Investments

There are many ways to invest and many investment investments and products to invest in.

Pension plan sponsors face significant risks when selecting investments. DB plans have short and long-term needs. CAP investment options must be appropriate for the plan's membership. CAP sponsors are obligated for ensuring 'appropriate' investments and information is available to CAP members.

New Investment products and approaches continually are continually entering the market - lots of hype but very little performance history to support investing in them.

The basic rule: make sure you understand what you are getting into i.e., the nature of the investment, where it is located, whether it makes sense, the cost(s), and the risks. Make sure you understand the fees and costs associated with mutual funds or any new product or latest money-making 'sensational' idea. Tax issues related to different types of investments are also critical in non- register accounts.

Know the 'rules' - Caveat Emptor!!!

Topics

#1 Understanding Preferred Shares

#2 Capital Gains, dividend tax credits vs. interest Income (in Pension Accounts)

#3 Investing in Passive (Index) Funds vs. Exchange Traded Funds (ETF’s)

#4 CRYPTOCURRENCIES – Basics

#5 Special Purpose Acquisition Companies (SPACS)

#6 More about Preferred vs. Common Shares

#7 Dividends are not all treated the same for tax purposes

#8 Target date funds - may not be right for all retirees

#9 Target date funds - problems for members - a legal minefield for sponsors

#10 Are GICs really a "safe' investment?

#1 Understanding Preferred Stock

Preferred shares are equities issued by corporations that pay dividends that qualify for dividend tax credits (in Canada only). The shares are "preferred" because the dividends must be paid preferentially before any dividends are paid on the corporation's common shares.

Preferred shareholders have priority over common stockholders re: to dividends and generally have higher yields than the common stock. The dividends may be paid monthly or quarterly and may at a fixed rate, or determined by a benchmark interest rate like the LIBOR. There are also adjustable-rate preferred shares where the dividend rate or yield depends on certain other factors.

‘Participating’ preferred shares may also be issued and are structured to pay additional dividends related to the company’s common stock dividends or, the company's profits. The decision to pay a preferred share dividend is made by a company's board of directors prior to each payment date.

Preferred shares are equity, but in many ways, they are mixed assets with features similar to both a stock and a bond. Preferred shareholders have a prior claim on a company's assets if it is liquidated, though their claim is subordinate to bondholders.

Failing to pay a preferred dividend is not considered a default. Preferred shares usually have a lower credit rating than issuers' bonds because they have fewer rights. Preferred shares usually have higher yields than an issuer’s bonds. Preferred stockholders have limited rights which usually does not include voting.

Preferred stock has debt and equity-like features but generally provides a consistent predictable cash flow.

If a company has multiple series of preferred stocks, they may in turn be ranked in terms of priority.

Cumulative Preferred Shares

If a company is in trouble and suspends the preferred dividend, the shareholders may have the right to receive payment in arrears before dividends to common shareholders are paid Shares that have this arrangement are known as cumulative preferred shares.

Callable preferred stock

A ‘callable’ preferred stock is another type of preferred stock. The issuer has the right to recall or redeem the stock at a pre-set price at a certain date.

Callable preferred stock terms include the re-call price, the date after which it can be called, and a ‘call premium’ (in some cases). The terms are outlined in the preferred shares prospectus. The terms of a callable preferred share term cannot be changed after the issue date.

What happens to preferred shares if a company is taken over?

Preferred shares are generally not voting shares, so a purchaser does not have to redeem or buy the preferred shares when taking over a company. The buyer has the same options as the original owner/issuer regarding the preferred shares.

Sometimes the offer to buy a company is a 'stock-for-stock’ deal i.e. the buyer offers shares as part of the purchase price in a combined company to replace the existing shareholdings. The buyer could also offer a combination of cash and stock in making the offer for the company.

Taxation of Dividends

Canada

Eligible dividends from Canadian companies are taxed at a much lower rate than interest and foreign dividends. If you make less than $40,000 the tax rate on dividends is actually negative. Canadian dividend-paying stocks are generally considered to be tax-efficient investments.

Eligible dividend income from Canadian preferred shares is taxed more favourably than interest income because of a dividend tax credit. Dividends are not deductible in determining their taxable income by the issuing company but are taxed in the hands of the individual receiving them. The tax applicable to dividends may vary from province to province.

For dividends to officially be recognized as eligible dividends and qualify for the dividend tax credit they have to be designated as eligible by the company paying the dividend.

Eligible dividends from Canadian corporations received by an individual are "grossed up" by 38%, as of 2018The gross-up rate for non-eligible dividends, as of 2019, is 15%. The federal dividend tax credit is 15.0198% for eligible dividends and 9.0301% for non-eligible dividends.

There is no gross-up or dividend tax credit for dividends received by a corporation and dividends received from Canadian corporations may be deductible under s. 112 of the Income Tax Act (ITA), but Part IV tax (ITA s.

