Canadian Investment Review

The Target Date Timing Bomb

Written by Gerry Wahl on Monday, January 24th, 2011 at 11:39 am

448542_lemon_timerDefined contribution (DC) plans and other tax assisted savings vehicles such as RRSPs, and Tax-Free Savings Accounts are a critical part of Canada’s pension system as plan sponsors move away from defined benefit (DB) plans. The switch to Capital Accumulation Plan (CAP)s has resulted in three critical changes to the way pension plans work:

1.     Investment risk is shifted from the sponsor to the plan member

2.     Longevity and inflation risk is shifted from the sponsor to the plan member ; and

3.     CAP participants are required to become investors (effectively, to become “balanced fund” managers).

One of the ways the investment industry in the US and Canada have responded to the shift of investment risk onto plan members is by introducing target date funds (TDFs).  TDFs  are a  family of time defined investment funds that link  specific  asset mixes to a particular time horizon (risk profile) i.e., a  formula is developed by each TDF provider to determine the asset mix (allocation) in each TDF  option. The asset mix in each fund (the “glide path”) is based on the  number of years remaining  until  the target date is reached. The time-defined funds within a TDF family usually cover five-year periods (i.e., 2015, 2020 etc).

TDFs are a step in the right direction given the challenges faced by CAP plans, however the higher level of Administrator investment sophistication required places a significant additional burden on a Canadian plan administrator. The education and communication responsibilities of the sponsor and administrator also remain.

At the same time, while TDFs may appear to make it easier for CAP members they can also be counter-productive if members become totally reliant on the funds and less involved in the retirement planning process.

Each fund in a TDF is a balanced fund combining domestic and foreign equities and fixed income funds elements but in differing proportions i.e., asset mixes which are assumed to be appropriate for a specific age group. It is assumed that a younger investor can tolerate greater risk in order to increase returns and/or minimize future contributions. The asset mix in each TDF fund is adjusted to a higher proportion of fixed income over time (i.e., the portfolios become less exposed to risk/equity volatility over time).

In a recent survey by Watson Wyatt, 63% of plan sponsors felt that TDFs would help CAP members save for retirement. As a result, they are becoming more common and are often also selected as the default fund by plan sponsors. The popularity of TDFs in the US is also driven by “safe harbour”-type protection that is not available in Canada.

However, the concepts, assumptions and philosophy used by TDF providers in developing target date funds vary significantly.

TDFs are a complex investment option. Sponsors need to be aware of these differences and how the underlying assumptions impact the construction and performance.

General issues CAP plan sponsors should consider when selecting a TDF provider include the appropriateness of a virtually locked-in long term relationship with one supplier. They should also determine to what extent the TDFs include third party funds or are just the other funds of the TDF provider. Another area to look at involves the reasonableness of fees and costs.

In addition, a TDF family may have a style bias, which may not be appropriate  (i.e., value vs. growth; large vs. small cap; active vs. passive; quantitative vs. fundamental or sector biases).

The types of investment options used in a TDF also need to be considered (i.e., alternative investments, real estate funds,  etc.) Plan sponsors should also be wary of any potential for lack of transparency for members and the pension committee members. Keep in mind the provider has the sole right to change asset mix, style and investments: the sponsor has no say or control in this.

There is also limited regulation of TDFs and a lack of sufficient performance history and benchmarks in Canada to properly evaluate the TDF.

In my next blog post I will explore more closely some of the conceptual issues plan sponsors should be aware of when considering TDFs.

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