Target Date Funds – Under the Bonnet

A sponsored article by Neil Latham, Aon Hewitt

Target Date Funds (TDFs) are one area where the recent shake-up of defined contribution (DC) pension provision has sparked renewed interest, in particular from product providers

As well as new fund launches, we have seen a number of managers revamping existing funds to reflect the new pension flexibilities now available. But what effect has this had? Aon’s DC Survey identified that 12% of respondents are using TDFs, but there was also a startling knowledge gap – two out of five respondents were not familiar with TDFs.

You could certainly be forgiven for being in the ‘don’t know’ camp. The pace of change in DC has been staggering, and is certainly proving a challenge for many trustees. TDFs are not new. Pioneered in the US back in the early 1990s, US TDF assets are now more than $750 billion according to Morningstar research, and growth is set to continue. The best known UK use of TDFs is by NEST (the National Employment Savings Trust) which uses TDFs as its default strategy. The fact that TDFs control the asset shift within the fund has a number of important implications.

Advantages of TDFs, compared to lifestyling
• Professional management • An easier concept to communicate to members; pick a planned retirement date and stay invested until fund maturity of glidepath asset allocation and underlying fund components
• Tactical views to adapt to changing market conditions • Ease of making changes at the fund level
• Simpler administration, by removing the need for asset allocation switches • Custom fund design is sometimes possible, although requires sufficient scheme size

Disadvantages of TDFs, compared to lifestyling
• Lack of tailoring to match target year of retirement; often span three to five-year periods
• Not always best in class funds; typically comprise funds from a single provider or manager, regardless of skill across different asset classes
• Member retirement plans may change which may mean having to disinvest and reinvest in another vintage
• Potentially more expensive: fees are payable for both TDF management and design of the glidepath • Less transparent in the eyes of some commentators, but could be overcome by thoughtful communication

A question of governance
Both TDFs and lifestyling are geared towards the same objective; providing an investment strategy which maintains an appropriate balance between risk and reward over the working lifetime of the members. Both approaches can follow a similar glidepath, investing in higher risk assets during the early part of a member’s career and progressively moving into lower risk assets as a member approaches retirement.
But do not be lulled into thinking this is purely an investment decision. The key question is one of delegation, and how much of the decision-making you are comfortable delegating to one fund manager or provider. By using TDFs, you are delegating not only the design of the glidepath but also the choice of underlying asset class structure and manager.

This means that understanding how a TDF strategy works is critical, as well as picking a provider with the necessary skills to deliver the best possible outcomes for your members. One pitfall investors need to avoid is failing to examine the detail of the underlying components. Remember to look under the bonnet, and consider the pros and cons in the context of your individual scheme circumstances.