Target Date Fund Selection: More Than Simply Active vs. Passive

Target Date Fund Selection: More Than Simply Active vs. Passive May 2018 Not FDIC Insured May Lose Value No Bank Guarantee INVESTMENT MANAGEMENT

Table of Contents Executive Summary 2 Introduction 2 Glide Path Design Is the Primary Driver of Target Date Returns and Volatility 4 Benchmark Selection Remains Complicated 6 Asset Allocation Approach Impacts Diversification and Flexibility 8 Conclusion 10 Executive Summary While choosing between active and passive target date funds is important for a plan sponsor, it is only one consideration among many that ultimately drive participant outcomes Decisions around a target date fund s glide path and asset allocation active choices that even passive target date funds must make likely will have much more impact on participant outcomes than the potential cost differences between the active or passive portfolios underlying the fund A fiduciary s responsibility includes providing participants with a suitable selection of investment choices, both across a plan s lineup of investment options and within its target date offering Passive target date managers tend to offer less breadth and depth in asset class choices, particularly with respect to non-traditional or alternative asset classes Tactical asset allocation the freedom to deviate from long-term allocation policy to capture shorter-term opportunities is a potentially valuable practice that is often missing from passive target date funds In choosing between active, passive or blend funds, sponsors should weigh all potential benefits and drawbacks of the various methods not only fees since diversification, tactical flexibility, alpha potential in different asset classes and suitability for participants may all be affected Introduction Over the past decade, target date funds have moved from the fringes of the defined contribution world to the mainstream. Selecting a target date fund has become one of the most important decisions a plan sponsor will make on behalf of plan participants. Despite this shift into the mainstream, significant differences in investment philosophies and processes among managers have produced wide dispersion in performance and risk over time. What s more, unlike equity and bond asset classes, target date funds do not have an accepted industry-wide benchmark with which to compare and contrast historical results (such as the S&P 500 Index for U.S. large-cap equity managers). Therefore, as the Department of Labor outlined in its 2013 target date bulletin, plan fiduciaries should thoroughly review all aspects of their target date fund situation and document that fund selection and monitoring have produced a plan that is the right fit for plan participants. 1 One aspect of target date design that has received a lot of attention recently is whether the underlying funds are 100% actively managed, 100% passively managed or a blend of the two approaches. While this feature of target date design is unquestionably important it impacts both performance and fees it is only one consideration among many that ultimately will drive participant outcomes. In fact, passive target date funds are a bit of a misnomer; regardless 1 Target Date Retirement Funds Tips for ERISA Plan Fiduciaries, United States Department of Labor, Employee Benefit Security Administration, www.dol.gov, February 2013. 2 Target Date Fund Selection: More Than Simply Active vs. Passive

of whether the underlying portfolios that comprise a fund are managed actively, passively or a blend of both, all target date managers make numerous active decisions that significantly impact performance and risk. These include: Glide path construction To vs. through landing points Asset allocation Asset class breadth Tactical or static asset allocation approach Portfolio construction and management As a result, unlike an equity or bond fund in which a preference for active or passive may be based mainly on fees or a belief about the value of active management, a target date fund s use of active, passive or blend strategies should not be the sole or even primary determinant for selection. In fact, one could argue that decisions such as glide path and asset allocation will have a much larger impact on participant outcomes than the fee differential between active and passive target date funds. As can be seen in Figure 1, the average performance dispersion between managers in each Morningstar Target Date category over the past five years has been as high as 8%, far in excess of the approximately 0.40% annual fee differential between passive and active target date funds. In this paper, we examine this active/passive debate relative to the other design choices and discuss some of the tradeoffs between active, passive and blend approaches within the target date space. Figure 1. The Range of Returns across Target Date Funds is Remarkably Wide Range of Five-Year Annualized Returns by Morningstar Category Annualized Return (%) 14% 12 10 8 6 4 2 9.1 2.9 10.4 4.6 11.5 4.2 12.1 5.8 12.4 5.0 12.6 6.1 12.6 5.6 The average performance dispersion far exceeds the fee differential between active and passive funds 0 2020 2025 2030 2035 2040 2045 2050 Source: Morningstar Direct 2018 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Use of information from Morningstar does not necessarily constitute agreement by Morningstar, Inc. of any investment philosophy or strategy presented in this publication. Data as of March 31, 2018 May 2018 3

