With more than 80% of Canadian plan sponsors currently offering a DC option in their employer-sponsored pension plans, the shift to DC is firmly entrenched. In the U.S., nearly 60% of
all pension assets flow into DC plans, according to the 2012 Towers Watson Global Pension Assets Study.
There is no shortage of choice for DC plan members. Mercer’s 2009 Global DC Survey indicates that more than 60% of DC plans offer 20 or more investment options to their members. (A choice of 10 to 15 is typically the norm.) But what about members who choose not to choose? Despite sponsors’ efforts to create an informed workforce through promotion and education, many members stick with their plan’s default fund choice. Moreover, half of U.S. DC plans offer investment advice or managed accounts, yet use of these features by members is a woefully low 10% or less, according to Mercer’s 2010 U.S. Defined Contribution Investment Survey.
The lesson here is that not only are sponsors paying close attention to their plan’s default option, but preferences are changing rapidly. In particular, the apparent “no action required” features of target date lifestyle funds are attracting increasing attention (see Figure 1.).
Target date funds (TDFs) are multi-asset-class funds that gradually reduce portfolio risk as the retirement “target date” approaches. They typically build capital when a plan member is younger by holding mostly stocks, then shift to bonds and other conservative assets as the need for reliable retirement income grows. TDFs offer plan members the benefits of diversification, with higher yields to meet capital accumulation needs, yet remove a significant amount of timing risk. All without member involvement in the investment allocation decision.
The default evolution
When DC plans began to ignite in the 1970s, fixed income was the common default option. In those days of high interest rates, guarantee investment certificates (GICs) and money market funds dominated. Surprisingly, GICs and money market funds still play a major role even at today’s record-low returns. As Figure 1 shows, more than one-third of all default plans were in the secure (but low-yielding) cash and money market categories in 2011.
Although these default options meet the need to protect contributions, plan members can’t expect to retire on the current yield from a money market fund.
As a result, default options evolved, with many sponsors turning to balanced funds. The combination of fixed income, equities and other assets classes in these funds can generate higher wealth accumulation for plan members. It’s certainly a better default option than cash and short-term instruments. But, as Figure 1 shows, just 32% of DC plans used balanced strategies as a default option in 2011, unchanged from 2007. The challenge is that while balanced funds meet members’ needs for capital growth during the early phases of their working life, the need for greater security increases as retirement draws closer.
The Great Recession of 2009 highlighted the timing risk inherent in one-size-fits-all balanced funds—those closer to retirement couldn’t recover from market losses by their planned retirement date.
According to Mercer’s quarterly balanced pooled fund surveys, stocks comprise approximately 60% of a balanced fund, and the weight is essentially static over time. This compounds the timing risk and partly explains the trend to offering multiple default options within DC plans. By dividing the default balanced fund into several options of varying risk levels (conservative, moderate, aggressive), members have a menu to choose from based on their age and risk tolerance.
These balanced funds may have solved the problem for engaged plan members—those with the interest and knowledge to become actively involved in managing their retirement plans—but what about the least engaged? Their risk appetites change over time, too; yet, due to a continued lack of involvement, they’re unlikely to move away from a plan’s default option. A default fund that automatically adjusts for risk as a member’s target retirement date approaches might fit the bill for those seeking a hands-off solution.
TDFs
Often called lifecycle funds, TDFs follow a predetermined path (the glide path) of asset mix allocations based on an individual’s years to retirement. Much like a typical plan member’s needs and risk preferences, the glide path starts out with a high equity weighting, then reduces stock exposure to (and sometimes through) retirement.
In effect, the fund’s allocation to stocks is a proxy for an investor’s risk tolerance. But, as Figure 2 shows, not all glide paths are created equal. While all TDFs follow the same principle—tilt heavily to stocks in the early years, then gradually cut the exposure over time—there is both a science and an art to creating an appropriate glide path for each plan sponsor. The key is to understand how and why TDFs differ from one another. Following are several factors:
Plan sponsors looking to set a TDF as their default option will need to think about these factors. The decisions can be more significant than for other investment offerings in a plan sponsor’s mix of DC options.
TDFs aren’t limited to the traditional asset classes. More sophisticated TDFs add non-traditional asset classes such as real estate, mortgages or high-yield debt. These asset classes can change the glide path, curb volatility and help smooth the transition from a heavy equity weighting.
As there isn’t a standard glide path, it can be tough to compare different TDFs products and managers. Performance can vary, too, depending on the assumptions underlying the glide path. According to Morningstar’s Target-Date Series Research Paper: 2012 Industry Survey, TDF returns for U.S. funds intended for investors retiring in about 2015 had a performance range of just under 10% (-4.9% to +5.5%). The variance is principally due to equity weights at the target retirement date.
U.S. and Canadian trends
The U.S. government endorsed TDFs as qualified default investment alternatives in the Pension Protection Act of 2006, prompting employers to begin using them when automatically enrolling workers in U.S. 401(k) plans. According to a 2011 report by the Plan Sponsor Council of America, a Chicago-based trade group, more than half of DC plan sponsors in the U.S. that automatically enrol participants in 401(k) plans pick TDFs as the default option. Looked at more broadly, from 2006 to 2011, assets in U.S. TDFs grew more than 430% (to $378 billion from $71 billion), according to Morningstar’s Target Date Series Research Paper: 2012 Industry Survey.
According to Mercer’s quarterly pooled fund surveys, Canada’s TDF growth rate is equally dramatic, growing by nearly 140% between Q4 2009 and Q2 2012 (to $8.1 billion from $3.4 billion). While only 12% of Canadian DC plans offered TDF options in 2008, three years later, nearly one in four did, according to The Canadian Institutional Investment Network’s annual DC Benchmark Report). The federal government’s proposed pooled registered pension plan regulations state that the default must be a balanced fund or a portfolio that takes a member’s age into account—in other words, a TDF. So expect the shift to TDFs to keep accelerating.
TDFs give DC plan sponsors access to a diversified asset allocation that automatically rebalances without members needing to take action. And since TDFs can go beyond stocks and bonds into small cap stocks, high-yield bonds, mortgages and real estate, extra diversification adds a measure of security.
TDFs also distance members from making impulsive decisions based on short-term events. That makes TDFs a superb default option for plan sponsors that deal with a large number of disengaged members.
But what TDFs don’t do is remove plan sponsors’ fiduciary responsibility to pick the right fund (or funds) for their workforce, nor do they eliminate the need for member education. Given the huge differences among TDFs, plan sponsors need to take exacting care that the one chosen as the default option is, indeed, the best match for their plan members.
Zaheed Jiwani is senior vice-president, client strategy, with Greystone Managed Investments Inc. zaheed.jiwani@greystone.ca
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