Canadian Investment Review

Target-Date Funds: The Conceptual Hurdles

Written by Gerry Wahl on Tuesday, February 1st, 2011 at 9:48 am

1173129_elephantYou will need to have a better understanding of target-date funds (TDFs) as they become more common in the marketplace, and especially if you are considering adding them to your CAP. In this blog post I cover some of the conceptual issues you should be aware of when you’re looking at TDFs for your plan.

One size fits all?

Each TDF is a unique series of funds that attempts to address a range of member needs. However, it is unlikely that a single family of TDFs satisfies all situations so consider the following:

A recent PIMCO survey indicated that, 90% of consultants in the US now claim to be offering custom target date products. Customization will however result in greater administrative costs and fiduciary responsibilities.

Retirement date: “to or through”?

Some TDFs focus on savings accumulation only to the date of retirement while others are designed to assist savings throughout the retirement period. The key issue is the level of risk and equity exposure in each fund in the later stages of the TDF. This is an important difference that TDF suppliers build into their TDFs.

Committees are often not aware of this distinction. A July 2009 Financial Times article reported that the distinction between “to or through” is not filtering through to plan participants or Committees. This issue was also the subject of an SEC and DOL hearing in 2009 on the relative performance of different supplier TDFs in 2008.

Glide path

Asset mix is one of the more critical factors affecting the volatility and performance of a fund over time. The allocation between equities and fixed income is automatically adjusted in TDFs over time. This range of asset mixes used is referred to as a glide path. Each TDF provider determines their own glide path which often results in significant differences between TDFs with respect to equities (risk) exposure before and after the target date. Ask yourself these questions:

Brinson, Hood and Beebower (1986) argued that asset mix explained over 90% of the average funds performance over time. Further research (Ibbotson, 2010) indicates this is too high and that most of the time series variation is a result of general market movements. In any case, asset mix is very important and glide paths are one of the more critical features of a TDF. The Committee should be familiar and comfortable with all aspects of this concept.

Risk /return expectations

TDF asset mixes reflect assumptions about historical return and risk performance, which is common to all portfolio construction and management and may not be appropriate in the future. In the case of TDFs there is a risk that members will rely entirely on a TDF provider’s judgment and management of the fund to provide them with a retirement income. The TDF provider should outline the risk and return expectations for each stage of the TDF.

The same article mentioned above reported that a recent survey indicated that “61% of respondents said that target date funds make some type of a promise. Over 60% of the employees say…they will be able to retire on the target date (using TDFs)  …  and, 38% think target date funds offer a guaranteed return”.

The lack of understanding of the nature of TDFs by plan members should be a concern for sponsors. Members have to clearly understand that there are no implicit guarantees in a TDF.

Long-term performance and fees are significant factors to consider. Passively managed TDFs are available and, from a fiduciary perspective, may be a good alternative.

In next week’s post I’ll outline additional conceptual hurdles like benchmarking, transparency and fees. Stay tuned…

Copyright 2018. Canadian Investment Review. All Rights Reserved.