Glide Path Design is the Primary Driver of Target Date Returns and Volatility A key defining feature among the many available target date funds and a primary determinant of their returns and volatility is their glide path. A target date fund s glide path reflects how its allocation to equity and fixed income investments change over time in accordance with the presumed risk-return profile of plan participants as they age. As shown in Figure 2, the target date fund industry currently employs a wide range of glide paths, with different beginning and ending equity allocations as well as different rates at which equity exposure declines over the life cycle. Figure 2. Glide Path Approaches Differ Significantly among Fund Managers 100 99 Equity Allocation (%) 80 60 40 20 0 74 Maximum Average Minimum 50 45 40 65 58 29 8 35 30 25 20 15 10 5 0 Years to Retirement Glide paths can vary significantly even among passive target date managers Source: Morningstar Fund Research. 2018 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Use of information from Morningstar does not necessarily constitute agreement by Morningstar, Inc. of any investment philosophy or strategy presented in this publication. Data through March 31, 2018 Each investment manager, whether it employs an active, passive or blend approach, has its own glide path philosophy and proprietary design process. Thus, the equity and bond mix of participants portfolios will vary dramatically over their lifetime depending on their plan s target date provider. As is apparent in Figure 3, glide paths can vary quite significantly even among passive target date managers. Figure 3. Glide Paths of Passive Target Date Funds Lack any Semblance of Uniformity 100% Equity Allocation (%) 80 60 40 20 Passive TD Manager 1 Passive TD Manager 2 Passive TD Manager 3 0-50 -45-40 -35-30 -25-20 -15-10 -5 0 5 10 15 20 25 Years before and after retirement Source: Morningstar Target-Date Fund Series Report, updated as of March 31, 2018. 4 Target Date Fund Selection: More Than Simply Active vs. Passive

These equity/bond allocation differences will have a significant influence on performance results, particularly during periods of heightened volatility. Figure 4 compares the returns for the same sample of passive target date managers in Figure 3; managers performance shows not only wide dispersion relative to the category average over time but also relative to each other. The most aggressive 2025 fund manager (passive manager 3) produced the best performance results over the past five years, when equities meaningfully outperformed bonds. The most conservative, passive manager 1, trailed slightly despite the lift of a generally rising stock market. Figure 4. Passive 2025 Target Date Funds Show Wide Dispersion in Performance Annual Returns 25% 20 Passive TD Manager 1 Passive TD Manager 2 Passive TD Manager 3 15 Percent 10 5 0-5 2017 2016 2015 2014 2013 2012 2011 Name Annual Returns (%) Equity Allocation at 65 Years of Age (%) 2017 2016 2015 2014 2013 2012 2011 Passive TD Manager 1 52 15.15 7.46-0.95 6.27 14.17 11.53-0.74 Passive TD Manager 2 35 15.00 7.33-1.15 5.95 17.38 13.26-1.24 Passive TD Manager 3 50 15.94 7.48-0.85 7.17 18.14 13.29-0.37 Dispersion between best and worst performer 0.94 0.15 0.30 1.22 3.97 1.76 0.88 Morningstar Target Date 2025 Category 53 14.67 6.73-1.59 5.07 15.30 13.03-2.06 Source: Morningstar Direct. The percent equity allocation at 65 years of age represents the average, net-equity position of all open-ended target date funds in the Morningstar Target Date 2025 category. Note: Equity allocation reflects each provider s reported holdings as of March 31, 2018 Given these wide differences in equity allocations, one could argue that glide path design where no truly passive option is available is one of the most important active decisions in the target date management process and thus by default, one of the most critical decisions a plan sponsor must make. Glide path design where no truly passive option is available is one of the most important active decisions Further complicating target date comparisons is the fact that there are multiple target date index suites provided by reputable firms such as Standard & Poor s and Morningstar attempting to stake a claim as the industry s benchmark glide path. The question then arises, which benchmark should be utilized in any given context? May 2018 5

Benchmark Selection Remains Complicated Despite the dominance of target date funds in defined contribution plans, an industry-wide benchmark for evaluating these funds remains elusive. Since target date management requires active design decisions as well as capital market, plan and participant assumptions, they are unquestionably difficult to benchmark, and a consensus has yet to be formed about the best way to do so. This is in stark contrast to equity or fixed income funds, where there is general industry consensus on indexes for each asset class. There is no industry consensus on the best way to benchmark target date funds In an effort to fill this vacuum, major index providers have created five major target date indexes with vastly different approaches to the key design aspects as summarized in Figure 5. Figure 5. Major Index Providers Have Different Approaches to Target Date Benchmarking Primary Prospectus Benchmarks within the Morningstar U.S. OE Target Date 2045 Category S&P Target Date Series S&P Target Date Style Series Dow Jones U.S. Target Date Series Dow Jones Global Target Date Series Morningstar LifeTime Allocation # of Managers using Index as Benchmark 19 2 1 2 4 29 To or Through Through Both Through Through Through Number of Asset Classes 10 10 8 8 19 Source: Morningstar Direct, Morningstar, Standard & Poor s, S&P Dow Jones, as of March 31, 2018. Custom & Others An illustration of the glide paths of the most popular indexes in Figure 6 shows the remarkable disparities between them. Figure 6. Target Date Indexes also Lack Glide Path Consistency 100% Equity Allocation 80 60 40 20 0 S&P Target Date 2025 Morningstar Lifetime Aggressive 2025 Morningstar Lifetime Moderate 2025 Morningstar Lifetime Conservative 2025 2060 2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005 2000 Income Source: Morningstar, Standard & Poor s, S&P Dow Jones, as of March 31, 2018. Age 6 Target Date Fund Selection: More Than Simply Active vs. Passive

