Target Date Fund - 4 Articles 

#1 Why TDFs aren’t a magic bullet for CAP plans (Part 1 of 3 articles) 

Defined contribution (DC) plans and other tax assisted savings vehicles such as RRSPs, and Tax-Free Savings Accounts are a critical part of Canada’s pension system as plan sponsors move away from defined benefit (DB) plans.

 

The switch to Capital Accumulation Plan (CAP)s has resulted in three critical changes to the way pension plans work:

1.     Investment risk is shifted from the sponsor to the plan member

2.     Longevity and inflation risk is shifted from the sponsor to the plan member ; and

3.     CAP participants are required to become investors (effectively, to become “balanced fund” managers).

One of the ways the investment industry in the US and Canada have responded to the shift of investment risk onto plan members is by introducing target date funds (TDFs).  TDFs  are a  family of time defined investment funds that link  specific  asset mixes to a particular time horizon (risk profile) i.e., a  formula is developed by each TDF provider to determine the asset mix (allocation) in each TDF  option. The asset mix in each fund (the “glide path”) is based on the  number of years remaining  until  the target date is reached. The time-defined funds within a TDF family usually cover five-year periods (i.e., 2015, 2020 etc).

TDFs are a step in the right direction given the challenges faced by CAP plans, however the higher level of Administrator investment sophistication required places a significant additional burden on a Canadian plan administrator. The education and communication responsibilities of the sponsor and administrator also remain.

At the same time, while TDFs may appear to make it easier for CAP members they can also be counter-productive if members become totally reliant on the funds and less involved in the retirement planning process.

Each fund in a TDF is a balanced fund combining domestic and foreign equities and fixed income funds elements but in differing proportions i.e., asset mixes which are assumed to be appropriate for a specific age group. It is assumed that a younger investor can tolerate greater risk in order to increase returns and/or minimize future contributions. The asset mix in each TDF fund is adjusted to a higher proportion of fixed income over time (i.e., the portfolios become less exposed to risk/equity volatility over time).

In a survey by Watson Wyatt, 63% of plan sponsors felt that TDFs would help CAP members save for retirement. As a result, they are becoming more common and are often also selected as the default fund by plan sponsors. The popularity of TDFs in the US is also driven by “safe harbour”-type protection that is not available in Canada.

However, the concepts, assumptions and philosophy used by TDF providers in developing target date funds vary significantly.

TDFs are a complex investment option.

Sponsors need to be aware of these differences and how the underlying assumptions impact the construction and performance.

General issues CAP plan sponsors should consider when selecting a TDF provider include the appropriateness of a virtually locked-in long term relationship with one supplier. They should also determine to what extent the TDFs include third party funds or are just the other funds of the TDF provider. Another area to look at involves the reasonableness of fees and costs.

In addition, a TDF family may have a style bias, which may not be appropriate  (i.e., value vs. growth; large vs. small cap; active vs. passive; quantitative vs. fundamental or sector biases).

Investments used in TDFs 

The types of investment options used in a TDF also need to be considered (i.e., alternative investments, real estate funds,  etc.) Plan sponsors should also be wary of any potential for lack of transparency for members and the pension committee members. Keep in mind the provider has the sole right to change asset mix, style and investments: the sponsor has no say or control in this.

There is also limited regulation of TDFs and a lack of sufficient performance history and benchmarks in Canada to properly evaluate the TDF. 

 

Be aware of the issues before jumping on the TDF bandwaghon.

G Wahl, Managing Director, The PensionAdvisor 

www.pensionadvisor.info  

#2  TDFs Advantages and disadvantages of one size fits all.  February 17, 2011

The key conceptual issues that need to be considered when looking at TDFs have been discussed in a previous article. An overview of the advantages and disadvantages of TDFs is covered in this article.  

It is generally recognized that getting employees involved in planning and saving for retirement is difficult and can be costly. Retirement planning and investment education and communication programs have also had limited success. TDFs address many of these concerns and situations, which gives them the following advantages:

  • Plan members are automatically slotted into a “one size fits all” family of balanced funds;

  • Asset mix and investment options are automatically selected and managed professionally;

  • The asset mix is automatically adjusted over time;

  • Each TDF fund is rebalanced regularly;

  • The TDF can provide better diversification if a wider range of asset classes and options are used than are otherwise available to members in the plan;

  • There is no minimum investment requirement;

  • Management fees are lower versus retail funds;

  • The members can still make use of the other investment options available and the planning tools and information provided by the sponsor and record keeper;

  • Employees can opt out of the TDF and start to manage their own investments in whole or part;

  • Employees can become more involved when it suits them (in the meantime, they will be invested in a reasonably prudent manner); and,

  • TDFs can be customized in some cases to better fit the sponsor and member needs.

