The investment community has made significant strides in understanding and evaluating target-date fund (TDF)1 strategies over the past decade. Now, however, we have reached a plateau in target-date communication characterized by overly-simplistic dichotomies, such as “to” versus “through,” “open” versus “closed,” “custom” versus “off the shelf,” and “active” versus “passive.” This jargon can be limiting and, in some cases, downright misleading.
This post will break down four key labels commonly used in target-date manager evaluation. We hope this more nuanced understanding of these four topics provides readers with greater insight into the risks inherent in retirement investing, including longevity2, market, and sequence-of-returns3 risks.
Mapping the risks plan investors face makes TDF evaluation and selection more effective: defining the risks particular to the investors in the plan allows for selecting a TDF best suited to a given plan.
1. “To” Versus “Through”
First, it is important to disprove the myth that “to” versus “through” tells you all you need to know about risk along the glide path. This particular dichotomy gives the user just one insight: whether the equity allocation continues to decrease in retirement. The reality is that there are more dimensions to risk in the glide path than equity alone.
The reality is that there are more dimensions to risk in the glide path than equity alone.
These other dimensions include slope and exposure to other risk assets, such as commodity-related investments, which exhibit very high levels of volatility and downside risk4. Including these other risk assets along with equity allocation presents a more informed picture of the true risk posture.
In addition, the glide path fails to distinguish among different types of equity investments, effectively treating large- and small-cap, U.S. and non-U.S., and growth and value, and specialty equity allocations, for example, as equals.
Slope is important because it relates to sequence-of-returns risk and the distribution of outcomes in retirement – the range of possible total portfolio returns retirees may receive after starting withdrawals, factoring in the risk of changing market conditions. In short, the steeper the glide path, the greater the risk from a poor sequence of returns, and the harder it will be to determine how long the retirement income will last. This more holistic approach to the glide path paints a very different picture from looking at equity glide paths in isolation.
2. Open Versus Closed
Now, let’s examine the claim that multi-manager, open-architecture approaches are superior to closed because they provide the flexibility to hire “best-in-breed” managers. (Open series are made up of funds of more than one provider, while closed series use the funds of a single proprietary provider.)
The reality is that multi-manager strategies (so far) typically failed to deliver performance in excess of proprietary approaches. Why? The answer likely has to do with the long-term persistence in mutual fund returns, or lack thereof. The truth is, today’s highest-rated manager is unlikely to be tomorrow’s highest-rated manager.
The truth is, today’s highest-rated manager is unlikely to be tomorrow’s highest-rated manager.
With this in mind, plan sponsors should think about how the underlying portfolios in their TDF lineup function together across varying market regimes, rather than evaluate each portfolio in isolation on the basis of a single characteristic, such as a Morningstar rating or total return.
3. Custom Versus Off-the-Shelf
Next, we turn to the question of custom versus off-the-shelf TDFs. Proponents of customized approaches argue that these strategies may provide diversification benefits versus a proprietary, single-provider lineup.
Currently, there are more than four dozen “off-the-shelf” providers of target-date strategies, each with a different approach. The range of ready-made offerings includes to, through, open, closed, active, passive, and virtually everything in between. This begs the question: Why would a plan sponsor need to customize an approach that already exists in some form, likely at a more reasonable price?
This begs the question: Why would a plan sponsor need to customize an approach that already exists in some form, likely at a more reasonable price?
In reality, the decision to utilize a custom or off-the-shelf lineup is complex, with the vast majority of plans likely to be satisfied by current offerings.
4. Active Versus Passive
Finally, let’s examine the classic “active versus passive” debate. Proponents of passive fund strategies argue that higher fees offset the potential for benchmark-beating returns by active managers. The blanket conclusion is that active management doesn’t pay for itself and, therefore, passive management is a smarter solution.
However, it is crucial to understand that the distinction between active and passive investment strategies is essentially a false one in the TDF context. There can be no such thing as a passive TDF portfolio in the full sense of the word, when the portfolio’s composition, allocation, and glide path construction involve active decisions.
Nevertheless, we have seen a shift towards passive strategies in recent years. This has been part of a renewed and totally appropriate focus on carefully managing expenses in retirement plans. The trend likely also follows the increased availability of low-cost vehicles, such as exchange-traded funds and other index trackers. Be aware, though, that index-based investing faces certain limitations in the TDF context.
Be aware, though, that index-based investing faces certain limitations in the TDF context.
One challenge to building a well-diversified portfolio of passive strategies is that not all asset classes and geographies can be indexed efficiently or cheaply. What’s more, because the weightings of securities in the index vary with the market, passive strategies may introduce unintended risks along the glide path.
The optimal retirement investment program is a complex solution and must reflect each investor’s unique risk profile, age, wage, and income needs in retirement.
At present, no fully customizable, individualized retirement solution exists. Given this, plan sponsors should strive for a balance of risks intended to meet the retirement needs of the broadest range of plan participants. The search for a prudent and appropriate target-date fund demands a careful, in-depth analysis of the many factors describing these strategies.
Investment Professionals: Find more target-date insights in our white paper “Beyond Labels: Advancing Your Approach to Target Date Evaluation & Selection” (log-in required).
1 The target date of a target-date fund is the approximate year when investors plan to retire or start withdrawing their money. The principal value of the investment is not guaranteed at any time, including at the target date.
Each target-date fund seeks the highest total return consistent with its asset mix. Over time, the asset mix and weightings are adjusted to be more conservative. In general, as the target year approaches, the portfolio’s allocation becomes more conservative by decreasing the allocation to stocks and increasing the allocation to bonds and money market instruments.
2 Longevity Risk is the risk retirees may outlive their retirement savings due to an increase life expectancy.
3 Sequence-of-Returns Risk is the risk of market conditions impacting the overall returns of an investment portfolio during the period when a retiree is first starting to withdrawal money from investments as income. For example, if a retiree has to withdrawal income from his or her portfolio when market prices are depressed, the portfolio may lose out on the potential returns that income could have made once market prices recovered.
4 Downside Risk is an estimation of what an investor may stand to lose from particular investment if market prices decline.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Diversification does not assure a profit nor does it protect against loss of principal.