As a result of these differences, the performance dispersion between target date indexes is quite wide, with differences as high as 12% in 2017 and 17% in 2013. Which is the right target date index fund choice? Figure 7. Performance Dispersion Between Target Date Indexes is Very Wide Name Annual Returns (%) Equity Allocation (%) 2017 2016 2015 2014 2013 2012 2011 S&P Target Date 2025 61 14.55 7.82-0.25 5.56 17.03 12.51-0.28 S&P Target Date Retirement Income 32 8.54 5.01-0.18 4.86 6.28 7.51 3.98 DJ Target 2025 35 12.02 6.39-1.11 5.14 12.84 10.94 0.49 DJ US Target 2005 14 5.51 3.62 0.38 6.66 4.86 7.08 6.40 Morningstar Lifetime Agg 2025 74 17.73 9.82-2.28 6.14 22.13 15.10-1.95 Morningstar Lifetime Con 2025 37 11.51 7.04-1.90 5.90 9.04 11.75 3.37 Morningstar Lifetime Mod 2025 56 14.54 8.39-2.06 6.04 16.28 13.67 0.24 Dispersion between Best and Worst 12.22 6.20 2.66 1.79 17.26 8.02 8.35 Source: Morningstar Direct, Standard & Poor s, S&P Dow Jones Note: Equity allocation reflects each provider s reported holdings as of March 31, 2018. Wide performance dispersion among target date indexes The practices of target date managers and plan sponsors exemplify the lack of consensus on an appropriate target date indexes (Figure 8). According to a recent Callan Associates survey, more than a third of target date offerings use a benchmark provided by the investment manager, about one-quarter use peer benchmarking or an industry benchmark, about one-eighth use a custom benchmark and a few use retirement income adequacy analysis. Figure 8. Little or No Consensus Exists among Plan Sponsors about Benchmark Choice Question: Which primary benchmark does your plan use for DOL-required participant disclosures for your target date offering? Retirement income adequacy analysis 5% Custom benchmark 15% Benchmark provided by investment manager 35% Industry benchmark 21% Peer benchmarking 24% Source: Callan Associates, 2018 Defined Contribution Trends Survey May 2018 7

Asset Allocation Approach Impacts Diversification and Flexibility A fiduciary s responsibility to participants includes providing a suitable selection of investment options to help participants reach their retirement goals while remaining consistent with the plan s objectives. As part of this commitment, the plan sponsor must provide a range of options that is appropriate for the goals and risk tolerances of all employees which helps explain the popularity of target date funds (Figure 9). Does the target date fund provide sufficient diversification? Figure 9. Target Date Funds are the Overwhelming First Choice as a Qualified Default Investment Option QDIA Choice by Percentage of Respondents Balanced Fund 3.5% Stable Value/Money Market 0.9% Managed Account Target Risk & Other 2.6% 7.8% Target Date 85% Source: Callan Associates, 2018 Defined Contribution Trends Survey This responsibility should also be considered in the context of the target date fund chosen for the plan, since many participants will have a majority, if not all, their assets concentrated in this option given its popularity as the top qualified default investment alternative (QDIA) among plan sponsors. Therefore, it is critical to assess whether the target date fund provides sufficient diversification to meet plan objectives. General tendencies can be discerned about passive target date managers asset class breadth relative to those of active or blend managers. In general, passive target date managers tend to offer less granularity in asset class choices, particularly with respect to non-traditional or alternative asset classes. As Figure 10 shows, the number of Morningstar category asset classes represented across the top three (ranked by assets under management) passive target date fund suites is quite limited. In fact, while a passive manager may provide exposure to certain asset classes through a broad-based index fund, many do not have any specific funds dedicated to peripheral asset classes such as domestic small-cap equity, emerging market equity, REITs, commodities, global bonds, high yield bonds, short-term bonds and senior bank loans. Some of these asset classes are difficult or costly to replicate passively. In other cases, the manager may not believe the added diversification is justified. 8 Target Date Fund Selection: More Than Simply Active vs. Passive