TDFs do provide plan members with a convenient, diversified CAP investment portfolio where the issue of too much vs. too little risk is addressed for them. For plan members who feel intimidated by having to make investment decisions (or who are too busy or not interested) TDFs are often seen as a “set it and forget it solution” allowing them to focus on other things.

At the same time, TDFs pose challenges for the plan sponsors and administrators – that leads to a series of disadvantages that they need to consider. Specifically, some of the issues that need to be addressed in providing TDFs are:

  • Members may become reliant on the TDF and, hence, disengaged from retirement planning and investing;

  • Members often believe that TDFs include guaranteed returns or safety of capital;

  • The plan sponsor is entering a long-term relationship with a single supplier making it difficult to change if things don’t work out;

  • The Administrator is still responsibly for overseeing the TDF provider and funds;

  • There is general a lack of transparency with TDFs;

  • One family of TDFs may not be suitable for all plan members;

  • The TDF manager may use other investment funds not available in the plan, which are  not part of the SIPP. That means monitoring and overseeing the TDF program is  more difficult;

  • Managers who use only or primarily in-house funds which perform poorly or are costly may represent a conflict of interest;

  • Benchmarking and/or ranking of each TDF fund and a family of TDF funds is difficult;

  • The philosophy with respect to retirement dates (“to” or “through“ ) may not be appropriate;

  • TFDs are exposed to market volatility (a concern for retired members or close to retirement);

  • CAP Guidelines still require you to provide member education and communication, etc.

  • TDFs are often quite different – it is difficult to assess and compare fees and costs;

  • Assessing performance is complex and there is no practical recourse if the TDF underperforms;

  • There is minimal regulatory supervision or guidance with respect to TDFs; and,

  • Fiduciary responsibilities are the same or more complex with TDFs.

 

The increased governance and administrative burden and complexity of issues related to TDFs are significant and need to carefully considered before junping on the bandwagon. 

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3# Target-Date Funds: When one size doesn't fit all.  February 1, 2011

Does one size fit everyone?

You will need to have a better understanding of target-date funds (TDFs) as they become more common in the marketplace, and especially if you are considering adding them to your CAP.

Each TDF is a unique series of funds that attempts to address a range of member needs. However, it is unlikely that a single family of TDFs satisfies all situations so consider the following:

  • Does the TDF generally meet the objectives of the plan?

  • Do the members generally have the same financial and risk profiles and/or do you expect any significant changes in the membership etc.?

  • Does the TDF provider allow customization to better reflect the demographics and /or objectives of a plan?

  • If you currently have asset allocation or other balanced funds will you continue to offer them?

  • Will you allow members to invest in TDFs and the other investment options concurrently?

  • Is the TDF an appropriate “default” fund? This will depend on the nature and features of the TDF.

A PIMCO survey indicated that, 90% of consultants in the US now claim to be offering custom target date products. Customization will however result in greater administrative costs and fiduciary responsibilities.

Retirement date: “to or through”?

Some TDFs focus on savings accumulation only to the date of retirement while others are designed to assist savings throughout the retirement period. The key issue is the level of risk and equity exposure in each fund in the later stages of the TDF. This is an important difference that TDF suppliers build into their TDFs.

Committees are often not aware of this distinction. A July 2009 Financial Times article reported that the distinction between “to or through” is not filtering through to plan participants or Committees. This issue was also the subject of an SEC and DOL hearing in 2009 on the relative performance of different supplier TDFs in 2008.

Glide path

Asset mix is one of the more critical factors affecting the volatility and performance of a fund over time. The allocation between equities and fixed income is automatically adjusted in TDFs over time. This range of asset mixes used is referred to as a glide path. Each TDF provider determines their own glide path which often results in significant differences between TDFs with respect to equities (risk) exposure before and after the target date.

Ask yourself these questions:

  • Have you looked at the ranges of glide paths offered by other TDF providers?

  • Does the chosen glide path conflict with your other Life Cycle fund (asset allocation funds) if you have them?

  • As a fiduciary are you comfortable at all stages with the asset mixes and level of risk (equity volatility)?

  • Have you looked at the tracking error performance of the TDF?

  • Have you looked the research or approach used by the TDF provider in developing their glide path?

  • What are the disclosure requirements if the TDF provider adjusts the glide path?

Brinson, Hood and Beebower (1986) argued that asset mix explained over 90% of the average funds performance over time. Further research (Ibbotson, 2010) indicates this is too high and that most of the time series variation is a result of general market movements. In any case, asset mix is very important and glide paths are one of the more critical features of a TDF. The Committee should be familiar and comfortable with all aspects of this concept.

