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Agency Problems in Target-Date Funds
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Sandhya, Vallapuzha, "Agency Problems in Target-Date Funds." Dissertation, Georgia State University, 2012.
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Vallapuzha Sandhya i
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The author of this dissertation is:
Vallapuzha Sandhya Department of Finance Georgia State University 35, Broad Street, Suite 1229 Atlanta, GA 30303-3083
The director of this dissertation is:
Dr. Vikas Agarwal Department of Finance Georgia State University 35, Broad Street, Suite 1207 Atlanta, GA 30303-3083 ii
AGENCY PROBLEMS IN TARGET-DATE FUNDSBY
VALLAPUZHA VAIDYANATHAN SANDHYAA Dissertation Submitted in Partial Fulﬁllment of the Requirements for the Degree Of Doctor of Philosophy In the Robinson College of Business Of Georgia State University
GEORGIA STATE UNIVERSITYROBI
This dissertation was prepared under the direction of the Vallapuzha Vaidyanathan Sandhya’s Dissertation Committee. It has been approved and accepted by all members of that committee, and it has been accepted in partial fulﬁllment of the requirements for the degree of Doctoral of Philosophy in Business Administration in the J. Mack Robinson College of Business of Georgia State University.
I thank Vikas Agarwal, Jonathan Berk, Douglas Blackburn, Michael Brennan, Conrad Ciccotello, Gerry Gay, Lixin Huang, Narasimhan Jegadeesh, Jayant Kale, Omesh Kini, Yee Cheng Loon, Brigitte Madrian, Reza Mahani, Pedro Matos, Olivia Mitchell, David Musto, Theo Nijman, Andy Puckett, Chip (Harley) Ryan, Vijay Singal, Laura Starks, Paula Tkac, Isabel Tkatch, Marno Verbeek, Luis Viceira and the seminar participants at Georgia State University, University of Tennessee, Chicago Quantitative Alliance Annual Fall Conference, NETSPAR International Pension Workshop, and FMA Doctoral Consortium at New York for helpful discussions and comments. I am grateful for generous ﬁnancial support from NETSPAR (an independent network for research on pensions, aging and retirement in the Netherlands) and CEAR (a research center for economic analysis of risk promoted by Robinson College of Business in partnership with Andrew Young School of Policy Studies and Federal Reserve Bank of Atlanta). All errors are mine.
Committee Chair: Dr.Vikas Agarwal Major Academic Unit: Department of Finance Target-Date Funds (TDFs) facilitate retirement planning by varying asset allocation over time with the goal of reducing portfolio risk. We explore potential agency problems in TDFs by examining their return performance and ﬂow-performance relation. We ﬁnd that TDFs under-perform balanced funds (BFs) which are also approved as a default option along with TDFs in 401(k) plans with automatic enrollment. We show that the under-performance is driven by TDFs that have a fund-of-fund structure and constituent funds with high expense ratios or poor performance within the fund family. Additionally, we discover an absence of ﬂow-performance relation in TDFs while BFs exhibit the convex ﬂow-performance relation shown for mutual funds. Our evidence suggests the presence of agency problems in TDFs arising from investor inertia, weak incentives for fund managers to outperform peers, and opportunities for fund families to gain private beneﬁts.
“Of all the issues that the SEC is examining at the moment, our review of target date funds is one that may most directly aﬀect everyday Americans... ”
Target-Date Funds (TDFs) are popular retirement investment vehicles that follow a predetermined schedule for rebalancing their mix of equity and ﬁxed-income securities over time. Pension Protection Act (PPA) of 2006 resulted in widespread adoption of TDFs as the default option in 401(k) plans with automatic enrollment.1 This paper provides evidence of agency problems in TDFs that arise when economic agents are not properly incentivized or when agents face conﬂicts of interest while executing their duties to principals. Provision of incentives in the case of mutual funds can be in the form of greater (lower) ﬂows following good (poor) performance while conﬂicts of interest manifests through self-dealing. Our ﬁndings raise questions regarding the suitability of TDFs as a default option in 401(k) plans.
In the ﬁrst part of the paper focusing on incentives facing the TDFs, we study the ﬂowperformance relation and ﬁnd that ﬂows do not respond to past performance suggesting 1 Among plans with automatic enrollment, 87% administered by Vanguard and 96% by Fidelity used TDFs as the default instrument in 2008. See GAO report to Chairman, Special Committee on Aging, U.S.
Senate, at http://www.gao.gov/new.items/d1031.pdf that retirement plan participants neither reward nor punish TDFs.2 This, in turn, seems to indicate lack of incentives for TDFs to provide superior performance for their investors. In contrast to TDFs, balanced funds (BFs), which are also approved but are not as widely used as default option in 401(k) plans, exhibit convex ﬂow-performance relation indicating that its investors chase performance. The test of relative performance shows that TDFs trail BFs by 48 (86) basis points annually based on risk-adjusted net-of-fee (gross-of-fee) performance.
In the second part of the paper, we examine diﬀerent subgroups within TDFs to show that the subgroup with the greatest scope for conﬂicts of interest under-performs the rest.
TDFs structured as Single Funds (SF) invest directly in stocks and bonds while those with the fund-of-fund (FOF) structure either invest in other mutual funds within the same fund family (Internal FOF) or in funds outside the family (External FOF). Of the three structures, Internal FOFs are likely to have the greatest potential for conﬂicts of interest. In particular, they may choose to include funds with high expense ratios to increase revenues to the family.
