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Target Date Fund Selection: More Than Simply Active vs. Passive

May 2018

Target Date Fund Selection: More Than Simply Active vs. Passive2

Executive Summary ■ While choosing between active and passive target date funds is important for a plan sponsor,

it is only one consideration among many that ultimately drive participant outcomes

■ Decisions around a target date fund’s glide path and asset allocation — active choices that even passive target date funds must make — likely will have much more impact on participant outcomes than the potential cost differences between the active or passive portfolios underlying the fund

■ A fiduciary’s responsibility includes providing participants with a suitable selection of investment choices, both across a plan’s lineup of investment options and within its target date offering

■ Passive target date managers tend to offer less breadth and depth in asset class choices, particularly with respect to non-traditional or alternative asset classes

■ Tactical asset allocation — the freedom to deviate from long-term allocation policy to capture shorter-term opportunities — is a potentially valuable practice that is often missing from passive target date funds

■ In choosing between active, passive or blend funds, sponsors should weigh all potential benefits and drawbacks of the various methods — not only fees — since diversification, tactical flexibility, alpha potential in different asset classes and suitability for participants may all be affected

IntroductionOver the past decade, target date funds have moved from the fringes of the defined contribution world to the mainstream. Selecting a target date fund has become one of the most important decisions a plan sponsor will make on behalf of plan participants. Despite this shift into the mainstream, significant differences in investment philosophies and processes among managers have produced wide dispersion in performance and risk over time. What’s more, unlike equity and bond asset classes, target date funds do not have an accepted industry-wide benchmark with which to compare and contrast historical results (such as the S&P 500 Index for U.S. large-cap equity managers). Therefore, as the Department of Labor outlined in its 2013 target date bulletin, plan fiduciaries should thoroughly review all aspects of their target date fund situation and document that fund selection and monitoring have produced a plan that is the right fit for plan participants.1

One aspect of target date design that has received a lot of attention recently is whether the underlying funds are 100% actively managed, 100% passively managed or a blend of the two approaches. While this feature of target date design is unquestionably important — it impacts both performance and fees — it is only one consideration among many that ultimately will drive participant outcomes. In fact, passive target date funds are a bit of a misnomer; regardless

1 “Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries,” United States Department of Labor, Employee Benefit Security Administration, www.dol.gov, February 2013.

Table of Contents

Executive Summary 2

Introduction 2

Glide Path Design Is the Primary Driver of Target Date Returns and Volatility 4

Benchmark Selection Remains Complicated 6

Asset Allocation Approach Impacts Diversification and Flexibility 8

Conclusion 10

May 2018 3

of whether the underlying portfolios that comprise a fund are managed actively, passively or a blend of both, all target date managers make numerous active decisions that significantly impact performance and risk. These include:

■ Glide path construction

■ “To vs. through” landing points

■ Asset allocation

■ Asset class breadth

■ Tactical or static asset allocation approach

■ Portfolio construction and management

As a result, unlike an equity or bond fund in which a preference for active or passive may be based mainly on fees or a belief about the value of active management, a target date fund’s use of active, passive or blend strategies should not be the sole or even primary determinant for selection. In fact, one could argue that decisions such as glide path and asset allocation will have a much larger impact on participant outcomes than the fee differential between active and passive target date funds. As can be seen in Figure 1, the average performance dispersion between managers in each Morningstar Target Date category over the past five years has been as high as 8%, far in excess of the approximately 0.40% annual fee differential between passive and active target date funds.

In this paper, we examine this active/passive debate relative to the other design choices and discuss some of the tradeoffs between active, passive and blend approaches within the target date space.

Figure 1. The Range of Returns across Target Date Funds is Remarkably WideRange of Five-Year Annualized Returns by Morningstar Category

0

9.1

2.9

10.4

4.6

11.5

4.2

12.1

5.8

12.4

5.0

12.6

6.1

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TDF2025

TDF2035

TDF2045

TDF2020

TDF2030

TDF2040

TDF2050

6

8

2

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Annu

aliz

ed R

etur

n (%

)

12

14%

Source: Morningstar Direct © 2018 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Use of information from Morningstar does not necessarily constitute agreement by Morningstar, Inc. of any investment philosophy or strategy presented in this publication. Data as of March 31, 2018

The average performance

dispersion far exceeds the

fee differential between active and

passive funds


Glide Path Design is the Primary Driver of Target Date Returns and VolatilityA key defining feature among the many available target date funds — and a primary determinant of their returns and volatility — is their glide path. A target date fund’s glide path reflects how its allocation to equity and fixed income investments change over time in accordance with the presumed risk-return profile of plan participants as they age. As shown in Figure 2, the target date fund industry currently employs a wide range of glide paths, with different beginning and ending equity allocations as well as different rates at which equity exposure declines over the life cycle.