Risk /return expectations

TDF asset mixes reflect assumptions about historical return and risk performance, which is common to all portfolio construction and management and may not be appropriate in the future. In the case of TDFs there is a risk that members will rely entirely on a TDF provider’s judgment and management of the fund to provide them with a retirement income. The TDF provider should outline the risk and return expectations for each stage of the TDF.

  • The objectives and risk and return expectations should be documented when selecting a TDF provider.

  • If a TDF is selected for reasons other return performance i.e., stability of the TDF, pricing etc. this should be documented.

  • Consider the asset classes the TDF provider uses. Do they fit with your investment beliefs etc.?

  • Will the TDF provider primarily use in-house managed funds in the TDFs or utilize 3rd party funds as well?

  • Is there anything you can do if poor performing in-house funds are used vs. third-party funds?

  • Consider whether a TDF using all passive funds or all or active funds is more appropriate over the long term.

  • Consider whether the view of risk and return used in the TDF is consistent with the approach used in adding the other CAP investment options.

The same article mentioned above reported that a recent survey indicated that “61% of respondents said that target date funds make some type of a promise. Over 60% of the employees say…they will be able to retire on the target date (using TDFs)  …  and, 38% think target date funds offer a guaranteed return”.

The lack of understanding of the nature of TDFs by plan members should be a concern for sponsors. Members have to clearly understand that there are no implicit guarantees in a TDF.

Long-term performance and fees ae significant factors to consider. Passively managed TDFs are available and, from a fiduciary perspective, may be the least risky TDF alternative.

G. Wahl, managaing Director, The PensionAdvisor

www.thepensionadvisor.info 

#4 Trouble With TDFs:Benchmarking, Fees and other issues. February 8, 2011

Plan sponsors need to have done their due diligence and be comfortable with before introducing target-date funds (TDFs) into their plans:

Benchmarking

Benchmarking is an important part of pension governance and it’s an area of concern with TDFs. There does not appear to be consensus on the best way to benchmark TDFs. A common approach is to create a market-related benchmark for each fund within a TDF family based on the weighted average composite equity and fixed income indices. However, this requires assumptions about the future asset mix and the availability of appropriate benchmarks for all equity styles.

Questions for plan sponsors to ask here are what is the appropriate benchmark for each TDF fund or stage of the TDF? And are indices used to constructing each fund readily available to allow a benchmark to be constructed?

Given the nature of and purpose of the TDFs and the fact that they are often used as the capital accumulation plan (CAP) default fund, an absolute return benchmark may be appropriate or perhaps CPI plus, say, 4% as is often used in defined benefit (DB) plans.

Fee Structure –The fees and costs paid by a CAP member have a significant impact on their asset accumulation over time. Because of this, plan sponsors need to consider the following:

  • They must determine (and monitor) whether the management and administrative fees and costs charged directly to each TDF fund are reasonable.

  • Understand that the differences between TDFs make it difficult to compare fees and costs.

  • Ask what portion of the administrative fee is paid to the TDF provider as opposed to the fund manager.

  • Are high fee in-house funds used instead of lower cost and perhaps better performing third party funds?

  • What are the cost disclosure requirements for the members? If high cost funds are added what are the disclosure requirements and what recourse does the sponsor have?

Given that asset mix changes over time, fees should also decrease (e.g. more fixed income and/or the use of passive managers should result in lower fees).

Once you have selected the TDF supplier, you are locked in with respect to fees. The amount paid increase automatically as contributions are received and the market values increase which is very advantageous to the TDF provider.

 

Peer group comparisons  

Peer group comparisons of TDFs are not readily available in Canada because of the limited number of providers and differences between TDFs. TDF families can be quite different with regard to things like passive vs. active, the philosophy regarding glide paths, and retirement dates. These differences make it difficult to compare TDFs.

 

Transparency and Conflict of Interest 

A TDF family may utilize other pooled funds managed by the providers or an associated organization. If a TDF provider is using primarily its own funds and, the TDFs are not performing appropriately it raises a number of fiduciaries issues. Plan sponsors should consider the following:

  • What can or should the administrator do if a TDF is not performing from a fiduciary perspective?

  • What does the sponsor need to know about the underlying funds and what should members be told about the investments used in a specific TDF fund?

  • Consider the administrative, cost and risks implications of having to terminate of change TDF providers.

 

Regulation

Regulation of TDFs is still in an evolutionary phase in Canada and the US, which leaves plan sponsors with a limited regulatory framework. An article in the Financial Times (July 2009) reported that “(US) Fund managers are working hard to convince regulators to keep their hands off target date funds”. The article also goes on to state, “the majority of fund manager company representatives testifying said regulating target date funds would stifle innovation.”

 

Now, think back a few years to when this type of situation existed before….

G. Wahl, managing Director, The PensionAdvisor

www.thepensionadvisor.info