Since target-date funds were introduced to the Canadian market in the early 2000s, they’ve become the dominant investment choice for defined contribution pension plan members.
The funds, which are balanced with dynamic asset mixes that adjust as members approach retirement, are offered in a series — typically, one fund for each five-year target retirement band — with each fund designed to offer an optimal asset mix for investors with similar time horizons to retirement.
But there are key differentiating factors to consider when evaluating different TDF options.
1. Asset classes
Traditional asset classes incorporated in a TDF typically include cash, equities (domestic and foreign) and fixed income. For fixed income, Canadian TDFs tend to have a high domestic allocation, since Canadian bond yields are more highly correlated to Canadian inflation levels. For equities, there’s typically less of a bias toward domestic equities.
Read: Target-date funds a game changer for plan member outcomes: research
Some TDFs include other specialized asset classes such as small-cap equity, emerging market equity, long-term bonds, real-return bonds and foreign bonds. Other TDFs may include small allocations to less liquid alternative asset classes, such as real estate, infrastructure and mortgages. These exposures may be achieved through funds or through liquid alternatives and, in some cases, through exposure to exchange-traded funds.
Using a broader range of asset classes may enable a TDF to achieve a more attractive risk return profile than those limited to traditional asset classes.
2. Underlying portfolio structure
Some funds use a best-in-class approach that employs a multi-manager structure. They identify the optimal investment managers in each asset class and use them in the TDF regardless of the relationship to the TDF provider. Others build proprietary TDFs that only use in-house managers. The issue with TDFs using proprietary funds is the concern over the difficulty of any single investment manager to excel in all asset classes. Accordingly, they may incorporate certain suboptimal portfolio strategies.
Read: Exploring the active nature of target-date funds
The other big distinction in categories relates to the use of actively managed strategies versus passive or index-based strategies. Active TDFs are designed with the objective of outperforming the fund benchmark, while passive ones are designed to replicate their benchmarks. There’s a preference for passivity among some plan sponsors, which fear potential fiduciary risk associated with the selection of an active strategy that may significantly underperform the benchmark in certain phases of a market cycle. Plan sponsors that believe in active management often prefer active ones that employ a more style neutral approach, using style offsetting managers in key asset classes to limit potential underperformance in extreme style-biased markets.
3. Glide path construction
Glide path construction is the methodology used to derive the shape of the asset mix glide path. When evaluating a glide path, it’s important to have a well-reasoned methodology backing the assumptions. Often, the glide path will be modelled on a target investor.
There may be features of a specific glide path that makes it a better fit for a given population. Glide paths should be reviewed periodically to ensure their modelling assumptions remain current.
Some of these features may include:
High equity allocations in the early years. This approach will typically provide higher expected returns over the life of the TDF, but may experience greater volatility and more extreme corrections in market downturns.
Read: Boosting the glide path to optimize target-date funds
A steep decline in equity exposure near retirement. This will enable the TDF to maintain a higher equity content over much of the working years, resulting in a steep decline in equity near retirement. This approach will increase the expected returns and volatility. It may also limit the diversification offered to members over a large part of the glide path.
To retirement versus through retirement. To retirement glide paths terminate the active glide path at the expected retirement date (often age 65). At that stage, the mix will remain in a static retirement mix, dominated by fixed income. A to retirement glide path may be a fit for a population that tends to annuitize their balances at retirement.
In contrast, through retirement glide paths continue to modify the asset mix beyond the assumed retirement date, on the assumption that most retirees will remain invested through a good portion of their retirement phase and would benefit from continued equity exposure and an active glide path.
Asset/liability approach. Some glide path optimization approaches focus on the asset side only, using an efficient frontier approach to optimize the asset mix over time. Other glide paths consider both the assets and liabilities (the income requirements in retirement). This approach requires the modelling of expected income replacement in retirement and may necessitate the modelling of spending patterns in retirement.
Read: More pension plans using target-date funds as default option
Risk-adjusted glide paths. This approach offers multiple glide paths for different risk profiles of DC members. The challenge with this structure is the requirement that each member fill out a risk questionnaire, which directs them to the optimal glide path for their personal circumstances. This added customization erodes the simplicity of the TDF model, which slots investors in the appropriate fund based on their target retirement.
4. Investment performance
Past performance should be evaluated, but not overemphasized. A TDF series requires a sufficient track record to ensure the funds are operating as expected. Performance should be evaluated relative to a TDF’s stated benchmark. Performance relative to peers is less useful, even when comparing funds with the same target retirement dates since they may have broadly divergent asset class allocations and categories.
For passive TDFs, the funds should closely track their benchmarks. Active TDFs should be adding value over longer time horizons. It’s also important to assess the performance of a TDF series over periods of high volatility in order to assess how it performs through a deep market correction.
5. Fees
Fees are a factor, but not the only factor to consider in selecting a TDF. A passive TDF will tend to attract a lower fee than an active TDF. Those plan sponsors that select an active TDF strategy believe the active structure will add value over the benchmark over time. It’s important that the TDF can demonstrate the ability to generate sufficient value added to offset the fee differential over passive TDFs or other active TDF strategies. The higher the fee differential, the lower the probability that the TDF will outperform the fee differential.
Read: Taking a risk-based approach to evaluating target-date funds
It’s important to note that fund of fund strategies will often attract a higher fee than single manager strategies. Fund of fund TDFs often incorporate two separate levels of fees: the investment management fees paid to the underlying managers and the fee to the fund of fund manager to build and maintain the structure.
There are an increasing number of TDFs available in the Canadian market offering different fund structures and glide paths. When selecting a TDF, it’s important to understand the different TDF options in order to select the optimal fit for a program.
Colin Ripsman is the president of Elegant Investment Solutions Inc.