Addressing risk tolerance: choosing a target date solution for Canadians.
Compared with investors in other countries, Canadians tend to be more risk-averse where their finances are concerned. The Canadian appetite for risk is tangibly lower than that of the U.S., as shown in an analysis of average allocations from the two countries.
A sample Canadian portfolio holds less equity, more fixed income and considerably fewer fixed income investments with an average credit rating below B. Not surprisingly, the U.S. sample portfolio’s three-year standard deviation is also higher when compared with the Canadian sample portfolio, according to Morningstar Research Inc. (Dec. 31, 2008). In addition, Canadians have always saved more and carried less personal debt than Americans. During the recent market volatility, Canadians have moved out of long-term funds and into the relative safety of money market funds.
Conventional target date solutions consider only the plan member’s retirement date, but this is not enough. For the Canadian marketplace, solutions that address risk tolerance in addition to retirement date are crucial. A made-in-Canada target date solution should provide plan members with portfolio choices that accommodate their ability to assume investment risk. Risk management permeates every aspect of the target date solution: diversification strategies, glide path selection, risk target, style selection and asset allocation.
Diversification depth – The goal of diversification is to provide the best returns with the least amount of risk. To operate comfortably in a highly competitive global environment, solution providers require extensive tools, experience and expertise—both locally and on a global scale. It is important to consider different asset classes, strategies and investment structures and to partner with a solution provider that has expertise in managing these different areas.
Glide path – A single glide path is insufficient to address the divergent needs of plan members with different levels of risk tolerance. Configuring the target date solution to include conservative, moderate and aggressive levels of risk acknowledges these differences. Despite its importance, however, relatively few target date solutions offer a target risk overlay.
Style selection – A target date program should have exposure to multiple styles: growth, value, core and deep value. While a single-style growth or value model is cost-effective and may perform adequately in stable, rising markets, it generally lacks the necessary resilience to cope with rapid fluctuations in sideways or bear markets. Incorporating several styles ensures that each style’s strengths will be captured at some point in the market cycle.
Asset allocation – Most target date solutions are constructed around strategic asset allocation. Asset class assumptions are developed, and strategic models are selected that offer the highest return given the particular level of risk. In a declining market, however, adherence to a single strategy can actually make a difficult situation even worse. One way to avoid this trap is to build in a component of tactical asset allocation that allows managers to review global economic and financial indicators on an ongoing basis and to implement asset mix recommendations as necessary.
To adequately address the differences in risk tolerance levels of each member, a comprehensive target date solution should be constructed on a tripartite foundation: a target date, a target risk overlay and a strategic asset allocation that also includes tactical management to allow asset managers a degree of manoeuvring room when dealing with market volatility, particularly in declining markets.
Duane Green is senior vice-president, institutional investment services at Franklin Templeton Institutional.
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the April 2009 edition of BENEFITS CANADA magazine.