Canadian-controlled private corporations (“CCPCs”)

Dividends can be paid by CCPCs, but income (other than investment income) is subject to tax at the general corporate income tax rate. CCPC eligible dividends are grossed up by 15% and the corresponding dividend tax credit is 10.4% (9/13ths of the gross-up) for 2019 and later years.

CCPCs can also pay a ‘capital dividend' This is a tax-free dividend paid but requires the CCPC o file a special election. The capital dividend results from 50% of the capital gains realized by a CCPC. The dividend tax-free because the CCPC has to pay tax on the capital gain.

USA

Most but at all preferred stock dividends are treated as qualified dividends and taxed at the lower long-term capital gains rate. However, investors at the highest tax bracket pay 20% on qualified dividends, while others pay only 15%. However, people in ordinary income tax brackets at 15% and below pay no tax on qualified dividends.

The treatment of dividends may vary from state to state. Also se "More about Preferred vs Common' shares below

G.Wahl, Managing Director, The PensionAdvisor

#2 Capital Gains, Dividend tax Credits Vs. interest Income

Capital gains and dividends are not applicable to pension (registered) accounts

While Capital gains and the treatment of dividends and the dividend tax credit get a lot of attention they provide no advantage in pension accounts

Capital Gains and the dividend tax credit are only applicable to regular investment accounts (non-register accounts).

Any type of earnings or increase in a pension account is treated as income and 100% tax at your marginal tax rate when you withdraw money from an RRSP, RRIF LIRA, LIF, etc,. Therefore, money from pension accounts is equivalent to getting pension income from a defined benefit (DB) plan, CPP, or OAS from a tax perspective.

The terms capital gain and taxable capital gain (50% of the capital gain) and dividend tax credits are tax terminology and have no bearing on pension accounts i.e., tax-deferred registered pension accounts. Again, you only have 'gains'(not Capital Gains) and dividend and interest income in pension accounts: everything is considered to be income and 100% taxed when it is withdrawn from the account.

Income earned in a TFSA, which is also a tax-deferred account, is an exception. When money is withdrawn from a TFSA it is not taxed.

The treatment of Capital Gains and Dividends in regular investment accounts is an advantage for all taxpayers. For most retirees, however, the source of their incomes is from pension plans and 100% taxable in the year the money is received.

Banks, financial institutions, and employer pension programs holding retiree pension accounts provide education and information about investments. The explanations provided about capital gains and dividends seldom emphasize or make it clear that Capital Gains and dividend tax credits do not apply to pension accounts and income. As a result, retirees are often confused about the tax treatment of gains and dividends in their pension accounts.

G. Wahl, Managing Director, THe PensionAdvisor

#3 Investing in Passive (Index) funds vs. Exchange Traded Funds (ETF’s)

An index (passive) fund is similar to an Exchange Traded Fund (ETF): both mirror the performance of a particular market. However, not all index funds are ETFs nor are all ETFs indexed.

Passive mutual funds do not trade on a stock exchange. When buying and selling units, values are based on the valuation of the units on either the same day or the next day, after receipt of a request to a dealer.

ETFs are ‘open-ended funds’ but trade like stocks, on an exchange. Index ETFs are generally low-cost because they are simply investing in equities already selected for them and in a market index. Passive investments require minimum time and research resources on the part of the fund manager. An index fund may be a mutual fund or a corporate mutual fund that invests assets. Both invest in the index securities in about the same proportion as the investments in an index. There is no active money management in passive or ETFs per se ( managers do not select the equities).

The argument for investing in index-based funds is solid. According to S&P, over the 10 years ending December 31, 2019, 89% of domestic equity funds and 65% of institutional separate accounts underperformed their benchmarks, net-of-fees.

There are many different indices that an EFT can use as its investment model and benchmark: all EFTS do not mirror the same indices.

Actively managed fund fees are higher because the manager tries to outperform the market (their respective benchmark) by rebalancing portfolios, selling and buying assets, and reinvesting assets. Passive funds avoid the additional research costs and have minimal transaction costs incurred in actively managed mutual funds - the savings are passed on to the investor.

Historically active management i.e. actively buying, selling, and seeking out opportunities, is not effective over the long run. Passive investments outperform almost all actively managed funds over time often simply because of lower passive fund management fees. For the average unsophisticated person saving for retirement, either passive funds or ETFs may be an alternative strategy.

G.Wahl Manafging Direcctor, The PensionAdvisor

#4 CRYPTOCURRENCIES – Basics

Cryptocurrencies are not hard to understand but the technology used is.

The cryptocurrency market refers to the public trading cryptocurrencies such as Bitcoin, Ethereum, XRP, etc. There were more than 4,000 cryptocurrencies in existence as of January 2021.

