Is Passive Truly the Safer Fiduciary Choice for TDFs? | Capital Group

Defined Contribution Investment Perspectives

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Is Passive Truly the Safer Fiduciary Choice for TDFs?

Given the rapid acceptance of target date funds (TDFs) as the primary retirement investment strategy for American workers, the choice of target date provider is now among the most important decisions for an investment committee.

The beauty of a TDF is its simplicity for participants. However, its underlying complexity can challenge committees tasked with assessing a TDF’s glide path design, risk/return profile and fee structure as part of fiduciary due diligence.

One of the considerations is whether the TDF should be actively or passively managed. In either case, appropriate due diligence must be conducted. When selecting a TDF provider, sponsors should remember:

  • Passive management does not provide inherent fiduciary protection.
  • Managed investment strategies may lead to better participant outcomes.
Jason Bortz
Jason Bortz Associate Counsel Los Angeles office 19 years of experience (as of 12/31/16)
Toni Brown
Toni Brown Senior Defined Contribution Specialist San Francisco office 28 years of experience (as of 3/1/18)
John Doyle
John Doyle Senior Defined Contribution Specialist New York office 31 years of experience (as of 3/5/18)
Sue Walton Senior Defined Contribution Specialist Chicago office 20 years of experience (as of 3/1/18)

Passive Management Does Not Provide Fiduciary Protection

Fiduciaries sometimes view passive strategies as “safer” choices out of concern over fees. Fees are an important consideration in the selection of a TDF provider, but not the only one. What ultimately matters are economic outcomes for participants.

As such, fiduciaries should analyze how a target date series is structured to deliver the best value for participants. Some factors to consider include:

  • The glide path design
  •  The ability to manage risk
  •  The potential to deliver above-average returns

“‘An unfortunate misconception’ exists among defined contribution (DC) plan fiduciaries that low cost is equivalent to low risk from either a market or a fiduciary perspective, says Jessica Sclafani, associate director at Cerulli …

‘What is unique to the DC industry is that demand for passive strategies is being driven by the misunderstanding of many plan fiduciaries that choosing passive is a way to offload or mitigate their fiduciary liability.’”

— PLANSPONSOR, October 2, 2015


No Target Date Fund Is Completely Passively Managed

All target date providers make active asset allocation decisions when creating the glide path. This has a big impact on risk and return.

The chart below shows how TDFs composed of mostly passive underlying funds have a wide range of equity exposures at age 65, the age at which a participant is assumed to retire and begin taking withdrawals. Note the equity allocation at retirement ranges between 21% and 50%. Because asset allocation can drive results, fiduciaries should review the change in allocations along the glide path as the fund moves closer to its target date.

Equity Exposure Can Vary Widely in Passive TDFs Percentage of assets in equity (as of 12/31/16)

chart-equity-exposure-472x198

Source: Capital Group, based on Morningstar data. Based on the eight target date series that have a three-year history and no more than 20% of assets actively managed.


Five Questions for Evaluating Target Date Funds

  1. How is the glide path constructed?
    Analyze how equity and fixed income work together along the glide path.
  2. What are the needs of participants?
    Balance the need for growth with the desire for volatility control relative to plan demographics.
  3. What underlying funds are used in the series?
    Review the long-term results of the underlying funds through market cycles.
  4. What types of risk does the target date series exhibit?
    Review such key risk characteristics as market, longevity, interest rate and sub-asset class risk.
  5. How much do participants pay for the funds?
    Determine the value received for the fees charged.

Passive Strategies Expose Participants to Potentially Unbalanced Equity Markets

Passive funds are based on indexes, which can become imbalanced. Consider:

  • On 12/31/89, Japan (P/E: 51.9) was 60% of the MSCI EAFE.
  • On 3/31/00, Information Technology (P/E: 63.1) was 32.2% of the S&P 500.

Managed equity funds can help mitigate the risk of asset bubbles by pursuing more defensive strategies in times of market stress.

“The disparagement of active management simply isn’t a rational response to the facts … Cap-weighted index funds by definition have maximum exposure to the most overheated parts of the markets at their absolute peaks.”

— Morningstar Advisor, October 5, 2015

“Bonds play a crucial role in a target date fund. Managing a bond portfolio to an index is challenging as full replication isn’t feasible, so most passive managers try to match the index in terms of key characteristics like duration, sectors, yield curve, etc. They do not have the flexibility to adjust holdings in response to market opportunities and threats.”

— Toni Brown, CFA


Conclusion

Passive investments do not have inherently greater fiduciary protection than actively managed investments. When selecting TDFs, sponsors should evaluate a range of criteria, including:

  • The glide path, including the quality and type of equity and fixed income exposures as they change over time.
  • The investment process, including the level of managerial ownership and oversight.
  • Fees relative to comparable strategies and value received.

Taking an active approach to target date selection can help sponsors meet their fiduciary responsibilities while facilitating sound and productive retirement savings for their workers.

“Funds with low fees and managers who have personal investments in the funds may be better aligned with participant objectives.”

— John Doyle

 


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Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses or the collective investment trust's Characteristics statement, which can be obtained from a financial professional, Capital or your relationship manager, and should be read carefully before investing. 

Content contained herein is not intended to serve as impartial investment or fiduciary advice. The content has been developed by Capital Group, which receives fees for managing, distributing and/or servicing its investments.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and not to be comprehensive or to provide advice.