Head to head: What’s the best type of default fund for a DC plan?

Although DC plan sponsors are legally responsible for selecting and overseeing the investment options offered in their plans, employees have traditionally been responsible for making their own portfolio construction decisions. The introduction of target-date funds, particularly as the default option, has altered this decision-making dynamic.

The inclusion of TDFs in DC plans’ investment menus has grown over time, up 20 per cent in 2020 from 2019 to reach US$2.8 trillion. Indeed, plan members with TDFs have been shown to increase their equity share, boost bond exposures, curtail cash/company stock holdings and reduce idiosyncratic risk.

Read: Which DC plan default funds are better for retirement outcomes?

Compared to other multi-asset class portfolios, TDFs offer two unique features. First, each fund is identified by an anticipated retirement year, which serves as a recommendation regarding which types of investors should hold each fund. Second, risk levels are automatically rebalanced over time by
a fund manager that follows an equity glide path, reducing risk as members near their target dates.

The use of TDFs signals a shift away from requiring DC plan members to make their own portfolio choices and toward the delegation of critical decisions to the investment managers selected by plan sponsors. This change has potentially sizeable benefits. My research has shown the adoption of low-cost TDFs could boost retirement wealth by as much as 50 per cent over a 30-year time horizon. Naturally, the ultimate impact will depend on fund fees and investment performance.

Read: More pension plans using target-date funds as default option

As TDFs’ presence in DC plans has increased, an emerging body of work shows their differing strategies, relative performance and equilibrium effects on stock and bond prices. Introducing TDFs into DC plan investment menus can help plan members who might otherwise opt out due to low levels
of financial literacy, inertia and what some perceive as the excessive complexity of financial decision-making.

Roman Kosarenko, director of pension investments at George Weston Ltd.

The default in a DC plan is meant to provide a good asset mix to the broadest group of plan members, harnessing the power of behavioural inertia.

Traditionally, a target-date, target risk or balanced fund served that purpose. However, no single fund can suit everyone — and certainly not at all times. As employees age, the dispersion of their circumstances increases, making the optimal (median) asset allocation less and less representative.

Read: Do TDF’s glide paths still make sense in Canada’s retirement landscape?

With advances in technology, customization becomes more accessible and inexpensive. In other words, the default can be more than just a fund — it can be a customized solution. Nowadays, most DC plan members enroll online. It’s totally possible to design an enrolment process in a way that avoids defaulting anyone. Robo-advisors don’t need to default anyone because all important data about the account holder is collected quickly and efficiently.

Projecting into the future, one can envision a plan with five large asset pools and 5,000 different optimal asset allocations, one for each plan member. And only five net asset values would need to be struck every day. In this type of system, the asset allocation function is pushed from the investment fund level to member account level. It can be performed either by the record-keeper’s own robo or managed account service or an integrated third-party service. The record-keeper systems will likely need an upgrade to link the asset allocation engine with plan member data. This is most obvious in the evolving lifetime income solutions, where such a link is a must.

Read: How default investment funds are becoming smarter

Canadian securities regulators can speed up the evolution toward customized default funds by providing exemptive relief for retirement income and risk calculators, which are essential
in any customized solution. This would be along the lines of how Australian regulation has evolved.

Customization leverages the best that DC plans can offer.