What is a cryptocurrency?

Cryptocurrencies are simply a specific type of database, stored in global databases, which contain all the transactions made. Cryptocurrencies require huge storage capacity and utilize many computers to in different locations store the blockchain databases.

All cryptocurrencies, run on a technology called a blockchain. Cryptocurrencies are just one of many uses for blockchain technology: BITCOINS are but one example. Blockchain technology is also ideal for use in many other industries like real estate, food supply chains, the retail industry, etc.

Think of blockchain and the associated cryptocurrency as a decentralized computerized accounting ledger: one ‘ledger’ for each separate cryptocurrency. The ‘ledger’ (database) for each cryptocurrency is maintained by the party setting up the specific cryptocurrency. These ledgers (databases) are stored in 100,000’s interconnected computer servers located around the globe: there is not a single repository for cryptocurrency data.

Most importantly, a cryptocurrency is tamper-proof. Tampering with a transaction record would result in all other servers, which cross-reference each other, pointing to the node with the tampered with and incorrect information. This would alert the cryptocurrency’s administrator of the problem. This ‘security’ process ensures an accurate and transparent order of events.

At any point in time, there are a limited number of specific cryptocurrencies ‘coins’ (units) in circulation e.g., BITCOINS. The price therefore can increase if demand increases. However, additional ‘coins’ can be created.

Bitcoin ‘mining’ is the way additional or new bitcoins are created and put into circulation. People using sophisticated computers, to solve complex computational math problems, can create more coins or a new cryptocurrency. Cryptocurrency mining is a painstaking and costly process. The appeal is that ‘miners’ (for example the creators of more or new BITCOINS bitcoins) receive cryptocurrency ‘coins’ (units) e.g., a BITCOIN, as a payment for completing "blocks" of verified transactions, which are then added to the blockchain. The coins can significantly appreciate in value however prices can be very volatile as shown in this recent chart.

Many people are buying cryptocurrencies hoping to make a 'quick buck' or don't want to 'miss out' without any appreciation of the volatility and risks involved. The price also depends on the last price on part of a coin sold. A seller may be willing to take a big cut just to get out.

Cryptocurrencies are commonly used to hide illegal activities or conceal income to avoid tax both of which are a concern for governments. China banned the use of cryptocurrencies because of concerns about facilitating illegal activities and losing financial control, and sovereignty. Many other governments in developed countries have similar concerns but haven't yet banned cryptocurrencies.

If the purpose in buying a cryptocurrency is money laundering (concealing illicit cash) the money launders aren't concerned about price: they will take a big cut just to get the money. In many respects, cryptocurrencies are similar to Ponzi schemes i.e, they only work because more and more people keep jumping into them - but exits can turn into stampedes - and result in huge losses.

The already large and increasing number of cryptocurrencies available will also result in over-supply and detract from prices.

While cryptocurrencies may have a limited life due to government intervention or die a natural death due to scams and other failures, the blockchain technology on which they are based is amazing - revolutionary - perhaps the next technology leap-forward after the computer, the internet, and mobile phones.

If something is too good to be true - it usually is - CAVEAT EMPTOR!

G.Wahl Managing Director, The PensionAdvisor

#5 Special Purpose Acquisition Companies (SPACS)

The new kid on the block - Caveat emptor!

SPACS are stock exchange-listed companies that give retail investors the opportunity to indirectly invest in private companies by investing in a company that acquires private corporations. The process is for a SPAC is to indirectly list the private company on a stock exchange via an IPO - Hopefully, increasing the SPAC's share value significantly.

market

SPACs raise capital via an IPO consisting of SPAC units priced at say $10 per unit which include a common share and a separate trade warrant. A SPAC is generally required to buy a private company within 2 years, or investors get their money back.

New investment products (with no history) are continually being offered. SPACs are often referred to as “blank cheque" companies. A cardinal rule for retail investors: have a clear understanding of an investment before buying it - caveat emptor!

Also, see - https://www.theglobeandmail.com/investing/investment-ideas/article-investors-push-back-on-blankcheque-company-insiders-payout-bonanza/

You can be sure someone will money - the private company owners, the SPAC issuer and the lawyers (if they get paid in shares)

"Fools rush in where angels fear to tread"

G.wahl, Managing Director, ThePensionAdvisor

#6 More about Preferred vs Common Shares

Preferred shares are the investment of choice for many retirees

(The terms “preferred stock,” “preferred shares,” and “preferreds” all mean the same thing.)

A public corporation issues two types of securities, equity (shares) or debt (bonds). Neither is without risk!

Bonds are debt securities issued by many entities. They are referred to as 'fixed income'

investments because they pay interest at fixed rates at specific intervals. There is no ownership element or creditor protection.

Common and preferred stock shares are equity or ownership in a corporation. There are significant differences between preferred and common shares.