Alternately, they may include funds with poor performance and/or low ﬂows to sustain funds that may be less marketable. Why would plan sponsors who have the ﬁduciary responsibility allow this? A possible explanation stems from their own conﬂicts of interest due to a desire to secure votes in favor of management on shareholder proposals and the prospect to overweight securities of the ﬁrm in institutional portfolios (e.g., Davis and Kim, 2007;
Cohen and Schmidt, 2009). In this study, we do not attempt to distinguish between the roles played by the plan sponsor and the fund family. Thus, TDFs with the Internal FOF 2 Plan participants’ failure to punish poor performance is consistent with the evidence shown in prior studies that suggest inertia among retirement investors in changing the asset allocation of their 401(k) plans (e.g., Madrian and Shea, 2001; Agnew, Balduzzi, and Sunden, 2003; Mitchell, Mottola, Utkus, and Yamaguchi, 2006; Choi, Laibson, Madrian, and Metrick, 2006; Benartzi and Thaler, 2007). In addition, Gruber (1996) suggests that pension plan participants that are restricted by their plans may not move money out of funds that perform poorly.
relation. We investigate the relative performance of the three sub-categories of TDFs and ﬁnd that the Internal FOFs under-perform SFs by 58 (132) basis points and External FOFs by 55 (63) basis points based on risk-adjusted net-of-fee (gross-of-fee) performance. In contrast, External FOFs perform at par with the SFs.
In the third part, we provide further evidence suggestive of the channels for the manifestation of agency problems using the holdings of TDFs with the FOF structure obtained from the N-Q, N-CSR, and N-CSRS ﬁlings mandated by the Securities and Exchange Commission (SEC). We ﬁnd that among funds that are constituents of TDFs, those with higher expense ratios or lower performance have a greater probability of inclusion in an Internal FOF than in an External FOF. Similarly, among funds that belong to a family that oﬀers TDFs with the Internal FOF structure, once again funds with higher expense ratios or lower performance have a greater probability of inclusion in their TDFs. Our results are robust after controlling for family and fund characteristics and to other speciﬁcations including estimation of alphas over diﬀerent horizons, alternate deﬁnition of expense ratios, trends over time, and variations in asset allocation. Furthermore, we perform bootstrap simulations using residual and factor resampling approach of Kosowski, Timmermann, Wermers, and White (2006) to show that the documented under-performance is not attributable to sampling variability.
Overall, the ﬁndings in this paper have important policy implications as retirement monies are defaulted into TDFs following their approval as Qualiﬁed Default Investment Alternative (QDIA) in 401(k) plans. During the ﬁnancial crisis in 2008, investors close to retirement lost anywhere between 3.6% and 41% among the 31 TDFs with 2010 Target Date.3 The loss prompted a joint public hearing by the SEC and the Department of Labor (DOL) 3 Speech by Mary Schapiro, Chair of SEC, at the hearing on TDFs held on June 18, 2009. A transcript of the hearing is found at http://www.dol.gov/ebsa/pdf/TDFhearingtranscript.pdf
material for TDFs. While the regulation helps in alleviating the ignorance of investors, it falls short of addressing the potential agency problems highlighted in this paper. The ﬁndings in our paper point to a conceivable solution that comes from understanding the diﬀerence in the ﬂow-performance sensitivity of BFs and TDFs resulting from their investor bases. While TDFs are almost exclusively used by retirement investors, a major portion of BFs’ assets are held outside retirement plans.4 Our results indicate that opening TDFs to non-retirement accounts whose investors are performance sensitive, as is the case with BFs, may help bridge the gap in performance of TDFs relative to BFs. In addition, closer attention could be paid to the holdings of TDFs with the Internal FOF structure where the mutual fund families might face conﬂicts of interest and therefore, may not always make investment decisions in the best interest of their shareholders.
The remainder of the paper is organized as follows. Section 2 presents the related literature and hypotheses. Section 3 describes the data and variables. Section 4 provides evidence on lack of ﬂow-performance sensitivity in TDFs followed by a discussion of the tests of under-performance. Section 5 performs a battery of robustness checks and Section 6 concludes.
2. Related literature and Hypotheses Development This paper contributes to several strands of the ﬁnance literature. First, theoretical studies analyze the life-cycle model of consumption and portfolio choice by introducing conAccording to a report by the Investment Company Institute, 88% of TDF assets were held in retirement accounts in the year 2007 compared to 46% of balanced fund assets. See The US retirement market, 2007 http://www.ici.org/pdf/fm-v17n3.pdf - Research Fundamentals, July 2008, Vol 17, No.3.
Bodie, Merton, and Samuelson, 1992; Viceira, 2001; Cocco, Gomes, and Maenhout, 2005;
Gomes and Michaelides, 2005; Benzoni, Collin-Dufresne, and Goldstein, 2007; Polkovnichenko, 2007; Gomes, Kotlikoﬀ, and Viceira, 2008; Viceira, 2009; Chai, Horneﬀ, Maurer, and Mitchell, 2009; Poterba, Rauh, Venti, and Wise, 2009; Koijen, Nijman, and Werker, 2010). In particular, Bodie and Treussard (2007) evaluate the choice of TDFs in retirement plans and conclude that they are not appropriate for risk averse investors or for those who have a high exposure to market risk through their human capital. Although TDFs are gaining popularity among investors, empirical research on these funds is still in its infancy. In their pioneering work, Mitchell, Mottola, Utkus, and Yamaguchi (2007) study the impact of inclusion of TDFs in 401(k) plans of a single provider and ﬁnd that TDFs reduce the problem of extreme asset allocation and idiosyncratic portfolio risk. Ours is the ﬁrst empirical study examining the cross-sectional variations in the return performance as well as the ﬂow-performance relation of TDFs.