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 years shifts to less risky more fixed income investments over time. TDFs are a one-size-fits-all solution and intended to be 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 glidepath is selected by each TDF provider and establishes the level of investment risk for each TDF fund. The glidepath is the critical feature of a TDF.
TDF glidepaths 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 aspect of a TDF and can be risky when exiting a TDF.
TDF Investment Mix
The following table shows the glidepath of a large US passive TDF provider and is representative of glidepaths 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 ‘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 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 to 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 in 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 are 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?).
· 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 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 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 members 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 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 does 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 TFDs are fertile grounds for legal actions.
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 CASPSA 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 a n 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 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 god send: 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 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 happen – “forewarned is for armed.”
G. Wahl, Managing Director, The PensionAdvisor - https://www.thepensionadvisor.info/
NOTENOTES [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/