Figure 10. The Largest Passive Target Date Funds Offer Limited Choice Compared to the Category Average Peer Fund Average Active Manager* Passive Manager 1 Passive Manager 2 Passive Manager 3 Equity Choices 11 Foreign Large Blend Foreign Large Blend Foreign Large Blend Large Blend Large Blend Large Blend Fixed Income Choices 7 Inflation-Protected Bond Inflation-Protected Bond Inflation-Protected Bond Intermediate-Term Bond Intermediate-Term Bond Intermediate-Term Bond Specialty Choices 2 Commodities Broad Basket Global Real Estate Tactical Flexibility Varies None None None Source: Morningstar Direct as of 03/31/2018. *Top 10 Active Suites by AUM as of 12/31/2018. Number of asset classes used (based on Morningstar categories) for the 10 largest active TD mutual fund suites (2020 and 2055 vintages) as of 12/31/17. Note also in Figure 10 the relative lack of diversity in fixed income, where no global bond, high yield bond or shortterm bonds are represented, potentially important omissions as inflation/deflation risk and income needs come into play. Finally, the breadth of asset classes within the plan s broad menu of investment options constitutes a de facto diversification philosophy. Plan sponsors should consider whether their chosen target date offering provides a level of diversity consistent with their implicit diversification philosophy. The largest passive managers are limited to fairly infrequent allocation changes governed by the glide path In addition to considering the asset class exposures offered within a target date fund, it is important to understand whether the target date manager has discretion to make short-term tactical moves that deviate from the fund s longer-term strategic asset allocation. As one can see in the bottom row of Figure 10, the three largest passive target date managers do not employ a tactical approach, with fairly infrequent allocation changes governed by the glide path. The managers may lack conviction in the benefits of tactical asset allocation or a practical limit may apply to tactical moves given allocation to broad-based indices and a lack of dedicated funds in non-traditional assets. For example, in Figure 10, passive managers 1 and 2 allocated to only two broad-based index funds within equities U.S. equities and international equities; as a result, tactical calls are not possible across the U.S. capitalization spectrum or between developed and emerging markets in the international space. In making the choice between an active, passive or blend approach, it is critical to weigh all the potential benefits and drawbacks of the various methods, not just fees, but diversification, tactical flexibility, the return potential of different asset classes and the suitability for participants may be affected. May 2018 9

Conclusion While there are merits to utilizing both active and passive target date funds, evaluating target date managers carries inherit risks and key design decisions which collectively constitute active choices to select the right fit for a plan s participants. Here is a summary of key considerations in target date selection: The glide path and asset allocation will likely have much greater potential impact on participant outcomes than the fee differential between active and passive target date funds Glide paths vary significantly even among passive target date managers, making a truly passive glide path effectively unattainable Since no consensus exists on an industry-wide target date benchmark, the very definition of passive is unclear Passive target date funds may not offer sufficient diversification, which in and of itself constitutes an active fiduciary decision Manager discretion to deviate from the strategic asset allocation may be valuable in volatile markets; some passive target date managers offer only the infrequent allocation adjustments governed by the glide path 10 Target Date Fund Selection: More Than Simply Active vs. Passive

Investment Risks There are no guarantees a diversified portfolio will outperform a non-diversified portfolio. Diversification does not guarantee a profit or ensure against loss. Past performance is no guarantee of future results. Inherent in all investing are the risks of fluctuating prices and the uncertainties of rates of return and yield. A target date is the approximate date when investors plan to start withdrawing their money; principal value fluctuates and there is no guarantee of value at any time, including at the target date. Price volatility, liquidity and other risks accompany an investment in equity securities of foreign, smaller capitalized companies. International investing poses additional, special risks including currency fluctuation, economic and political risks not found in solely domestic investments. For investments in emerging markets, such foreign investing risks are generally intensified. Important Information This paper has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors. The opinions, views and information expressed in this presentation regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Portfolio holdings are fluid and are subject to daily change based on market conditions and other factors. Products and services are offered through Voya family of companies. Please visit us at http://voya.com for information regarding other products and services offered through Voya family of companies. Not all products are available in all states. This document or communication is being provided to you on the basis of your representation that you are a wholesale client (within the meaning of section 761G of the Act), and must not be provided to any other person without the written consent of Voya, which may be withheld in its absolute discretion. This material may not be reproduced in whole or in part in any form whatsoever without the prior written permission of Voya Investment Management. 2018 Voya Investments Distributor, LLC 230 Park Ave, New York, NY 10169 All rights reserved. Not FDIC Insured May Lose Value No Bank Guarantee BSWP-PASSIVE 052518 IM0929-18065-0916 173517