The use of passive target date funds in defined contribution plans continues to grow, in part due to their low cost relative to other TDF options.

“There’s been a significant interest in move of assets to so-called passive target date funds, or index target date funds,” according to Jake Gilliam, senior multi-asset class portfolio strategist at Charles Schwab & Co.

Gilliam visited ThinkAdvisor’s office to discuss why plan sponsors and advisors should look beyond just the low cost of passive TDFs and dig deeper in their due diligence. Gilliam recently co-authored a white paper for Schwab that highlights three misconceptions about passive TDFs.

“Plan sponsors — as fiduciaries to their plan — are often very concerned with price,” Gilliam told ThinkAdvisor. “We also want to encourage them to be as concerned with the fit of the target date fund, the underlying glide path, the design of the target date fund.”

Misconception No. 1: Passive TDFs are always a safer fiduciary choice.

Prudent TDF selection is about process, not just pricing, according to the report.

“As a plan fiduciary, you can’t just look at cost. There’s much more to the story,” Gilliam explains. “Cost is important. Cost is incredibly important, but it’s just one thing.”

Going passive and low cost may seem like “the easy choice,” but it does not absolve fiduciaries of their due diligence and ongoing monitoring responsibilities, according to the report. The report states that “low fees alone are unlikely to be in the best interests of the plan fiduciary if the overall TDF design is a poor fit.”

Rather, as the report continues, a fiduciary must consider all aspects of TDF design to ensure the option is well suited for the plan.

For example, risk decisions around equity levels as well as allocations in more volatile sub-asset classes, such as emerging markets securities and high-yield bonds, should be conscious and deliberate.

According to the report, the slope of the glide path can lead to significant differences in risk and results over the multi-decade time horizon of TDFs.

Over-relying on fees as the primary selection driver without these sorts of considerations fails to offer the same degree of protection, the report states.

Misconception No. 2: Passive TDFs are always a better choice for investors.

Passive TDFs vary widely in risk/reward profile based on the many decisions that go into portfolio design, according to the report.

Not all passive TDFs are structured the same, with notable variances in key areas such as asset allocation, index selection and glide path that can all affect portfolio performance both in the short and long term.

“There can be value in looking at different designs, looking at structures that will incorporate active and passive,” Gilliam explains.

For example, the report looks at how three passive TDFs in the marketplace offer very different glide paths based on the number of asset classes, the allocation mix between these assets, the exposure to alternative or traditional assets, and the size of risk-asset allocations at retirement.

Each of the passive TDFs uses a different mix of asset classes, both in terms of the number of different categories included in the portfolio, as well as the sub-asset classes used in each segment. These types of active design decisions can translate directly into risk and return variances for investors, according to the report.

With this in mind, the report notes that a specific passive TDF can be an appropriate choice for a particular plan’s participants, but the evaluation process to reach this decision should include numerous inputs, of which cost is only one.

“The key message here is that it has to be the right fit for the plan … and the exposure that the participant’s getting needs to have been thoroughly vetted beyond just the cost component,” Gilliam told ThinkAdvisor.

Misconception No. 3: Active or passive is an either-or choice.

According to the report, implementation can be fully passive, fully active, or a blend of both — with pros and cons for all three approaches.

“All things being equal, lower fees will translate into higher returns. However, all things are not equal across TDFs, given the flexibility providers have in portfolio design,” the report states.

The report also points to the growing segment of blended active and passive TDFs, which can help bridge the best of both of these worlds.

The report looks at the pros and cons of each approach. Passive implementation can provide a plan with an effective, low-cost QDIA, but this approach might affect performance and force certain glide path decisions.

Meanwhile, an active implementation typically strives to add portfolio value for a higher fee. And these TDFs generally seek to adapt portfolios through time for return-seeking opportunities or for risk management by investing in underlying securities at different weights than the benchmark. This approach also creates risk that the underlying strategy managers may make the wrong investment choices and underperform.

A blended implementation combines both passive and active approaches by investing in both low-cost index funds as well as active managers to gain select market exposures. Using both types of strategies can allow the TDF manager to refine active risk levels at different parts of the glide path and may also provide diversification as markets cycle. A blended approach has a generally modest fee increase over a pure passive implementation approach.

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