Common stock shareowners own part of a company. They can vote at General Meetings for the board of directors, resolutions, and merger agreements.

Preferred shares have a preference over common stock shares if a corporation pays dividends. If a company wants to pay common stock dividends, it cannot reduce or suspend preferred share dividends.

Preferred Share Features

Preferred stock owners do not have voting rights. Each type of preferreds will have a specific set of features and restrictions.

Price and Yield: Preferred stock shares are issued at a $25.00 price with a fixed yield ( return% based on the issue price). To calculate the current yield multiply the fixed yield rate times the share price and divide by the current share price.

Fixed to Floating: Some preferred stock may be converted to a floating rate after the issue date. In other words, the fixed rate may be increased or decreased by the Board of Directors after a specific time period.

Cumulative: Some preferred shares have a cumulative feature which means the company must pay all missed preferred dividends if the common stock and preferred stock dividends have been suspended. The company cannot start paying common share dividends until all missed preferred dividends have been paid.

Convertible: Preferred shares with a convertible feature can be exchanged at a fixed ratio for common stock shares. The decision to convert lies with the holder of the preferred shares.

Callable: A callable feature allows the corporation to redeem preferred shares for the $25.00 or the par value. Newly issued preferreds have call protection until a set date. (Almost all preferred stock issues will be callable.)

Investment Considerations

Preferred stock prices will generally but not always trade around the par value but the current yield and the stock price will be influenced by current interest rates. Both fluctuate to reflect changes in market interest rates for similar securities.

Preferred shares, like common shares, can drop in value: there is no guarantee of the price or dividend. In the case of a takeover, the preferred shares will be taken up by the new owner and may or may not be redeemed at par or some other value.

Taxation of Dividends

Dividends from preferred and common shares are taxable but taxed differently depending on the type of account where the share is held. This is often a source of confusion.

Dividends from shares held in registered accounts e.g. pension accounts are 100% taxable, but only when withdrawn from the account (at your marginal tax rate). There is no tax otherwise applicable to a dividend in a registered account nor are earnings or gains made by investing the dividends received in the account taxed until they are withdrawn from the account.

Dividends from shares held in non-registered accounts e.g. regular investment type are taxed in the year the dividend is received. The amount taxed is the dividend amount received 'grossed-up ' by 38%. However, there is an offsetting non-refundable tax credit of 15.07%, based on the grossed-up amount. Effectively, dividends in a non-registered account are effectively taxed at the same rate as taxable capital gains.

In summary, dividends in registered accounts are taxed as income when withdrawn while the grossed-up value of a dividend is taxed in the year it is received.

Knowing the 'rules is an essential part of playing the (investment) game.

G.Wahl, Managing Director, The PensionAdvsior

#7 Dividends are not all treated the same for tax purposes

Don't assume dividends are treated equally for tax purposes - they aren't and it impact on after ax returns

The tax treatment of dividends depends on a number of factors including the source of the dividend.

Dividends from Canadian Companies

Dividends from qualifying shares from normal public Canadian companies held in non-registered accounts e.g. regular investment type are taxed in the year the dividend is received. The amount taxed is the dividend amount received 'grossed-up ' by 38%. However, there is an offsetting non-refundable tax credit of 15.07%, based on the grossed-up amount. Effectively, dividends in a non-registered account are effectively taxed at the same rate as taxable capital gains. This credit is not available to corporations.

Dividend from Canadian Controlled Private Companies (CCPC) from shares held in non-registered accounts e.g. regular investment type are taxed in the year the dividend is received. This credit is not available to corporations.

The Federal tax gross rate is 15% and offset with a 9.03% tax credit. Each province has sets its own rate for CCPCs for provincial income tax .

Dividends in a non-registered account are effectively taxed at about the same rate as taxable capital gains.

Foreign Dividends

Any dividend received from any type of foreign company is treated as income in Canada. However, the US has a withholding tax of 10%, deducted from the dividend paid, which is treated as a tax credit in for Canadian tax purposes.

#8 Target date funds - may not be right for all retirees

TDFs may not be appropriate for many people in the ‘Decumulation (drawdown) phase

Decumulation Phase

The decumulation phase starts when money is withdrawn from a retirement account to provide regular retirement income. Preparing for retirement and the decumulation phase should begin 10-15 years in advance of retiring, while there is still an opportunity to make changes. The decumulation phase is inherently ‘riskier’ because of aging and other timing issues.

Target Date Funds (TDFs)

A CAP is often the only non-government pension benefit. CAP accounts are similar to a Defined Benefit Plan (DB). Therefore, CAP members need a basic understanding of pension investing and the funding (an implied liability) issues.

