the highest — 1.68%.