Achieving Balance: Benefits of the Blend in Target Date Funds

There’s a disconnect between core menus and target date funds. When it comes to investment menus in defined contribution (DC) plans, nine out of ten plan sponsors have adopted the best practice of offering both active and passive fund options.¹ However, this blended approach doesn’t always carry over to target date funds (TDFs): Only 36% of plans choose TDFs that combine active and passive underlying strategies. Much of this is driven by fear of litigation. But the fact that recent lawsuits have targeted plans with passive TDFs demonstrates that choosing the cheapest option doesn’t shield sponsors from complaints about investment underperformance or fiduciary imprudence. 

Even passive TDFs are active. Despite their name, “passive” TDFs—as with all TDFs—require many active investment decisions, including glide path construction, “to” versus “through” landing points at retirement, and others. Such decisions about TDF design have historically caused a 10%+ annual dispersion in net returns among TDFs of the same vintage, far greater than the 0.3% average fee difference between passive and blended TDFs. ² 

Blended TDFs offer potential benefits that single-style options don’t. Because some asset classes tend to be better suited for active or passive management than others, blended TDFs may combine styles selectively to enhance potential returns without meaningfully increasing management fees. Blended TDFs also offer greater asset class diversification than passive options; the seven largest blended TDFs have an average of 16 (versus 4-5 for passive counterparts). 

The Department of Labor offers guidance for evaluating TDFs. When selecting TDFs, sponsors must have a thorough understanding of the plan’s objectives and the participant population. Using Department of Labor guidelines, we offer a step-by-step TDF selection process for sponsors. The essential step is documenting the process as part of fulfilling fiduciary due diligence requirements.

Offering a thoughtful mix of active and passive options within a DC plan’s core investment menu is widely considered a best practice by retirement and investment professionals. Sponsors recognize that a menu that offers a diversified roster of investment managers (and both active and passive management styles) can help them better serve their participants and meet their fiduciary responsibility. In fact, 91% of sponsors surveyed in Callan Institute’s 2024 Defined Contribution Trends Survey offered both active and passive funds in their core investment menus (Exhibit 1).

However, this blended approach often doesn’t transfer to sponsors’ TDF selection. Of the DC plans that offered a TDF suite, only 36% used TDFs that consisted of both active and passive underlying investments. Why isn’t there greater alignment between these approaches, with more sponsors using TDFs that blend active and passive underlying strategies? We see several potential reasons, including litigation risk, generalizations about passive funds and macroeconomic considerations. 

Fear of class action lawsuits 

Passive TDFs are often perceived to be a “safer” option from a litigation perspective (compared with active or blended TDFs), as many lawsuits allege high or excessive recordkeeping and investment fees. As a result, many sponsors believe that offering passive TDFs—which often have lower expenses than other types of TDFs—will circumvent a potential legal minefield. Unfortunately, that’s not the case.

Passive is not a panacea for protecting sponsors from legal action.

The reality is that passive TDFs don’t protect sponsors from lawsuits. Sponsors may be drawn to passive TDFs as a means of protection from participant litigation, but successful lawsuits have generally involved a combination of factors, including a weak process for selecting and monitoring plan investments, underperformance, conflicts of interest, and excessive management and/or recordkeeping fees. 

Litigation related to investment underperformance and fiduciary imprudence has increased in the last several years.³ For example, one law firm has filed about a dozen lawsuits on behalf of participants that involve the underperformance of a particular passive TDF suite relative to the five largest TDF suites on the market. There’s also some irony here. In 2014, a court ruled that a sponsor had breached its fiduciary duty by making an investment decision “with virtually no discussion or analysis,” where the “driving consideration” was its risk of fiduciary liability.⁴ This is a good reminder that sponsors are obligated to act exclusively in the best interests of participants.

Fiduciaries are also not obligated to select the least expensive investment options; rather, the focus should be on the value that an investment offers relative to its cost. The average fee difference between a passive TDF and a blended TDF is only about 30 basis points (bp)—but the return dispersion between passive and blended TDFs can be quite wide given the significant differences in investment philosophies and approaches (Exhibit 2).

Performance driver misattribution 

Historically, passive U.S. large cap equity funds have outperformed their active peers during times of market strength (Exhibit 3). This asset class generally represents the largest weighting in most TDFs and tends to be the biggest driver of returns. As a result, some sponsors may mistakenly assume the advantage extends to other asset classes.

However, analysis of the past 30 years shows that the relative advantage of passive or active styles is volatile and varies widely across asset classes and time periods, as shown in Exhibit 4, using index rankings as a proxy for passive strategies. The takeaway is that a blend of active and passive strategies in TDFs may help stabilize excess return volatility.

