With the overall growth or passive funds that track an index and target date funds (TDFs) provided by well-known indexers gaining popularity, it’s easy for plan sponsor to think in terms of Passive Target Date Funds. But since the most important element of a TDF is their glide path or their strategic asset allocation, TDFs by definition cannot be passive as there is no glide path index.
TDFs have three basic elements:
- “Glide Path” or how much risk is being taken which changes as investors get closer to retirement;
- “Assets Allocation” or how much is being allocated to each type of investment like equities and bonds; and
- Underlying investments selected or the actual funds used.
If you were baking a cake, the glide path defines the type of cake you want, asset allocation is the recipe to make that cake and the investments are the actual ingredients.
Sarah O’Toole, Institutional Portfolio Manager at Fidelity, explains that although the underlying investments can be passive, the decisions made about the glide path and asset allocation are by definition active. So the most important decision is the active one no matter which assets are deployed. Hence, “Passive Target Date Funds” is a misnomer.
TDFs are designed to improve income replacement taking into account such things as investor behavior, their risk tolerance and market conditions. That’s why the decision on which TDF is right for a company entails much more than fees and performance like with individual investments.
So there are TDFs that deploy only index funds like those offered by Vanguard and those that use active funds like those provided by Fidelity. In addition, there are so-called hybrid TDFs which use both index and active funds.
So which is better? That depends. While index funds are less expensive, they may not offer returns better than the market average and may not give exposure to certain asset classes hard to index. Active managers seek to beat their benchmark at a cost and risk under performing.
Most important for plan sponsors is to understand the demographics, behaviors and risk tolerance of their employees as well as whether they are on track to replace a substantial percentage of their income at retirement when they select a TDF. Analyzing the glide path is perhaps the most important element of the decision in that process.
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