Under Pressure to Reduce Fees, Passively Managed TDFs Finding Favor

Potentially fueled by the desires of plan sponsors to reduce fees, there continues to be a move toward passively managed target date funds, according to an analysis by Mercer.

In its “Target Date Funds – Highlights and Trends, 2017 Survey Update,” the firm notes that passively managed TDFs continued to gather interest among investors, with the market share increasing to 51.8% in the fourth quarter of 2017. This is up from 48.9% in fourth quarter of 2016 and 47.8% during the same period in 2015. In contrast, the market share of actively managed TDFs continued to slip, declining to 36.8% of market share in the fourth quarter of 2017.

Based on an analysis of 68 funds, the report further suggests that the shift toward passive funds has also led to downward pressure on fees for active funds, as many providers have reduced fees over the last few years. In general, all categories of TDFs (active, passive and hybrid) logged a decrease in median fees across vintage years, according to the report. (“Vintage year” refers to a TDF’s target year of retirement.)

As of the fourth quarter of 2017, median fees across vintage years for actively managed TDFs ranged from approximately 0.46% to 0.60% versus approximately 0.10% to 0.13% for passive funds, the analysis notes. Larger TDF providers, not surprisingly, appear to have benefited from their larger asset base, allowing them to charge lower fees compared to smaller counterparts.

Between the fourth quarters of 2015, 2016 and 2017, the median fee for passive TDFs decreased by one basis point, which, Mercer noted, is “significant relative to the already low fees for this space.” Active fees, meanwhile, were reduced by approximately three basis points, which may have been attributable to the introduction of several low-cost products disrupting the passive TDF space.

Overall, TDF assets reached $1.7 trillion in the fourth quarter of 2017, up from $1.3 trillion during the same period in 2016. This growth has been supported by strong participant-directed cash inflows, with TDFs being the QDIA in many DC plans, as well as strong equity markets both domestically and globally.

The firm further notes that, despite unbundling trends, the majority of TDF providers continue to construct their portfolios using proprietary funds as the underlying investments. Throughout 2017, the percentage of assets invested in closed architecture solutions increased from 92.1% to 92.3%, according to the data.

Home Equity Bias

While there has been an increasing allocation to international equities over the past five years, the authors note that international equity allocations this past year remained fairly static. “What is probably most interesting is how the international equity allocations are typically well below the international equity component of the All-Countries World Index (ACWI) (47.8%),” the authors explain.

Although a couple of providers do align with ACWI, Mercer notes that in their discussions with TDF managers, many have noted they have not aligned with the ACWI and have continued with portfolios that display home equity bias.

The reasons given include that American participants supposedly have a “natural home equity bias,” partially due to a greater familiarity with U.S. equities and given that their commitments are U.S.-based. In addition, the firm notes that there is some evidence that U.S. equities have displayed less downside risk in times of stress than international equities. Yet, Mercer’s analysis also confirmed that most other TDF peers similarly displayed home equity bias.

TDF Rollouts?

Meanwhile, even though AUM growth is strong, the report suggests that in addition to assets rolling out of TDFs around retirement, there appears to be some evidence that it could be happening sooner than retirement. The data shows strong growth in vintage years 2060-2020, but in the “retirement years” 2015-Income, the aggregate AUM grew marginally, but the rate of growth was far lower. The report explains how assets peak in the 2030 vintage year and then decline in the 2025 and 2020 vintages.

While the drop-off of assets in the retirement years was not a particular surprise, the report emphasizes that the decline in 2025 and 2020 vintages “is something to continue to monitor” and could be a sign that older participants are moving out of TDFs prior to retirement, as previous studies have suggested  may be the case.

In looking ahead and watching future developments, the authors note that they are beginning to see alternative solutions that tailor asset allocations to individuals and through technology advancements can do so without needing participant engagement. They note that “these products are in their early development, but it is worth watching this space.”

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