CAPs are often incorrectly referred to as pension plans. A DC plan, for example, is not a pension it is a savings program. A pension is defined as a retirement plan whereby employers promise to pay a certain defined benefit to employees after they retire. In a CAP, both employers and employees put money in an employer-sponsored investment account however, there is no promise or guarantee of a certain level of pension income. CAP sponsors usually emphasize that the intent of a CAP is simply to help save for retirement, but members often ignore this.

CAPSA Guideline # 8 highlights several key issues for sponsors to consider in the decumulation cycle:

the payout phase and retirement products.
the diminished role of the administrator in the ‘payout phase’.
the investments in the payout phase.
the need for retirement product information that facilitates informed member decision making; and,
members should be encouraged to use a financial advisor.

Sponsors have a fiduciary responsibility for education and to communicate in a way the members can understand the issues. Communications and education can be more of a challenge as retirees get older.

Also read- https://www.benefitscanada.com/expertpanel_/gerry-wahl/dc-plans-fatally-flawed/

Retirement – Decumulation (Payout Phase)

At age 71 members must transfer their CAP accounts to a LIF, LIFA, or RRIF with a financial institution. Decumulation, the payout phase, begins when a member draws funds out of a CAP account. Unfortunately, 24% of CAP members have a poor understanding of their plan and 41% believe the employer is responsible for providing an adequate retirement. What does this mean in terms of risk for sponsors?

The sponsor is a fiduciary and administrator of a pension plan and must always act in the members’ best interests. Sponsors can not waive their fiduciary responsibilities by delegating responsibilities such as education or communications to record keeper: the sponsor is always responsible and must monitor the actions of third-party service providers and the plan members.

Education and Communication
Education and communication are intended to promote CAP member engagement. The sponsor is responsible for determining the information and education that is provided. This requires careful monitoring of the members concerns and understanding of the pension programs offered.

The specific terms of each retirement account in the plan, demographics of the membership and the retirement products available must also be considered.

Documenting pension seminars and education sessions attendees, tools and information is also important. Frequently reminding CAP members that they are responsible for planning and managing their retirement, using the tool and information provided, and attending education sessions, will not eliminate risk but it will strengthen your legal position

CAP members are often forced to leave an organization’s CAP upon retiring or terminating. They must be told they are no longer plan members and the sponsor is not responsible for communication and education, etc.

Apparently only 32% of Canadian men and 43% of women don’t feel comfortable about managing retirement investments (Benefits Canada Nov 2021 - CIBC: Statistics Canada). This is likely an indication of overconfidence given that a majority of people don’t have a financial plan or use an advisor. It also emphasizes the role of education and communication. Communication and education issues are common sources of DC plan and 401(K) litigations in the US.

Fees

Fees significantly reduce asset accumulation and retirement savings over time. In most cases only return (before fees) information is provided for an investment option. Net returns (after fees) are also needed so members can effectively evaluate the investments and performance.

The CAPSA Guidelines recommend that CAP sponsors encourage members to use a financial advisor. This should help members develop a financial plan, set realist saving, return and retirement income goals and reduce sponsors’ legal risk exposure. However, it also results in additional costs. Providing some sort of a subsidy for advisor costs is a way to promote members to hire an advisor.

Employees are often forced out of a sponsor’s CAP programs and transferred to a financial institute upon retirement or termination. Their CAP accounts are transferred to a financial institution where fees are usually higher, and the level of service will decrease. While CAP members are should be informed of the higher fees, for effective financial planning purposes, this seldom happens.

Fee issues are one of the main sources of member litigation in the US. Sponsors are responsible for ensuring that CAP fees are reasonable. Therefore, formal fee reviews should be undertaken as part of the governance process. To minimize this risk, sponsors could simply pay the CAP fees.

Longevity, Time, and Timing

CAP members are encouraged to take a long-term view of investing. This is not necessarily appropriate for retirees: it depends on life expectancy and finances. The CAP Guidelines recommend that sponsors offer investments reflect the purpose of the plan and the diversity and demographics of the members. CAP investments often do not adequately address decumulation investment needs.

Longevity risk is increasing: 65-year-old males are now expected to live another 21 years and females 24 years. The fact that a spouse often out lives a CAP member is often overlooked. CAP members therefore need to consider both their own and spouse’s expected life spans. Up-to-date life expectancy information, by location and industry should be provided regardless of whether the members use this information or not.

The concept of a personal pension “liability” and how it relates to funding retirement income is usually ignored by sponsors because it is complex and may be confusing for members. Confusing or not, the concept needs to be explained and longer duration investments should be part of the investment options. Long bond funds, that better match duration and funding (liability) requirements and commonly used in DB plans are seldom available in CAPs. This is a shortcoming in most CAPs.

Investments

CAP members often have unrealistic return expectations. A Benefits Canada Survey found that the average CAP member expected annual returns of 15% or higher. However, the median professionally managed fund return over the last 25 years was 8.5%. The Globe and Mail previously suggested that 8% was more realistic.

