But how does a plan sponsor know which fund is best for its employee base? Let’s look at the benefits and risks of some historical and emerging default options.
Money market fund
Default funds have traditionally been low risk—for example, a money market fund, a fixed interest account or a guaranteed investment vehicle. A money market fund invests in securities for a short period of time (less than a year). Yet such a fund does have its purpose. “It has benefits with respect to liquidity,” says Stanton, “should members want or need to do something [with their money in the short term].”
But while the risk of losing money with a short-term fund is low, the risk of missing out on gains is high. The main challenge with a money market fund is growth. “If you earn a sustained return of 0% to 3% over your working lifetime, that’s not going to allow you to grow your assets and fund any kind of decent retirement,” says Parchment. Claude Leblanc, senior vice-president, group savings and retirement, with Standard Life, agrees. “A money market fund is the least preferable option that you can offer members, because there are no returns when you consider the economic conditions right now.”
Balanced fund
A balanced fund—which, according to Mercer’s survey, was the most common default, at 42%—is typically a mix of equities and bonds. Usually, the fund is 60% equities and 40% bonds. The balanced fund offers stability in terms of the fixed income component and growth in terms of the equities.
While the challenge with money market funds is not having enough growth, the growth component (equities) of the balanced fund will move with the markets and therefore be subject to volatility. However, the biggest challenge with a balanced fund is not the balance but the rebalancing.
Balanced funds generally have three risk profiles: conservative, moderate and aggressive, each with a different asset allocation. Marc Friebel, senior vice-president, head of global investment strategies, with Pyramis Global Advisors, says young employees may choose the more aggressive fund but generally would never rebalance it to a more conservative fund as they neared retirement in order to help protect more of their assets.
Target date fund
One of the newer defaults on the market, particularly in Canada, is the target date fund (TDF). With a TDF, the asset mix gradually becomes more conservative—
that is, moves from more equities to fewer equities—as the employee nears his or her retirement. This is a step up from the balanced fund, as the rebalancing is automatic. The employee, therefore, doesn’t have to think about rebalancing the portfolio. “The real benefit is that a member can be invested in a fund that is just generically appropriate for long-term savings at the outset,” says Devlin.
Kevin Drynan, president of State Street Trust Company Canada, says that TDF and lifecycle structures use passive vehicles such as indexes, which in their own right add some benefits—for example, reduced costs and greater transparency. “Not that it will be easy to educate employees on stocks, bonds and individual companies that they might be buying in their retirement plan—but it might be easier to explain an index and how an index works,” he says.
TDFs are built for the average member, says Stanton. “They provide a professionally managed product that controls risk in a very prudent way over time and allows the member to have exposure and risks that are appropriate given different points in their lifecycle.”
Though still new in Canada, TDFs are on the rise. In Mercer’s 2009 Global DC Survey, 19% of plan sponsors have a TDF or lifecycle fund as their default. And of the roughly 13% of those that were deciding to change their default over the next 12 to 24 months, most opted for a lifecycle fund.
Yet even a TDF has its risks. Employees may become complacent. If employees know that their asset mix is shifted for them, why would they need to worry? However, most TDFs still have an equity component, so there is the possibility of negative returns on these funds in certain markets. In addition, there’s still the risk of not contributing enough in order to have a comfortable retirement. “Do [plan members] understand that even though they’re in a TDF, it doesn’t guarantee that their investments won’t be negative in certain years?” says Parchment.
