Categories
Target Date
Dare to be different: Active underlying funds for target date
Rich Lang
Multi-Asset Investment Director
KEY TAKEAWAYS
  • Most retirement plan participants who use target date funds are invested in passively implemented solutions
  • In addition to cost, retirement savers should evaluate a target date retirement series’ history and the potential of its underlying funds to produce desired outcomes
  • Actively managed target date funds have three drivers of returns, of which underlying security selection is a key differentiator

When it comes to target date funds, cost matters. But since participants could be invested in these funds for decades, every potential advantage should be considered. For a fully active solution, there are three potential sources of excess return to consider, as actively managed target date funds seek to deliver value in three ways.


The first is through the choice of a strategic glide path, the long-term targeted allocations to various asset classes (primarily equity versus fixed income). The second is through tactical allocations, purposeful shifts from those asset allocations in response to market conditions. The third way — a critical differentiator — is through security selection, the potential to generate excess returns via active management decisions.


But passive target date solutions1 — which constitute the majority of the nearly $3 trillion invested in the industry2 — may not have access to the potential benefits of active security selection. While fees are incredibly important, they should not be the sole determining factor in selecting a target date series. Recent litigation has highlighted the importance of relative returns and overall participant outcomes as well as absolute returns. Simply focusing on fees and costs is no longer enough to avoid litigation risk. And, more importantly, it may not provide the best outcome for participants.


Actively implemented target date funds have three levers to pursue favorable outcomes

A stool is depicted in three distinct colors as an analogy for the three levers actively implemented target date funds can use to pursue favorable outcomes. The stool turns sideways to depict a pie chart, in which each slice of the pie corresponds to a source of excess return. The glide path, a strategic asset allocation that evolves over time, is depicted in dark blue. Flexibility, the ability to tactically deviate from strategic asset allocations, is depicted in green. Much of the pie corresponds to security selection, depicted in light blue, illustrating the impact of active investment decisions. This slice gives way to an illustration of the research and portfolio management process, wherein four hypothetical portfolio managers select their highest-conviction investment ideas from within their respective coverage universes.

Source: Capital Group. This is a hypothetical example for illustrative purposes only, not intended to portray an actual investment.

While strategic glide path differences between target date series are narrowing, other factors such as asset class allocations and active investment selection have played a greater role in affecting series outcomes and “plan sponsors and their consultants should focus on these factors” to better understand the disparity in target date outcomes.3


These factors are derived from an examination of the underlying funds, or “ingredients,” of an actively managed target date series, as the managers of these building blocks are responsible for fundamental security selection.


In the paper linked below, we take a closer look at the funds underlying the American Funds Target Date Retirement Series in terms of both return and risk to illustrate how they seek to drive better outcomes for participants.


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Rich Lang is a multi-asset investment director at Capital Group. He has 30 years of investment experience (as of 12/31/2023), all with Capital. He holds master's and bachelor's degrees from Loyola Marymount University.


Target date types as described by Morningstar, uses the percentage of a series’ assets in underlying active strategies to classify each series as active (80% to 100% actively managed), hybrid (20% to 80% actively managed) or passive (less than 20% actively managed). A passively managed target date series may benefit from active security selection based on the percentage of the series that may be actively managed.
 

2 SWAY research report, “State of the Target-Date Market: 2023,” January 2023.

Blanchett, David and Paul D. Kaplan. “Beyond the Glide Path: The Drivers of Target-Date Fund Returns,” The Journal of Retirement, 5(4), 25–39, Spring 2018.

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Although the target date portfolios are managed for investors on a projected retirement date time frame, the allocation strategy does not guarantee that investors' retirement goals will be met. Investment professionals manage the portfolio, moving it from a more growth-oriented strategy to a more income-oriented focus as the target date gets closer. The target date is the year that corresponds roughly to the year in which an investor is assumed to retire and begin taking withdrawals. Investment professionals continue to manage each portfolio for approximately 30 years after it reaches its target date.
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