• Part one of a two-part series

Lifecycle funds—also known as “target date” funds—have made their way into Canada a bit over two years ago. In the U.S., these funds have become very prominent, as they represent an “approved” default investment option under a set of regulatory conditions offering sponsors “safe harbour” against liability. Lifecycle funds are not taking off as quickly in Canada, as such regulatory protection does not exist.

Nevertheless, some service providers are promoting these funds quite actively. Do they represent such a good idea? Let’s take a closer look, first from a plan member’s perspective, then, in my next column, from that of plan sponsors.

Life made easy
Lifecycle funds’ big appeal comes from their ease of use. These funds typically come as a series of balanced funds, each labelled with a year corresponding to a “maturity” date(e.g., XYZ fund 2010, XYZ fund 2020, XYZ fund 2030, etc.). Each of these funds, in any point in time, has its own asset allocation, with the funds farthest from maturity being the most aggressive(i.e., having the largest portion invested in equity).

As the approach goes, all a plan member needs to do is to determine what year he/she wants to retire in and choose the fund labelled with the year closest to their target retirement date (i.e., “target date” funds). There is therefore no need to complete “risk tolerance” questionnaires or worry about other aspects related to investments. Quick and efficient makes for very few plan members ending up in the default option—still too often it’s a money market fund.

Each fund’s asset allocation will automatically be adjusted in time so that it gradually becomes more conservative as retirement gets closer. This way, the theory goes, the plan member can simply “cruise” on to retirement, confident that the fund will take him/her there in an appropriate way.

Can’t get much easier than this, right?

If only things were that simple!
Unfortunately, although quite appealing and much better than getting no investment instructions from the plan member, Lifecycle funds are far from perfect. Here are a few problems for plan members. First, Lifecycle funds are one-dimensional, in the sense that they only take into account time to retirement. But plan members come in all shapes and sizes and may have various needs in terms of risk profiles. Are they very well-off and can afford to take investment risks, or are they very indebted? Will they be purchasing an annuity at retirement, or will they continue managing their retirement savings through a LIF/RRIF?(For more on this, see my previous column The ‘progressively more conservative’ investment fallacy.)

Also, as the names of these funds are not very descriptive, plan members may not realize what their investment actually consists of and therefore not understand the amount of—particularly short-term—investment risk involved. Just because a member is invested in the XYZ 2035 fund does not mean he/she actually would agree to invest 80% in equity. Sure, the fund content and expected asset allocation evolution is communicated to members, but we all know how this information is studiously read…. So what would happen to the unaware member above if the stock market were to drop 15%?

Finally, after studying the forecasted asset mix of most Lifecycle fund families available in Canada, it seems that they very quickly become much too conservative much too soon(some have already allocated 20% or more into money market funds 10 years before the maturity date), thereby potentially leaving members’ savings seriously underinvested for many years, at a time where these assets are at their maximum and would generate the most growth!

What to do then?
If you decide to go with Lifecycle funds, do not underestimate the amount of education and communication that will be required so that members clearly understand the funds they will be investing in. Better yet: you may want to look at other options as well, such as asset allocation(or “target risk”)funds, which are generally easier to understand by members, or the new generation of Lifecycle funds, which allow for both target risk and target date concepts to be tackled.

In part two, Jean-Daniel will discuss lifecycle funds from the plan sponsor’s standpoint.

Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

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