An alternative to target date funds

Amid the recent market turmoil, many DC plan members having either chosen or been defaulted to TDFs were shocked by the negative returns they experienced. Particularly impacted were those close to retirement, who were told these funds became progressively more conservative when approaching their “target date”. As it turns out, near-retirees generally do not appear to consider having 30% or even 40% invested in equities two years before retirement (as some 2010 funds had last year) to be conservative enough.(Note that whether they are right or wrong about how much equity exposure they should have is another story I also talked about a couple of years back)

Well it looks like American regulators agree that TDFs are not transparent enough. So both the American Department of Labor and the Securities and Exchange Commission are now considering to regulate TDFs more closely (public hearings on the matter were held last June, but the outcome for now is unknown).

In Canada, TDFs are picking up speed, but still have only gathered limited assets up to now. The TDF offering is expanding, but remains thin when compared with what’s available in the U.S. Yet the same challenges apply here, as Canadian TDFs are built in pretty much the same way as their American counterparts. What’s a DC sponsor to do?

A target date process as a lifeline?
One alternative is using a target date process, whereby the DC provider’s administration system automatically moves plan members from one portfolio of funds to the next (let’s call each of these portfolios a “step”), becoming progressively more conservative as they get closer to retirement.

Although it requires a little more work, this approach presents significant potential benefits (note the availability of some of the characteristics described below varies from one DC provider to the next):

• clearer understanding for members since the sponsor can name each step as well as its overall TD process the way it wants (for instance, “Dynamic” for a step where the member is invested, say, 80% in equities, and “Annuity purchase savings path” for a TD process leading to the purchase of an annuity—and therefore finishing with almost exclusively fixed income);

• better risk exposure transparency, as members see the individual funds they hold at each step. For instance, where a member invested in a “ABC 2035” fund would see his account showing 100% of ABC 2035 fund units, the corresponding step in a TD process would show holdings as, say, 40% in a Canadian equity fund, 40% in a global equity fund and 20% in a Canadian bond fund;

• flexibility in setting personalized “glide paths” (asset allocation evolution) of the TD process, allowing for a better fit with the plan population’s needs;

• possibility of offering different glide paths, where the asset allocation will vary-particularly near retirement—to differentiate between those thinking of purchasing an annuity and those who will continue managing their own assets through a RRIF/LIF; so a sponsor could decide to offer both an “annuity purchase savings path” and a “self-directed retirement income path”, each ending with different equity contents;

• choice of fund managers; the sponsor could decide to individually select fund managers for each asset class, providing more flexibility.

TD processes do, however, suffer from a few drawbacks:

• even though there can be a number of asset allocation portfolios to go through using the process, these “steps” may result in rather sharp asset allocation movements, possibly not at the best of times. However, the more steps, the smoother the process’ “glide path”;• unless the TD process uses more sophisticated funds like asset allocation funds, it might be more difficult to make use of new alternative asset classes for further diversification—something many TDF families include in their products;

• not all DC sponsors are looking to take on the responsibilities linked to making all these decisions (glide path, portfolio construction, etc.). This approach typically requires more support from investment specialists like consultants; at the same time, not all aspects of the process need to be personalized.

Still, we are seeing increasing interest in the use of TD processes, as sponsors feel they have more control on their plan and are able to customize to their plan members’ needs and desires. The increased transparency has appeared to be a key driver for sponsors using this approach.

No (safe) harbour in sight
If you’re an American DC plan sponsor, you may be concerned for your participants, but not too much for yourself, as TDFs provide you safe harbour immunity when used as a default option. Not true in Canada, however, where one needs to be a bit more proactive at managing risk. In this context, using a TD process approach may be the right answer for you.