July 2020

Architecture is destiny.

Once a new product dominates a market such that the market begins to evolve around it, that original architecture gets locked in. Customers become accustomed to it. 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 a related ecosystem of products , such as the disk drive and the Ethernet for the Apple PC, to help it overcome the embedded switching costs. 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 last week, 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 put younger investors, who can weather short-term risks, more into equities. As time passes, TDFs shift the employee's assets more heavily into bonds. Those equity and bond allocations are, in practice, invested into passive funds run by the TDF vendor (see Fig. 1).

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

Source: Vanguard Fund Comparison

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

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

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). As time goes on, more funds will shift toward the TDF model and, thus, out of active funds and into passive funds.

Target-Date Funds Choose Passive Investing For You

Passive investing is now embedded into our retirement infrastructure. 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.

Last year, 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. An equally important reason is that they 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 in fact, policymakers are reinforcing the existing system with the recently passed SECURE Act. They see the current approach as the most credible solution to our retirement savings shortfall.

The TDF allocators themselves could also do it. 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 of this year. Earlier this summer, the Department of Labor 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.