Oct. 28 (Bloomberg) -- Target-date mutual funds suffer from high fees, limited choices and potential conflicts of interest, a Senate committee was told today.

Employers who offer workers the funds as part of their 401(k)s retirement plans typically can’t choose the investment mix, according to a staff report delivered to the Senate Special Committee on Aging at a Washington hearing. Companies often are limited to the administrator’s own mutual-fund offerings, the report said.

“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,” said Senator Herb Kohl, a Wisconsin Democrat and the panel’s chairman, at the hearing. “It seems the more we learn, the more concerns we have.”

Target-date funds, also known as lifecycle funds, move money from riskier investments such as stocks to more conservative alternatives like bonds as an investor approaches retirement. Contributions have grown 98 percent since they were endorsed as a default option for employers by the 2006 Pension Protection Act, according to Morningstar Inc.

“Participants often do not maintain their assets in their target-date fund throughout their retirement,” the committee report said. “Therefore, participants -- especially those who are less sophisticated and defaulted into these funds -- may lock in large losses.”

Big Losses

Target-date funds labeled 2000 to 2010 lost an average 23 percent last year with some dropping as much as 41 percent, according to data compiled by Morningstar, the Chicago-based mutual-fund research company. The average 2050 fund declined 39 percent in 2008, while the Standard & Poor’s 500 Index fell 38 percent.

“Most of us are concerned about a calamity coming down the pike of people not saving enough for retirement,” said Senator Bob Corker, a Tennessee Republican, at the hearing. “I hope we won’t overreact to a tremendous downturn in the market.”

More than $140 billion has flowed into target-date funds since 2007, and 96 percent of employers that offer automatic enrollment use them, the Senate report said.

Eighty-five percent of target-date funds are structured as funds-of-funds that invest primarily in affiliated funds, according to Strategic Insight, a New York-based research firm.

Choice is limited for employers selecting a target-date fund, said Laura Pavlenko Lutton, editorial director in Morningstar’s mutual-fund research group. The fund firms tend to use only their own proprietary funds rather than better- performing investments from competitors, she said.

Fiduciary Responsibility

Mutual-fund companies that include proprietary funds in their target-date offerings may be putting employers at risk of violating their fiduciary responsibilities, said Michael Case Smith, senior vice president and target-date fund manager of Avatar Associates, a New York-based investment management firm, whose research is cited in the Senate report.

“Parties of interest should be prohibited from self- dealing in target-date funds,” said Smith at the hearing. “We believe many target-date funds have embedded conflicts of interest.”

Firms should be required to use a third party when allocating assets in their target-date offerings or be restricted from having an economic stake in the funds they choose, Smith said.

There’s no incentive for managers to use underperforming funds, said Mary Podesta, senior counsel for pension regulation at the Investment Company Institute, a Washington-based trade group representing the mutual-fund industry.

Easy Access

“Target-date fund managers using their proprietary funds have the benefit of knowing the investment policies of these funds, as well as easy access to their portfolio managers,” keeping costs down, Podesta said.

An executive from Fidelity Investments, which manages 47 target-date funds with more than $93 billion under management, said the company supports rules that would require “clear and concise disclosure” about the relevance of the target date in a fund’s name and the fund’s investment assumptions.

“These funds are judged on their performance,” Ralph Derbyshire, senior vice president and deputy general counsel for Fidelity, said in an interview after the hearing. “It’s in the interest of the adviser to make the best choices.”

Target-date fund fees may be limiting investment gains, the Senate Aging Committee found. A 45-year-old who changes employers and leaves $20,000 in his 401(k) would have $70,500 at retirement, assuming 7 percent in annual returns and 0.5 percent in fees. The same employee would have $58,400 if he paid 1.5 percent in fees, a 17 percent difference, the panel said.

Fee Disclosure

“It is vital that action be taken to ensure that the fees associated with certain target-date funds are disclosed,” the committee report said. Fees for target-date funds range from 0.19 percent to 1.82 percent, Morningstar said in a September report.

The so-called glide path, which determines when and how quickly the fund shifts from equities into fixed income, varies from fund to fund. Morningstar, in its September report, said it found stock allocations among target-date 2010 funds ranged from 26 percent to 72 percent of assets. The public doesn’t seem to understand the difference among funds with the same target date, the Senate report said. Participants may believe their fund has moved money into the most conservative options at retirement.

The Department of Labor is considering restrictions on target-date funds, Phyllis Borzi, an assistant labor secretary, said in an interview after the hearing. The department isn’t inclined to regulate fund structure, she said.

“There’s no question in my mind that we need to look at the disclosure issue,” Borzi said.

Expense Ratios

The high concentration of stocks in target-date funds can be explained partly because mutual-fund companies make more money through higher expense ratios in those funds, said Chris Tobe, a senior consultant with BCAP in Louisville, Kentucky, who is a trustee for the $12 billion Kentucky Retirement Systems.

“Fees are really at the heart of it,” Tobe said. “Any time you have a bundled product, you have an inherent conflict of interest.”

In 2008, 49.8 million American workers participated in 401(k) plans with assets totaling $2.3 trillion, according to the Employee Benefit Research Institute and the Investment Company Institute, who together maintain a database of 24 million participants. Three-quarters of 401(k) plans in 2008 included a target-date fund, when they attracted $41.8 billion, according to the two groups.

To contact the reporters on this story: Jeff Plungis in Washington at jplungis@bloomberg.net; Margaret Collins in New York at mcollins45@bloomberg.net.

Last Updated: October 28, 2009 17:10 EDT