10 year Canadian government bonds currently yield ~1.7% while 30 year binds yield ~2. 5%. The median return for Canadian Balanced funds is ~7.7% for 5 years and ~8.9% for 10 years – before fees. Inflation is in excess of 4.7%: the lose of purchasing power is an issue for retirees.

One would assume it is the sponsors’ responsibility to ensure that return and long-term interest rate information is available. However 15, 20 or 30 year benchmark and investment returns are seldom provided.

The impact of volatility, time and timing is a critical in the decumulation phase. While managing volatility is critical in overseeing DB plans because of solvency funding requirements, this aspect of retirement planning in CAPs is ignored or downplayed. Only 31% responding to the BC Survey indicated they understood ‘investment risk’. Members need to understand that it is difficult it is to recover from loses in retirement. This is due in party because the amount available to invest is less because of the draw downs. Basic risk information about investment fund performance such as standard deviations, tracking error and information ratios is seldom provided.

Unlike a DB plan, CAP members cannot put more money into their CAP accounts if they have investment losses. This can result in “underfunding” of a retirement account. This is a critical difference and short coming of CAPs.

In the second part of this article the primary risks in the decumulation phase and target date funds will be discussed.

Gerry Wahl, Managing Director, The PensionAdvisor

www.pensionadvorery.info - see "Retirement #7"

#9 Target date funds - problems for members - legal minefield for sponsors

Target Date Funds are common in CAPs and often used as the default fund.

Many Canadians depend on defined contribution (DC) and or other tax-assisted savings Plans (Capital Accumulation plans – CAPS) and personal investments for their retirement income. The emphasis in CAPs has always been on accumulating saving rather than what happens when you retire (the decumulation phase). Target Date Funds (TDFs) were promoted on the basis they would address this and provide an expected retirement income, however, they come with risks for a plan sponsor.

Background – A TDF Primer

TDFs are structured around an anticipated retirement date hence the name – Target Date.[1] TDFs are very popular with mutual fund investors and often used in employer CAPs[2] as an investment option and, as the plan default fund[3]. 84% CAPs on the Sun Life platform, for example, include TDFs which represent 80% of monthly cash inflows into these plans.

TDFs are a mix of equities, fixed income, and other investments selected by the TDF provider. The objective is lowering the level of investment risk[4] as you age: higher equity exposure in the early year's shifts to less risky more fixed-income investments over time. TDFs are a one-size-fits-all solution and intended to be a long-term investment.

TDF structuring

A TDF portfolio manager follows a specific asset mix regime, a “glidepath[5]”: there is a specific investment mix for each of the target date funds. The glide path is selected by each TDF provider and establishes the level of investment risk for each TDF fund. The glide path is the critical feature of a TDF.

TDF glide paths vary from supplier to supplier and can be based on a ‘to’ or ‘through’ approach. The objective of a “to” approach is to invest up to the date of retirement. ‘Through’ TDFs focus on creating income throughout retirement.

A passive vs. active investment approach is used TDFs because of lower fees and to minimize volatility and investment risk.

The investment ‘time horizon’ shortens with age and is potentially riskier from an investment perspective. “Market ‘timing’ issues are particularly critical and contentious aspects of a TDF and can be risky when exiting a TDF.

TDF Investment Mix

The following table shows the glide path of a large US passive TDF provider and is representative of glide paths used in many TDFs. Note that the level of investment risk, in the form of equity investments, decreases the closer you get to the retirement date.

Is the level of risk in a TDF fund is appropriate i.e., will the ‘one size fit all approach’ provide sufficient retirement income? In individual cases, the level of investment risk may not be sufficient to create the expected retirement income, or it may be too risky. In addition, the asset allocations may not line up with a personal investment risk tolerance. Demographics should be considered to ensure the TDF funds offered to at least accommodate likely employee retirement periods e.g., 2055-2060 -2065

TDF Performance

TDFs are usually evaluated based on return performance rather than on the level of funding at a point in time.[6] The success in the ‘funded’ aspect of a TDF is a critical factor. While TDFs are intended as long-term investments long-term return performance history is simply not available. When selecting a TDF provider, return performance is necessary information but it is not sufficient information to evaluate TDF fund performance, from a member’s perspective: ‘funding’ performance is a critical feature.

TDF Fees

TDFs fees have a significant negative impact on member savings and are paid by CAP members. Fees include administration fees, recordkeeping fees, and investment management fees. In many cases, an advisor will be hired primarily to assist the employer in overseeing CAP administration and governance. The advisor’s cost is included in the fees paid by the members.

According to Morning Star[7] the average 2020 TDF fees in the US were approximately 0.52% and ranged from 1%-1.5%. This does not include the underlying cost of approximately 1.37 %. for fund manager fees. Combined, fees are in the 2% range. In Canada, the fees are even higher – 2-3%. Over a period of 45 years (working years), an annual fee of 2% represents about 37% of the account value[8].