Figure 2. Glide Path Approaches Differ Significantly among Fund Managers

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2065 2060 2055 2050 2045 2040 2035 2030 2025 2020 At Retirement

45Years to Retirement

15 02040

74

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6558

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83035 10 5

Equit

y Allo

catio

n (%

)

MinimumAverageMaximum

Source: Morningstar Fund Research. © 2018 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Use of information from Morningstar does not necessarily constitute agreement by Morningstar, Inc. of any investment philosophy or strategy presented in this publication. Data through March 31, 2018

Each investment manager, whether it employs an active, passive or blend approach, has its own glide path philosophy and proprietary design process. Thus, the equity and bond mix of participants’ portfolios will vary dramatically over their lifetime depending on their plan’s target date provider. As is apparent in Figure 3, glide paths can vary quite significantly even among passive target date managers.

Figure 3. Glide Paths of Passive Target Date Funds Lack any Semblance of Uniformity

0

Passive TD Manager 1Passive TD Manager 2Passive TD Manager 3

20

60

Equi

ty A

lloca

tion

(%)

80

100%

40

Years before and after retirement-50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25

Source: Morningstar Target-Date Fund Series Report, updated as of March 31, 2018.

Glide paths can vary significantly even among passive target date managers

May 2018 5

These equity/bond allocation differences will have a significant influence on performance results, particularly during periods of heightened volatility. Figure 4 compares the returns for the same sample of passive target date managers in Figure 3; managers’ performance shows not only wide dispersion relative to the category average over time but also relative to each other. The most aggressive 2025 fund manager (passive manager 3) produced the best performance results over the past five years, when equities meaningfully outperformed bonds. The most conservative, passive manager 1, trailed slightly despite the lift of a generally rising stock market.

Figure 4. Passive 2025 Target Date Funds Show Wide Dispersion in PerformanceAnnual Returns

2017

Perc

ent

2016 2015 2014 2013 2012 2011-5

0

5

10

15

20

25% Passive TD Manager 1Passive TD Manager 2Passive TD Manager 3

Annual Returns (%)

Name

Equity Allocation at 65 Years of Age (%) 2017 2016 2015 2014 2013 2012 2011

Passive TD Manager 1 52 15.15 7.46 -0.95 6.27 14.17 11.53 -0.74



Dispersion between best and worst performer — 0.94 0.15 0.30 1.22 3.97 1.76 0.88

Morningstar Target Date 2025 Category 53 14.67 6.73 -1.59 5.07 15.30 13.03 -2.06Source: Morningstar Direct. The percent equity allocation at 65 years of age represents the average, net-equity position of all open-ended target date funds in the Morningstar Target Date 2025 category. Note: Equity allocation reflects each provider’s reported holdings as of March 31, 2018

Given these wide differences in equity allocations, one could argue that glide path design — where no truly passive option is available — is one of the most important “active” decisions in the target date management process and thus by default, one of the most critical decisions a plan sponsor must make.

Further complicating target date comparisons is the fact that there are multiple target date index suites — provided by reputable firms such as Standard & Poor’s and Morningstar — attempting to stake a claim as the industry’s “benchmark glide path.” The question then arises, which benchmark should be utilized in any given context?

Glide path design — where no truly passive option is

available — is one of the most important

“active” decisions


Benchmark Selection Remains ComplicatedDespite the dominance of target date funds in defined contribution plans, an industry-wide benchmark for evaluating these funds remains elusive. Since target date management requires active design decisions as well as capital market, plan and participant assumptions, they are unquestionably difficult to benchmark, and a consensus has yet to be formed about the best way to do so. This is in stark contrast to equity or fixed income funds, where there is general industry consensus on indexes for each asset class.

In an effort to fill this vacuum, major index providers have created five major target date indexes with vastly different approaches to the key design aspects as summarized in Figure 5.

Figure 5. Major Index Providers Have Different Approaches to Target Date BenchmarkingPrimary Prospectus Benchmarks within the Morningstar U.S. OE Target Date 2045 Category

S&P Target Date

Series

S&P Target Date Style Series

Dow Jones U.S.

