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Are Target-Date Funds Sustainable?

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Director of Responsible Investing at Federated Hermes, leading ESG integration and engagement across $630 billion in global assets.  

The sustainability movement has plenty of targets. One of the most prominent is the 2015 Paris Agreement, which seeks to limit global warming to 1.5 degrees Celsius above pre-industrial levels. The United Nations Climate Conference, COP26, which recently took place in Glasgow, asked nations to update their carbon neutrality targets. Then there’s the Sustainable Development Goals (SDGs). There are 17 of these, from ending poverty to improving education to protecting the environment. And there are actually 169 objectives within these broad categories, making it a very ambitious mission. Many investment managers have used the SDGs as a basis for impact-focused investment solutions.

But there’s another goal-centered product earning the attention of sustainability-oriented investors: target-date funds. Most people saving for their retirement or children’s education are familiar with these one-stop shops. Since their launch in the 1990s, their convenience and low maintenance have risen in popularity, with target-date funds accounting for approximately $2.8 trillion in assets at the beginning of 2021, according to a recent Morningstar report.

Set It, But Don’t Forget It

The concept is simple enough. For instance, a retirement target-date fund takes the year you expect to leave the workforce. That time is typically identified in the mandate, and usually the name, of the fund. It applies an asset-allocation formula that regularly adjusts weightings of different asset classes, such as equities and fixed income, the closer it gets to that year. The account “rebalances” periodically, almost always from a more aggressive (mostly stocks) to a more conservative (mostly bonds) allocation. They essentially attempt to put investing on autopilot, often marketed with a “set it and forget it” slogan.

While autopilot is a convenient setting, it comes with less oversight because target-date funds are managed statically. Most will switch their composition on a fixed glidepath without paying any attention to the markets. They might add more bonds when interest rates are rising or sell stocks after market prices have plummeted. Active investment managers do not possess a crystal ball, of course, but they can adjust to a major unforeseen event or when attractive opportunities arise.

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ESG Integration

The emergence of environmental, social and governance (ESG) within finance has brought a new dimension to target-date vehicles. At the highest level, a preordained plan shifting from stocks to bonds to cash may not assess the legion of ESG issues potentially lurking beneath the asset. To date, the majority of target-date funds do not report how many of the underlying investments have formally incorporated ESG analysis into their investment processes. This issue has increased in relevance now that the Department of Labor has proposed a new rule making it easier for fiduciaries to consider ESG factors when selecting investments in a retirement plan such as a 401(k).

However, three specific issues remain for investors looking for authentic ESG integration. The first is that equity funds tend to dominate available ESG-focused investment options for a target-date fund, leaving fewer choices in fixed income, private markets and cash management.

The second is the fallacy that a portfolio’s gradual shift from equities to fixed-income lowers all risk. Of course, historically this has been the case from a market perspective. But material ESG risks don’t disappear simply because you are now invested in a company’s bonds instead of its stocks.

Lastly is the matter of degree. How much of a target-date portfolio integrates ESG? If incorporation only occurs in a small slice, one should question what type of risks exist in the rest of the pie.

Stewardship Is Not Seasonal

The assessment of material ESG issues has a broader role to play in responsible investing. Proactively engaging with a company’s board and management is a powerful tool in the long-term evaluation of an investment, irrespective of asset class. Many investors still equate active engagement solely with proxy voting, which is certainly an important voice for shareholders. But it also applies to bondholders and owners of other securities. Due to their static nature and equity orientation early in their glidepath, many target-date funds do not take active and holistic ownership of companies in their portfolios.

A robust engagement program does not only consist of an annual letter-writing campaign. Direct outreach that advocates for positive ESG change needs to occur year-round and be incorporated into all the underlying funds inside a target-date solution. Stewardship specialists are experts in the sustainability issues of the parent company, not the security, meaning their insights apply to both stocks and bonds. The key is to understand persistent ESG risks and progress of the issuer to address those in a meaningful dialogue. Adding ESG discovery to traditional financial due diligence seeks to present a more comprehensive view of a company’s trajectory. It should better answer the question: Is the issuer structurally sound and set to stay that way? And because effective stewardship and active ownership have a time horizon aligned with any target-date fund, engagement can help generate long-term sustainable wealth creation.

As 401(k)s and retirement plans expand to offer more ESG-oriented options, the key will be to look beyond their expiration dates and fully understand their ingredients. This is the aspect of responsible investing that is not fully captured in existing target-date offerings. Transparency of ESG integration and engagement activity for the portfolio will determine the future leaders in this critically important and evolving space. It’s all about reducing risk and helping investors reach their goals — the most important targets of all.


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