Macroeconomic considerations 

Factors such as interest rate cycles can often influence the chances of active management success. Within equities, the historically low rates that followed the global financial crisis generally shifted favor to passive. However, as rates have normalized more recently, the effectiveness of passive in some asset classes has diminished. 

Consider international developed equities. When the 10-year U.S. Treasury yield was below 3%, the MSCI EAFE Index was ranked in the 46th percentile within the Morningstar® Foreign Large Blend category—meaning that only 46% of funds in that category outperformed the Index (more favorable for passive). As interest rates rose, the proportion of active managers outperforming also increased, with the MSCI EAFE Index falling to an average 56th percentile ranking (Exhibit 5).

Post-Covid, the Federal Reserve’s aggressive rate hikes to tame inflation negatively affected some segments of the equity market and pushed bonds into bear market territory. Additionally, changes in structural economic drivers— including deglobalization, demographics, decarbonization, remilitarization and ongoing government deficits—may keep inflation higher for longer. These conditions may hinder the performance of some passive equity funds and could pave the way for active managers to outperform.

Beyond a potentially more favorable macro environment for active managers, the costs of actively managed strategies have declined significantly— another reason for sponsors to consider blended TDFs. 

Over the past 20 years, the average asset-weighted expense ratio for open-ended mutual funds and ETFs has dropped from 91 bp to 37 bp,⁵ mainly due to the decline in active fund fees. Blended TDFs have benefited from this trend, as they can now access active managers at costs that are more competitive with passive. Exhibit 6 illustrates the decline in the average blended TDF expense ratio, which has fallen from 55 bp in 2018 to 40 bp in 2023. 

Many plans now favor collective investment trusts (CITs) rather than mutual funds in their investment menus, resulting in further reduction in the cost of active strategies in TDFs. CITs have fewer regulatory requirements than mutual funds, and their fees can often be negotiated, both at the underlying TDF manager level and at the plan level.

Despite what the naming convention implies, managers of passive TDFs make many active decisions. Some of these include glide path design, “to retirement” versus “through retirement” landing points, asset allocation and underlying benchmark selection, and rebalancing frequency. 

Glide path construction is where some of the largest differences in TDFs can be observed. Each manager uses a proprietary glide path methodology, leading to a wide dispersion of equity allocations among TDF suites. Comparing TDF vintages five years from retirement, the most aggressive TDF glide path had a 65% equity allocation, while the most conservative had a 28% allocation—a difference of nearly 40% (Exhibit 7).

As Exhibit 8 shows, these significant differences in equity allocations often lead to wide dispersions in performance among TDF managers. Over the last 11 years, the best and worst TDFs with a 2025 vintage averaged a difference of more than 11%.

Certain asset classes are better suited to a particular style of management 

Our decision to use active or passive depends on many factors, including the excess return potential within each asset class, the current market environment and fees. For example, active fixed income managers have historically had a high degree of success outperforming their benchmarks net of fees due to the sheer size and structural inefficiencies of the asset class. A blended TDF can add value by using active strategies in less efficient asset classes, such as fixed income or non-traditional investments, where the success rate in enhancing returns has been higher. To help trim overall management fees, cost-effective passive strategies may be used in more efficient areas of the market, such as U.S. large cap equity or Treasury inflation-protected securities (Exhibit 9).

Better asset class diversification 

On average, the seven largest blended TDFs allocate to 16 asset classes, while the largest three passive TDFs allocate to only four or five (Exhibit 10). In some cases, blended TDFs also feature tactical asset allocation capabilities, which can lead to potentially better risk-adjusted returns than those returns available to passive TDFs.

Sponsors should document their process and rationale for selecting a particular suite of TDFs. The plan’s approach to its core investment menu can also serve as a guide for determining the most appropriate TDF style. 

Before starting the TDF evaluation and selection process, sponsors should have a thorough understanding of the objectives of the plan, including: 

• Whether the plan is the primary retirement savings vehicle for participants or is supplemental 
• The plan’s philosophy on active versus passive management, single-manager versus multi-manager approaches, and asset class diversification 
• The plan’s goal with respect to participant assets at retirement (retain them versus encourage rollovers or distributions)

Participant population is also an essential consideration, including: 

• Participant risk tolerances and actual behaviors 
• Contribution rates 
• How participant salaries are expected to grow over time 
• Participant engagement levels with the plan 
• Participant investment expertise 

In 2013, the Department of Labor provided guidance for sponsors on evaluating and selecting TDFs (Exhibit 11, see next page). Even now, over a decade later, these tips are still relevant. 

The process of selecting the most appropriate TDF suite for a DC plan requires a thorough understanding of the product and how it will align with the plan’s objectives, philosophy and participant needs. Deciding on the investment style is just one component of the process, and both active and passive approaches to TDFs can play a role. In our view, however, a blended approach offers the best of both worlds to sponsors and participants.