Target Date Series

Dow Jones Global

Target Date Series

Morningstar LifeTime

AllocationCustom &

Others# of TDF Managers using Index as Benchmark 19 2 1 2 4 29“To” or “Through” Through Both Through Through Through —Number of Asset Classes 10 10 8 8 19 —

Source: Morningstar Direct, Morningstar, Standard & Poor’s, S&P Dow Jones, as of March 31, 2018.

An illustration of the glide paths of the most popular indexes in Figure 6 shows the remarkable disparities between them.

Figure 6. Target Date Indexes also Lack Glide Path Consistency

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100%

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Age2060 2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005 2000 Income

Morningstar Lifetime Aggressive 2025S&P Target Date 2025

Morningstar Lifetime Moderate 2025Morningstar Lifetime Conservative 2025

Equi

ty A

lloca

tion

Source: Morningstar, Standard & Poor’s, S&P Dow Jones, as of March 31, 2018.

There is no industry consensus on the best way to benchmark target date funds

May 2018 7

As a result of these differences, the performance dispersion between target date indexes is quite wide, with differences as high as 12% in 2017 and 17% in 2013. Which is the “right” target date index fund choice?

Figure 7. Performance Dispersion Between Target Date Indexes is Very Wide

Annual Returns (%)

NameEquity

Allocation (%) 2017 2016 2015 2014 2013 2012 2011S&P Target Date 2025 61 14.55 7.82 -0.25 5.56 17.03 12.51 -0.28

S&P Target Date Retirement Income 32 8.54 5.01 -0.18 4.86 6.28 7.51 3.98

DJ Target 2025 35 12.02 6.39 -1.11 5.14 12.84 10.94 0.49

DJ US Target 2005 14 5.51 3.62 0.38 6.66 4.86 7.08 6.40

Morningstar Lifetime Agg 2025 74 17.73 9.82 -2.28 6.14 22.13 15.10 -1.95

Morningstar Lifetime Con 2025 37 11.51 7.04 -1.90 5.90 9.04 11.75 3.37

Morningstar Lifetime Mod 2025 56 14.54 8.39 -2.06 6.04 16.28 13.67 0.24

Dispersion between Best and Worst 12.22 6.20 2.66 1.79 17.26 8.02 8.35

Source: Morningstar Direct, Standard & Poor’s, S&P Dow Jones Note: Equity allocation reflects each provider’s reported holdings as of March 31, 2018.

The practices of target date managers and plan sponsors exemplify the lack of consensus on an appropriate target date indexes (Figure 8). According to a recent Callan Associates survey, more than a third of target date offerings use a benchmark provided by the investment manager, about one-quarter use peer benchmarking or an industry benchmark, about one-eighth use a custom benchmark and a few use “retirement income adequacy analysis.”

Figure 8. Little or No Consensus Exists among Plan Sponsors about Benchmark ChoiceQuestion: Which primary benchmark does your plan use for DOL-required participant disclosures for your target date offering?

Benchmark provided by investment manager

35%

Peer benchmarking24%

Industry benchmark21%

Custom benchmark15%

Retirement income adequacy analysis

5%

Source: Callan Associates, “2018 Defined Contribution Trends Survey”

Wide performance dispersion among

target date indexes


Asset Allocation Approach Impacts Diversification and FlexibilityA fiduciary’s responsibility to participants includes providing a suitable selection of investment options to help participants reach their retirement goals while remaining consistent with the plan’s objectives. As part of this commitment, the plan sponsor must provide a range of options that is appropriate for the goals and risk tolerances of all employees — which helps explain the popularity of target date funds (Figure 9).

Figure 9. Target Date Funds are the Overwhelming First Choice as a Qualified Default Investment OptionQDIA Choice by Percentage of Respondents

Target Date85%

Stable Value/Money Market0.9%

Balanced Fund3.5%

Target Risk2.6%

Managed Account & Other

7.8%

Source: Callan Associates, “2018 Defined Contribution Trends Survey”

This responsibility should also be considered in the context of the target date fund chosen for the plan, since many participants will have a majority, if not all, their assets concentrated in this option given its popularity as the top qualified default investment alternative (QDIA) among plan sponsors. Therefore, it is critical to assess whether the target date fund provides sufficient diversification to meet plan objectives.

