As the defined contribution (DC) plan becomes the central savings vehicle around the world, one industry expert says plan sponsors need to choose the right target date fund (TDF) to prevent their employees from running out of money.

“If properly designed, given all the behavioural vices that we know individual investors and employees exhibit, it is the ideal default option within the defined contribution plan,” said Karen Sesin, AllianceBernstein Institutional’s senior portfolio manager, blend strategies, at the DC Investment Forum in Toronto.

According to the company’s research, 70% of investors globally rate their investment skills as low. Also, most investors tend to invest too conservatively and don’t systematically rebalance.

That’s where a TDF comes in. She explained that a target date fund doesn’t require employees to make any investment decisions whatsoever. All they have to do is simply enter their age and retirement age.

However, when choosing a target date fund, Sesin said that plan sponsors tend to focus on market risk when they should be focusing on shortfall risk, inflation risk and longevity risk.

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Shortfall risk is not saving enough and not investing appropriately to have enough money to retire, inflation risk is about preserving purchasing power, and longevity risk is running out of money during retirement.

The average employee runs out of money at 80 but that age is not as old as one might think. Canadian men who are 65 have a 50% chance of living beyond 85 and a 25% chance of making it past 91. For Canadian women at age 65, they have a 50% chance of living past 88 and a 25% chance of living beyond 94.

“Every six years, there’s roughly another year of longevity added in the developed world,” she said. “Then clearly running out of money is a real problem.”

Plan sponsors can solve that problem by recognizing that an extra 1% in terms of investment return adds an additional 10 years of spending.

“And you can add this 1% very simply through effective operating cost focus, so reducing operating costs as well as active management,” explained Sesin.

She said it’s also important that a TDF doesn’t become too conservative as an employee nears retirement or enters retirement. The time horizon is still long and there are still opportunities for the savings to grow.

“Many, many plan sponsors and employees actually believe that lower equity has less risk. The risk that’s really the focus of a well designed target date fund is longevity risk,” said Sesin. “By having a higher equity glide path, you essentially minimize to a greater degree that longevity risk or that risk of running out of money in retirement.”

To comment on this story, email craig.sebastiano@rci.rogers.com.