Claims of excessive fees are the most common reason for litigation in the US, particularly in smaller plans. Since 2015 there have been over 200 lawsuits in the US concerning excessive fees, resulting in more than $1 billion in settlements. Fees in excess of 1% are considered indefensible.

TDFs – Advantages and Disadvantages

TDFs differ between suppliers - they are not all the same. Understanding the advantages, disadvantages, and differences between TDFs is important when selecting a TDF for a CAP. Sponsors need to be aware of the advantages and disadvantages of TDFs, and the potential legal risks.

Advantages

No minimum investment requirements in a CAP.
Automatic diversification of asset classes (equities, bonds, etc.).
Asset allocations and diversification are updated with age.
Lower fees (vs. retail or other providers).
Professionally managed investments.
Minimal employee involvement, knowledge, and time is needed (“set it and forget it”)
Sponsor communications and education are minimized, less onerous, and less costly.

Disadvantages

Member perspective

Possible suboptimal use by a TDF provider’s proprietary investments (conflict of interest?).
The level of risk may not be appropriate (‘one size’ is not necessarily a good fit for individuals).
No choice or influence over investment management fees (IMFs – fees are significant over time).
Flat IMF applies regardless of the amount invested (no additional value-added or help).
Exiting a TDF can be very risky re: timing (a major risk factor).
Lack of involvement in investing and saving (total dependency on sponsor).
Benchmarks are based on returns vs. funded position of savings (don’t know how you are doing).
Longevity risk (you or your spouse may live longer than expected -TDF fund will not reflect this risk).
Higher fee costs when you exit a CAP TDF.
Retirement income is not guaranteed (common misconception - a guaranteed income).

Sponsors perspective

Potential for litigation related to the sponsors’ fiduciary role and responsibilities.
Communication and education can be more of a challenge with younger and older members.
The level of risk in a TDF may not be appropriate for an individual (a member is not aware of this).
Regular formal fee reviews are critical (seldom done).
Changing TDF suppliers is risky (members may be exposed to losses re: timing)
Dependence on the sponsor to provide adequate retirement income (expectation of guaranteed income)
Limited employee involvement in the investing and saving processes (“set it and forget it”).
Fiduciary responsibilities do not end when a CAP member retires (CAPSA Guideline #8)

Also, see - https://www.osler.com/osler/media/Osler/reports/pensions-benefits/Pension-plan-governance-in-Canada-Trends.pdf

A sponsor has a fiduciary role and responsibility to act in the member's best interests as long as they or their spouses remain in a CAP.

Also see: https://www.benefitscanada.com/news/bencan/sounding-board-considering-the-legal-risks-of-caps/

The tendency for CAP members to rely on the sponsor to generate an adequate (guaranteed level) of retirement income, the lack of employee involvement and understanding of their investment, fees, and timing issues, are potential areas for litigation by CAP members.

Litigation concerns

Despite the fact, there are few if any legal actions regarding TDFs in Canada. However, employers should be aware of the types of issues resulting in the US. Class action suits related to TDFs (smaller US DC plans are also ending in court). Class actions suits are common in the US, and there are concerns about TDFs by US regulators and the government.

See Table A-List of ERISA cases https://crr.bc.edu/wp-content/uploads/2018/04/IB_18-8.pdf

The US Congress had concerns about TDF returns, that go back to the ‘Great Recession of 2011. More recently, the leading retirement plan oversight committees in Congress requested a review of target-date funds “The millions of families who trust their financial futures to target-date funds need to know these programs are working as advertised ..”

The committee asked the GAO to investigate:

what steps have TDF providers taken to mitigate the volatility of TDF assets?
how do the asset allocation and fee structure vary across those TDFs used as default options in 401(k) plans, and
how do fees compare with other investment products?

The most common issues in class actions suits are 1) fund manager and administrative fees, 2) improper investment selection 3) lack of investment performance history, 4) poor investment performance and number of investment choices.

A recent US Supreme Court case, Hughes vs. Northwestern University [9], explained that a pension fiduciary has a duty of prudence, and must monitor investments and remove imprudent ones. In 2015 the US Supreme Court ruled that fiduciaries are at fault if high-priced funds are used when materially identical but lower-priced funds are available. Given the unique long-term nature of TDFs and the reliance members place on TDFs are fertile grounds for legal actions.

See- https://www.scotusblog.com/2022/01/court-reaffirms-duties-of-retirement-plan-sponsors-to-monitor-and-update-plan-options/

Although there are no class actions suits regarding TDFs in Canada at this time, it is a matter of time before TDFs become a legal issue in Canada.

Minimizing Fiduciary and Legal Risk

While there are potential legal and financial risks in TDFs (and CAPs) there are things that can be considered to mitigate the risks.

