No Such Thing as a Passive TDF

January 14, 2016

Written by Bill Ryan and Paul Kennedy

Bill Ryan is the Head of Target Date Fund Research and Paul Kennedy is an Equity Manager Research Consultant on Aon Hewitt’s target date fund team and based in Chicago.  

Today, target-date funds (TDFs) are the fastest growing investment strategy within defined contribution (DC) retirement plans. TDFs are currently offered within 89% of all DC plans1. As shown in Exhibit 1, TDF utilization has quickly trended upwards from 2006 to 2014 with the percentage of new participants investing in pre-mixed funds jumping from 45% to 68%2
We are watching the future of DC plan asset allocation through the amazing growth in pre-mixed funds.

Asset Allocation
Nearly three decades ago (1986), a study conducted by Gary Brinson, Randolph Hood, and Gilbert Beebower concluded that asset allocation explained roughly 94% of the average investments return variation . Although the findings have been widely debated, it is evident that asset allocation plays an integral part in the long-term outcomes of various portfolios.

Within TDF portfolio construction, strategic asset allocation (SAA) is the strategy of setting long-term target allocations in a portfolio for various asset classes and periodically rebalancing the portfolio back to the original allocations due to differing returns from the various asset classes. The action to construct an SAA is an active decision. As such, the ongoing need to monitor and adjust a pre-mixed/targeted asset allocation requires a thoughtful, intentional, and impactful implementation. 
Target-Date Fund Glide Path
How an investment manager implements an SAA within a TDF’s glide path may be via passive, active, or mix of the two investment strategies.  

  • Passive Investing is a low cost investment strategy that closely approximates the performance of an investable market index.
  • Active Investing (also called active investment management) is a portfolio management strategy where the manager makes specific buy and sell decisions with the goal of outperforming an investment benchmark or index.

The construction of a TDF’s glide path is an example of an active SAA decision. Exhibit 2 shows three sample glide paths from large “off-the-shelf” target date fund providers that implement their glide paths with passive management. 


As demonstrated in Exhibit 2, not all “passive” TDF glide paths are identical. When TDF providers create, monitor, and modify their glide paths (which is another way of saying asset allocation), they express a number of investment views. These views include expected returns of various asset classes, volatilities, correlations, inflation rates, life expectancy, contribution rates, and numerous other factors. Each provider will inevitably have varying opinions based on their research, all of which will end up directing the asset allocation decisions in their TDF’s strategic glide paths. Although passive investing is generally considered to involve taking the market portfolio without expressing a view, passive TDF providers must make active decisions when determining their glide paths—even if the portfolios themselves are not implemented with active investment management. An example of another active decision is shown in Exhibit 3 illustrating a single TDF provider that changed their strategic glide path significantly from 2014 to 2015 based on evolutions in their capital market and modeling assumptions.  

Plan Sponsor Decision
When selecting a TDF, a sponsor’s reasons may include such items as risk-return objectives, costs, or investment strategy. However, a sponsor also needs to comprehend the concept of looking beyond “To vs. Through” and understand how those underlying investments are combined within a glide path, as suggested by the Department of Labor TDF Tips.
Plan Sponsor Decision Points: 

  1. Does the investment manager have the knowledge and skill to build a good TDF glide path?
  2. Is the TDF glide path appropriate for the objectives and circumstances of the DC plan’s population, including other sources of lifetime retirement income such as a defined benefit (DB) plan benefit?
  3. Does the investment manager have the skills required to expertly manage each asset-class used within a TDF’s investment strategy?
  4. Are the total costs borne by participants reasonable for the portfolio construction and investment strategy implementation?

[1] Aon Hewitt: 2015 Hot Topics in Retirement
[2] Aon Hewitt: 2015 Universe Benchmarks Measuring Employee Savings and Investing Behavior in Defined Contribution Plans

Content prepared for U.S. subscribers, but available to interested subscribers of other regions.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

Previous Article
PPA 2006: A Rising Tide Lifting Driverless Boats
PPA 2006: A Rising Tide Lifting Driverless Boats

Next Article
ESG Investing: A (Re)Introduction to Responsible Investing
ESG Investing: A (Re)Introduction to Responsible Investing