Over the past decade, target date funds have moved from the fringes of the defined contribution world to 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. In addition, 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 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 and/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 0.25–0.40% annual fee differential between passive and active target date funds. This level of dispersion is also much higher than that found in single asset class categories such as the Morningstar U.S. Large Blend and U.S. Intermediate Bond peer groups.
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.