Do not allow retirees, spouses, or terminated employees to remain in the CAP
Only offer one investment option in a CAP (avoiding the CAPSA guidelines)
Only use passive investments as investments (minimizes Investment risk)
Limit the number of savings plans to a DC or RRSP
Make contributions to an employee’s personal RRSP vs offering an employer savings program
Offer an incentive e.g., subsidy for employees to use an independent advisor of their choice
Pay the investment management fees as part of the employee benefit package
Undertake regular formal fee reviews
Have a solid governance process (and follow it)

Documentation of all decisions and actions regarding a TDF's other investment options is essential.

Summary

CAPs transfer all longevity, volatility, stock market, interest rate, and timing risk to the CAP members vs. a DB plan. CAPs have fallen short of their promise to deliver DB-type benefits to CAP members. This can be a potential concern particularly in the case of DB to DC conversions.

The intent in adding TDFs as investment options, or as the default fund, was to make investing and saving easier but this is not necessarily a good fit.

Dependency on the stock markets in CAP retirement saving portfolios is a godsend: It can add significant value to savings over time. However, stock markets fluctuations can also undermine retirement savings and income due to short-term price or interest rate fluctuation and timing.

While TDFs are appropriate in certain situations, it is debatable whether they are appropriate in the decumulation (retirement) phase, when funds are being withdrawn and the investment time horizon is limited by the expected lifespan. TDFs may be appropriate for younger employees, but with age, the ‘one size fits all approach may not be effective.

While legal challenges related to TDFs and CAPs are not a major issue in Canada sponsors using TDFs as an investment option or, as the default fund should be aware of issues that may lead to TDF litigation rather than waiting for it to happen – “forewarned is for armed.”

G. Wahl, Managing Director, The PensionAdvisor - https://www.thepensionadvisor.info/

[1] TDFs consist of a series of 5-year funds. Each of these funds has a specific glidepath (asset mix) which becomes more conservative over remaining target time period.(Investors select the TDF closest to their retirement date).

[2] Capital Accumulation Plans are tax-assisted savings plans registered under the Income Tax Act. They include DC plans, RRSPs, RRIFs LIRAs TFSAs, PRPPs etc. CAPs fall under the CAPSA Guidelines.

[3] Employee contributions are made to the default fund if an employee elects not to make investment decisions. The sponsor selects the default fund.

[4] ‘Investment risk’ is defined as the statistical deviation of a fund from specific (return) bench for any type of fund.

[5] A TDF glidepath is the allocation of equities and fixed-income investments at a point in time. The glidepath changes over time increasing the exposure to fixed income while reducing equity investments. CAP sponsors are responsible for monitoring glidepaths.

[6] TDF may offer a ‘guaranteed value’ if the TDF fund is held to maturity. The guarantee is based on the greater of the unit issue price or the highest unit price achieved price until maturity. This however does not guarantee a specific level of retirement income.

[7] WWW.The Street.com - Christopher Sahl Nov 2007

[8]Estimate using contributions of $1000/year plus returns of 5% for 45 years – then no contributions to age 65. Total Fees37% or $35,000 vs account balance ~$93,000.

[9] https://www.scotusblog.com/2022/01/court-reaffirms-duties-of-retirement-plan-sponsors-to-monitor-and-update-plan-options/

#10 Are GIC’s really a ’safe’ investment?

Many believe that GICs are a safe place to put savings:

In a GIC you get interested, have CIDC insurance on up to $100,000 (in each separate institution), and the amount returned is the amount you invested.

There are 2 types of GICs - redeemable GICs which allow you to get your money back at any time (no penalty), or non-redeemable, where there is a penalty if redeemed before the maturity date. The rate of interest paid is higher for non-redeemable GICs. The Interest paid is a percentage of the purchase value and is typically compounded. In some cases, the interest may be paid out annually instead of being compounded. The interest may be paid monthly, quarterly, annually or, upon maturity.

The major downside of GICs iis they seldom provide inflation protection, and the income tax on interest further reduces the return. The interest paid on GICs is typically quite low - generally, well below the rate of inflation. This means the investor is usually losing purchasing power which is a real, not a theoretical, loss. The interest is also taxed as income annually, at your marginal tax rate, which further lowers the return and reduces purchasing power. GICs with terms greater than one year may be automatically re-invested, but you still pay tax on the interest earned at each anniversary date of each year, regardless of whether or not you received an actual interest payment.

If you need to invest funds for a very short period, or if peace of mind about never losing a dollar of the principal invested is important, then GICs may be the answer for you. However, this doesn’t really mean GICs are a ‘safe’ longer-term investment. GICs are more complicated and riskier than they appear. Banks love GICs because of the low interest paid and the fact the bank can use the money for long periods.

​