General tendencies can be discerned about passive target date managers’ asset class breadth relative to those of active or blend managers. In general, passive target date managers tend to offer less granularity in asset class choices, particularly with respect to non-traditional or alternative asset classes. As Figure 10 shows, the number of Morningstar category asset classes represented across the top three (ranked by assets under management) passive target date fund suites is quite limited. In fact, while a passive manager may provide exposure to certain asset classes through a broad-based index fund, many do not have any specific funds dedicated to peripheral asset classes such as domestic small-cap equity, emerging market equity, REITs, commodities, global bonds, high yield bonds, short-term bonds and senior bank loans. Some of these asset classes are difficult or costly to replicate passively. In other cases, the manager may not believe the added diversification is justified.

Does the target date fund provide sufficient diversification?

May 2018 9

Figure 10. The Largest Passive Target Date Funds Offer Limited Choice Compared to the Category Average Peer Fund

Average Active Manager* Passive Manager 1 Passive Manager 2 Passive Manager 3

Equity Choices 11 Foreign Large Blend Foreign Large Blend Foreign Large Blend

Large Blend Large Blend Large Blend

Fixed Income Choices 7 Inflation-Protected Bond Inflation-Protected Bond Inflation-Protected Bond

Intermediate-Term Bond Intermediate-Term Bond Intermediate-Term Bond

Specialty Choices 2 Commodities Broad Basket — Global Real Estate

Tactical Flexibility Varies None None None

Source: Morningstar Direct as of 03/31/2018. *Top 10 Active Suites by AUM as of 12/31/2018. Number of asset classes used (based on Morningstar categories) for the 10 largest active TD mutual fund suites (2020 and 2055 vintages) as of 12/31/17.

Note also in Figure 10 the relative lack of diversity in fixed income, where no global bond, high yield bond or short-term bonds are represented, potentially important omissions as inflation/deflation risk and income needs come into play. Finally, the breadth of asset classes within the plan’s broad menu of investment options constitutes a de facto diversification philosophy. Plan sponsors should consider whether their chosen target date offering provides a level of diversity consistent with their implicit diversification philosophy.

In addition to considering the asset class exposures offered within a target date fund, it is important to understand whether the target date manager has discretion to make short-term tactical moves that deviate from the fund’s longer-term strategic asset allocation. As one can see in the bottom row of Figure 10, the three largest passive target date managers do not employ a tactical approach, with fairly infrequent allocation changes governed by the glide path. The managers may lack conviction in the benefits of tactical asset allocation or a practical limit may apply to tactical moves given allocation to broad-based indices and a lack of dedicated funds in non-traditional assets. For example, in Figure 10, passive managers 1 and 2 allocated to only two broad-based index funds within equities — U.S. equities and international equities; as a result, tactical calls are not possible across the U.S. capitalization spectrum or between developed and emerging markets in the international space.

In making the choice between an active, passive or blend approach, it is critical to weigh all the potential benefits and drawbacks of the various methods, not just fees, but diversification, tactical flexibility, the return potential of different asset classes and the suitability for participants may be affected.

The largest passive managers are

limited to fairly infrequent allocation

changes governed by the glide path


ConclusionWhile there are merits to utilizing both active and passive target date funds, evaluating target date managers carries inherit risks and key design decisions — which collectively constitute “active” choices — to select the right fit for a plan’s participants. Here is a summary of key considerations in target date selection:

■ The glide path and asset allocation will likely have much greater potential impact on participant outcomes than the fee differential between active and passive target date funds

■ Glide paths vary significantly even among passive target date managers, making a truly “passive” glide path effectively unattainable

■ Since no consensus exists on an industry-wide target date benchmark, the very definition of “passive” is unclear

■ Passive target date funds may not offer sufficient diversification, which in and of itself constitutes an active fiduciary decision

■ Manager discretion to deviate from the strategic asset allocation may be valuable in volatile markets; some passive target date managers offer only the infrequent allocation adjustments governed by the glide path

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Investment RisksThere are no guarantees a diversified portfolio will outperform a non-diversified portfolio. Diversification does not guarantee a profit or ensure against loss. Past perfor-mance is no guarantee of future results.

Inherent in all investing are the risks of fluctuating prices and the uncertainties of rates of return and yield. A target date is the approximate date when investors plan to start withdrawing their money; principal value fluctuates and there is no guarantee of value at any time, including at the target date.

Price volatility, liquidity and other risks accompany an investment in equity securities of foreign, smaller capitalized companies. International investing poses additional, special risks including currency fluctuation, economic and political risks not found in solely domestic investments. For investments in emerging markets, such foreign invest-ing risks are generally intensified.

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target date fund selection: more than simply active … date... · 6 target ate un election ore han...

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