Propriety TDFs Continue to Dominate QDIA Market

Despite an ongoing plan sponsor investment unbundling trend, the majority of TDF providers continue to construct their TDF portfolios using proprietary funds as the underlying investments.

Mercer has published a target-date fund (TDF) industry analysis that shows passive TDFs continue to garner substantial new assets, with the market share of passively managed TDFs increasing to 51.8% in the fourth quarter of 2017.

According to Mercer, this figure is up from 48.9% as of year-end 2016 and 47.8% the year prior. On the other hand, the market share of actively managed TDFs continued its decline to 36.8% of market share by the end of last year.

Also important to note, Mercer says, is that despite an ongoing plan sponsor investment unbundling trend, the majority of TDF providers continue to construct their TDF portfolios using proprietary funds as the underlying investments. In fact, this closed architecture approach is used to manage the vast majority of TDF assets, and the proprietary trend marginally increased from 92.1% to 92.3% during the last quarter of 2017. In a related result, the largest four providers continue to dominate the TDF industry in terms of assets under management, though their total market share has slightly declined over the past five years, constituting about 75% of the market.

Digging down into these numbers, the analysis finds performance played only a small role in the asset growth. Instead, contribution cash flow is cited as a much bigger factor.

“Strong growth was shown in vintage years 2060 to 2020,” Mercer finds. “In the 2015 and near-retirement vintages, the aggregate assets under management did grow marginally, but the rate of growth was far lower. In addition, an interesting aspect is how the assets peak in the 2030 vintage year and then decline in the 2025 and 2020 vintages. This is much more pronounced than shown in the 2016 study.”

According to Mercer experts, the drop off of assets in the retirement years was not a particular surprise, “given we know that many participants still transfer assets out of the plan at or after retirement.”

“In addition, TDFs only really became the dominant default fund choice after the passing of the Pension Protection Act in 2006, and therefore many older participants were not defaulted into TDFs,” Mercer researchers explain. “The decline in 2025 and 2020 vintages is something to continue to monitor; it could be a sign that older participants are moving out of TDFs prior to retirement. Previous studies have suggested this may be the case.”

Over the past five years, Mercer has seen two key changes to the international equity allocations of TDFs. First, in general, there has been an increasing allocation to international equities. Second, and related to this, typically there has been a higher international equity allocation in longer dated vintages.

“The past year has seen the international equity allocations remain fairly static,” Mercer researchers observe. “However, the asset-weighted average international equity allocation is higher than the median across the board. Maybe a higher international equity allocation helps to attract TDF assets? 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%). Although a couple of providers do align with ACWI, they are the exceptions.”

In its discussions with TDF managers, Mercer has found many managers say they have not aligned with the ACWI, and have continued with portfolios that display home equity bias for a number of reasons. These include that “American participants have a natural home equity bias, partially due to a greater familiarity with U.S. equities, but also given that their commitments are U.S.-based. In addition, most of the TDF peers similarly display home equity bias. Further, there is some evidence that U.S. equities have displayed less downside risk in times of stress than international equities.”

The analysis goes on to suggest, unsurprisingly, that funds in the TDF universe have experienced very different return profiles, and the differences in returns make a real difference in participant outcomes. Offering one anecdotal example, researchers examine several 2030 funds, showing the accumulation over five years of a $1,000 initial investment for the median manager would have amounted to $1,579. At the 95th percentile for performance, the asset accumulation would have been $1,699, and at the 5th percentile, the amount would have been $1367.

“Doing the same calculation for the 2050 fund gives a difference of $320, and for the income fund (a smaller) difference of $178,” Mercer shows. “As you can see, TDFs returns can vary quite significantly, and these can have a meaningful impact on participant outcomes. It is key to remember that past performance is not always a good predictor of future performance, and it is future performance that matters. If a TDF consistently underperforms its peers, it may not be a reason to change providers, but it is important to understand why the underperformance may have taken place.”

The reasons for underperformance could include glide path and roll down structure; differing strategic asset allocation or asset diversification; use of dynamic or tactical asset allocation; amount of exposure within underlying funds to active or passive management; and underlying manager alpha (or negative alpha).

Turning to fee data surrounding TDFs, as of the end 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. Larger TDF providers appear to have benefited from their larger asset base, allowing them to charge lower fees relative to smaller providers.

“This increased success for larger providers may also be due to the prevalence of fiduciary litigation that has occurred specific to plan fees,” Mercer speculates. “Between 4Q15, 4Q16 and 4Q17, the median fee for passive TDFs decreased by one basis point, which is significant relative to the already low fees for this space. Active fees reduced by approximately three basis points. This fee reduction may be attributable to the launch of several low-cost products disrupting the passive TDF space and the necessity for providers to remain fiscally competitive.”