Separate Myth From Reality When Considering Passive Target-Date Funds

Passive TDFs are not always the safer fiduciary choice and not always the better choice for DC plan investors.

Plan sponsors are increasingly using passive target-date funds (TDFs) in their defined contribution (DC) plans. Demand is being driven largely by the low cost of the funds, but it is important for plan sponsors and their advisers to remember that cost is only one factor to consider when selecting TDFs.


Additionally, the term “passive TDF” is somewhat misleading and often only truly applies to the final implementation of the TDF strategy. Before implementation, there are many active decisions that go into the creation and management of a TDF. For example, there is no such thing as a passive glide path design—referring to the weight of stocks and bonds in the TDF. There is also sub-asset class allocation, underlying index selection, investment vehicle choice, use of security lending, and more. These “active” decisions can translate into meaningful differences in investment risks and results.


While passive TDFs can be a great choice for a DC plan, plan sponsors and their advisers need to dig deep during their due diligence when evaluating these funds. To help make good choices that are aligned with their participants’ needs, it’s critical to separate myth from reality.


Myth 1: Passive TDFs are always a safer fiduciary choice

Selecting the lowest-cost TDF should not lure plan fiduciaries into a false sense of security. There is no free pass when it comes to TDF evaluation—active, passive or blended, the choice must be prudent. Simply going passive and low cost may seem like the easy choice, but it does not absolve fiduciaries of their due diligence and ongoing monitoring responsibilities.


Fees are certainly an important consideration in this process but not the only one. Indeed, low fees alone may not be in the best interests of plan participants if the overall TDF design is a poor fit. A fiduciary must consider all aspects of TDF design to ensure the option is well-suited for the plan.


Nowhere is this more evident than in the critical years leading up to and into retirement. This is the point when glide path differences, particularly in equity exposures, become most apparent. It is also when investors may be most likely to react emotionally in volatile or down markets, and when fiduciary risk may be at its highest. Risk decisions concerning equity levels as well as allocations in more volatile sub-asset classes, such as emerging market securities and high-yield bonds, should be conscious and deliberate.


Myth 2: Passive TDFs are always a better choice for investors

As mentioned earlier, not all passive TDFs are structured the same, with notable differences in areas such as asset allocation, index selection and glide path. These all affect risk and performance, both in the short and long term. So, while passive TDFs could be a great choice for some plans’ participants, it doesn’t mean they are the right choice for all plans.


Below are some of the major points to consider when evaluating TDFs, regardless of whether the manager utilizes passive or active strategies in portfolio construction. Different plans can have different needs, and reviewing these types of questions can help build a deeper understanding of how different passive TDF families may align with specific plan participant needs.


  • Asset class diversification and allocation strategy – What asset classes are included in the TDF, and what are the allocation’s starting and end points?


  • Slope and speed of glide path progression – How quickly does the TDF dial down risk, and is the glide path managed to or through retirement?


  • Sub-asset shifts – How does the TDF manage exposure to sub-asset classes, and are these allocations static or do they evolve through the glide path?


  • Underlying index selection – Which indices are used to gain market exposure, and how does this affect the underlying risk/reward profile?


  • Investment vehicles – Does the TDF use mutual funds, separate accounts, collective investment trusts (CITs) or exchange-traded funds (ETFs)?


  • Securities lending – If allowed, what are the risks involved, and does the generated revenue help offset fees?


  • Portfolio rebalancing – How are cash flows managed, and what are the bands allowed around policy allocations?


Myth 3: Active or passive is an either/or choice

All things being equal, lower fees will translate into higher returns. However, all things are not equal across TDFs, given the flexibility providers have in portfolio design. As a result, there are compelling reasons why a plan may select a passive TDF or an active TDF. Additionally, there is a growing segment of blended active and passive TDFs that can help bridge the best of both of these worlds. Consider the high-level pros and cons of each approach.


Passive implementation. This approach can provide a plan with an effective, low-cost qualified default investment alternative (QDIA), but it may eliminate certain potentially additive asset classes that are difficult or costly to replicate in terms of passive performance. Underlying indices used in portfolio construction may also shape allocation decisions, not only at the stock and bond level, but in sub-asset class exposures as well. There can be notable portfolio characteristic differences when using a broad market index to gain equity exposure versus market capitalization equity indices that may allow further refinement in a glide path’s risk/reward profile.


Active implementation. Typically, this method strives to add portfolio value for a higher fee. These TDFs generally seek to adapt portfolios, through time, for return-seeking opportunities or for risk management by investing in underlying securities at different weights than the benchmark. Of course, this approach also creates risk that the underlying managers may make the wrong investment choices and underperform.


Blended implementation. This combines the previous two approaches by investing in both low-cost index funds and active managers to gain select market exposures. Typically, active managers are utilized to expand asset class diversification or to boost return potential in more inefficient markets where active managers tend to outperform. Using both types of strategies can allow the TDF manager to refine active risk levels at different parts of the glide path and may also provide diversification as markets cycle.



Passively implemented TDFs can be a very effective retirement investment solution for many investors. However, it is important to remember that when the term passive is applied to a TDF, it can be misleading as it refers specifically to portfolio implementation. Glide path design, including asset class exposure within the glide path, is the most important decision and is always the result of active choices by the manager.


Because of this, a passive TDF approach does not necessarily reduce risk or offer more reliable performance on its own. Nor does it automatically offer a safer fiduciary choice. Instead, passive

TDFs are as varied in glide path structure and other design choices as any other type of TDF. The same can be said for their resulting risk/reward exposures.


There is no question that the low costs of passive implementation are compelling, but plan sponsors and their advisers should consider first and foremost how a TDF’s overall portfolio design aligns with the demographic needs of their participants. Fees, while important, should not be the most important consideration in this process. From a fiduciary perspective, it is more critical to evaluate how the multiple factors and considerations that go into developing and delivering a glide path collectively work together to shape potential outcomes for participants.



John Greves is vice president, head of multi-asset strategies, Charles Schwab Investment Management, Inc.; Jake Gilliam is senior multi-asset class portfolio strategist, Charles Schwab & Co., Inc.; and

Natallia Yazhova is senior research analyst, Charles Schwab Investment Management, Inc.




The values of target-date funds will fluctuate up to and after the target dates. There is no guarantee that the funds will provide adequate income at or through retirement.

Target-date funds are built for investors who expect to start gradual withdrawals of fund assets on the target date, to begin covering expenses in retirement. The principal value of the funds is not guaranteed at any time and will continue to fluctuate up to and after the target date.


Target-date funds’ asset allocations are subject to change over time in accordance with each fund’s prospectus.


The material contained in this document is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. The information contained herein should not be construed as financial or investment advice on any subject matter.


This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Strategic Insight (SI) or its affiliates.