Active TDFs May Help With Market Volatility, Sequence Risk

Passive target-date funds (TDFs) dominate the defined contribution (DC) retirement plan market, according to Cerulli Associates.

It notes in The Cerulli Edge―U.S. Retirement Edition, 1Q 2019 issue cost and plan design are the primary drivers of passive TDF flows. In a 2Q 2018 survey of TDF managers, Cerulli asked respondents to identify which factors they believe DC plan sponsors consider when selecting a TDF. Cost clearly ranked as the top factor, gathering 89% of responses. Meanwhile, investment management style (i.e., active vs. passive) ranked significantly lower (19%).

In addition, the advent of automatic enrollment in the DC plan market and use of TDFs as qualified default investment alternatives (QDIAs) for most plans provides TDFs with a repeatable source of inflows resulting from each participant’s paycheck.

According to Cerulli, during years of roughly flat and negative equity market performance (2015 and 2018, respectively), active TDFs exhibited slightly higher market-assisted growth. The inverse of this scenario is true during years of strong equity market performance (2016 and 2017). “These statistics suggest an increasingly volatile market that could present opportunities for active managers to display their relative value,” Cerulli says.

TDFs are long-dated investments intended to be held for decades of an individual’s working career. In this respect, Cerulli says DC plan participants’ lack of reaction to market volatility can be taken as a positive sign, particularly for young investors who have an extended horizon to recoup near-term losses.

However, participants near retirement age face greater sequencing risk (i.e., the risk of market volatility occurring when individuals transition into retirement and begin to draw down savings). Some argue that passively managed TDFs do little to address this risk and put participants in danger of realizing a steep drop in account balance at an inopportune time. Cerulli suggests that active target-date managers should highlight the downside protection offered by their products and seek to appeal to plan sponsors concerned about the well-being of near-retirees and retired participants.