While the debate over passive versus active investing deserves consideration, there are several other factors that can have a bigger impact over time, according to a new white paper from T. Rowe Price.
For many plan participants, a qualified default investment alternative (QDIA) may be the first and only investment they ever hold, and factors such as the shape of a target date fund’s glide path and the level of diversification within the asset mix loom large, the firm explains in Three Tips for Evaluating Target Date Solutions.
For plan sponsors, the stakes can be high, especially because U.S. workers have a savings shortfall, many participants are living longer and their needs are difficult to predict, explains Lorie Latham, Senior Defined Contribution Strategist and author of the paper. “We think it can be a valuable exercise for plan sponsors to take a step back and carefully evaluate the target date solutions in their plans to ensure they still are aligned with the plan’s objectives, the investment committee’s beliefs and preferences, the characteristics of the participant population, and the needs of the covered workforce,” writes Latham.
Plan Objectives and Characteristics
Latham suggests that plan objectives and characteristics are two key factors to begin with when selecting a target date solution. For some sponsors, the focus is on helping participants achieve their long‑term retirement income goals by delivering high returns, while others may focus on minimizing balance variability at retirement or in volatile markets, she explains. “Most sponsors likely want to achieve both aims. And finding an approach that promises the right levels of possible growth and risk management is central to the target date evaluation process, in our view,” the paper emphasizes.
Meanwhile, plan characteristics, such as employees’ salary levels, deferral rates and employer contributions, can offer a “thumbnail sketch” of plan participants’ current retirement preparedness and can help inform the glide path design, the paper explains. For instance, plan sponsors with higher pay levels may opt for a TDF whose glide path maintains a higher proportion of equities for a longer period so that employees will have a higher income-replacement rate later in life. In contrast, plans with higher employer contributions may opt for a lower equity glide path, since the higher level of savings can offset the need for growth.
Distribution-based Glide Path
The T. Rowe Price paper further observes that developing a glide path for an entire plan population is challenging, as participants typically vary widely in their earnings, savings behavior and preferences. As such, creating one glide path for a large group of employees requires a different way of looking at them and their needs, it suggests. Yet, to find a glide path that fits everyone, many TDF providers select a glide path for a hypothetical average participant, which may not be ideal for all participants, including those who are more vulnerable financially.
“That’s why we believe it can be more effective to use statistical distributions of key characteristics to design a glide path,” writes Latham. When the firm ran simulations of a glide path using an average participant versus one using statistical distributions of those values across a hypothetical population, it found that the distributions‑based glide path outperformed in terms of asset accumulation at retirement and consumption replacement during retirement.
Finally, Latham suggests that plan sponsors take a step back and review the plan, its goals, characteristics and participant population to be better equipped to address questions, such as the relative merits of active versus passive investments in a target-date option.
The paper suggests looking beyond fees and considering a wide range of potential benefits when considering active and passive strategies for a target date solution—while being mindful of the tradeoffs. For instance, the paper notes that from the standpoint of management fees, a target date solution comprised of passive vehicles should be cheaper than an active strategy. Latham observes, however, that the emphasis should be on the value‑for‑cost equation in relation to the performance of active management and how it fits with the sponsor’s objectives. “Whether sponsors choose a purely active or purely passive approach, or a combination of both (often referred to as a blend strategy), we believe it is imperative that sponsors carefully consider their own beliefs and objectives relative to these techniques,” she notes.