July 2020

Once a new product dominates a market such that the market begins to evolve around it, that original architecture gets locked in.

Startups in the market face a choice: comply with the prevailing standard or fight the embedded switching costs. Seemingly better products may not win if these switching costs are too high. This is how Sequoia Capital’s famous “aircraft carrier” investment strategy works so well.

Invest in a leading product like the Apple computer (that’s the aircraft carrier). Fund complementary product startups, such as the disk drive and the Ethernet for the Apple PC, to cross sell (those are the fleet support vessels). Together, this ecosystem can become the new prevailing standard. Sequoia's investment in Cisco is an analogous example.

In the retirement market, the Qualified Default Investment Alternative is the aircraft carrier, and the Target-Date Fund is the support vessel that enables customer adoption.

How Target-Date Funds Enable the QDIA

The Target-Date Fund is the most popular QDIA implementation. As a reminder from the previous memo, the QDIA permits employers to enroll employees (1) by default into defined contribution retirement plans and (2) without legal liability for the investment returns.

TDFs allocate heavily into equities for younger investors, who can weather short-term risks. As time employees age, TDFs shift the allocation toward bonds. These equity and bond allocations tend to be invested into passive funds run by the TDF vendor.

Fig 1. Vanguard allocates Target-Date Funds to passive vehicles

Source: Vanguard Fund Comparison

TDFs and their passive funds are much more widely adopted by younger generations whose employers have enrolled them by default (note in Fig. 2 how the median Millennial & Gen X households are much closer to the model TDF allocation than older generations).

Fig 2. Age-based equity allocations among Vanguard retail investors

Source: Vanguard, Risk-taking Across Generations (2018)

The shift toward the TDF model is a shift from active to passive funds. It doesn’t matter if the stock market seems overvalued or undervalued. So long as people earn wages and, by default, make deposits into their TDF accounts, those accounts will buy equities via passive funds.

Target-Date Funds Contribute to the Rise of Passive

In 2019, US passive mutual funds surpassed active funds in assets under management. The oft-cited reasons are that passive funds offer cheaper and tax-advantaged exposure compared to active funds. It's equally important that TDFs became the default retirement product.

Fig 3. The rise of passive over active investing

Source: Morningstar

What could change this shift from active to passive investing?

A regulatory shift could do it, but legislators are reinforcing the existing system (e.g. see the recently passed SECURE Act). Policymakers see the current approach as the most credible solution to our retirement savings shortfall.

Theoretically, TDF allocators themselves could also increase active fund allocations. But do you see Vanguard suddenly pulling an about-face, hiring hundreds of analysts, and favoring active investing? It doesn’t seem likely.

Private equity funds, however, are a distinct possibility on the horizon.

Private Equity Enters Stage Left

Private equity funds have been lobbying for access to Target-Date Fund assets since at least 2012. One early proposal suggested replacing defined contribution plans (read: TDFs) with defined benefit plans invested partially in private equity. The more recent push has been to keep defined contribution plans and to redirect TDF assets into private equity. Over the past few years, organizations like the Georgetown Center for Retirement Initiatives and the Institute for Private Capital have published studies supporting the investment of retirement savings into private equity.

Perhaps seeing the writing on the wall, Vanguard unveiled plans to launch a private equity fund in February. The Department of Labor recently ruled that defined contribution plan allocators may invest retirees’ assets (read: TDFs) into private equity.

The retirement infrastructure of the 2010s piped assets from defined contribution plans to Target-Date Funds to passive public equity funds. The 2020s present a more complicated picture. The system faces a stress test as the Boomer generation retires, and private equity may steal allocation away from passive public equity. Next week, I'll give some thoughts on the potential investment impacts of these shifts.

Special thanks to Mike Green of Logica for his work and commentary on retirement flows and passive investing.