The Canadian CAP market is about five years behind the U.S. in terms of pension investment patterns, comments Dave McLellan, vice-president, defined contribution solutions, with Fidelity Investments Canada ULC. A survey conducted by Hewitt in the U.S. among Fortune 500 companies suggests that 77% of defined contribution (DC) pension plans now offer asset allocation funds, of which 58% offer TDFs. In contrast, only 32% of Canadian DC plans offer asset allocation funds, with 54% of these making TDFs available to their members, according to the Canadian Pension Fund Directory 2007 DC Benchmark Report. In total, Canadian market data suggest that there is presently about $1 billion invested in institutional-type TDFs, with an additional $2.2 billion invested in the retail marketplace.
But while the growth in Canada may be slower, it’s still a growing market. Much of the current Canadian interest in TDFs is due to the fairly high cross-border parent ownership of companies, which has influenced pension plan policies, suggests Dianne Lee, a consultant with Hewitt Associates. Any Canadian-based company with a U.S. affiliation will have become aware of the popularity of TDFs across the border, concurs Michelle Loder, a principal with Mercer. “Many [Canadian] plan sponsor committees have been interested in finding out more detail [on TDFs]. The last two years have been an educational/learning process, but since early 2007, there has been a dramatic increase in TDF take-up, and the level of assets under management through these funds has risen significantly. Just about any [DC plan] project to review investment structure we’re working on now is contemplating a TDF option,” she adds.
Off-the-shelf Options and Customization
Fidelity was the first recordkeeper/investment manager to introduce institutional TDFs to Canada in 2004—a move that most consultants agree sparked the rapid rollout of similar product offerings by the top 15 recordkeepers. While the Canadian CAP market has lacked the momentum that swept up TDFs in wake of the PPA, McLellan believes that the simplicity of the product will continue to draw strong interest from plan sponsors and members alike. “What we’re seeing in Canada is what I call ‘hockey-stick growth’—a flat line with a sharp upward curve,” he adds.
Standard Life has placed its focus on customization. “With the guidance of a consultant, [Standard Life] allows the plan sponsor to decide the TDF’s asset allocation over the course of the fund, as well as establishing the number of ‘time horizons’ of the glide path whereby the asset mix is altered. There is greater transparency and flexibility,” notes Andrea Kreutzer, manager, business development, group savings and retirement, with Standard Life.
What are TDFs?
Target date funds (TDFs)—also known as lifecycle or age-based funds—are a balanced-asset investment solution whereby the asset mix (composed mainly of traditional investment classes such as domestic or foreign equity, bonds and money market instruments) is automatically adjusted over the member’s term to retirement age (the “target”) to reflect an increasingly conservative investment portfolio. A TDF strategy reduces exposure to more volatile-performing securities as the de-accumulation phase approaches. For example, a TDF may start off with a 95% equity exposure, which remains relatively high for the first 10 to 15 years of the fund and then declines over time to reflect a 30% to 40% equity holding by the target date, with the remainder in money market instruments.
Franklin Templeton believes that one of its TDF products takes customization a step further. In addition to allowing members to select from “conservative,” “moderate” and “growth” options within the TDF (thus addressing individual risk tolerance), the investment manager has built a tactical asset allocation component into the glide path (the trajectory the investment follows as the individual approaches retirement). This effectively allows the fund manager to adjust the asset mix according to developments within the investment markets. “The fund manager is therefore not stuck to a linear glide path and is able to maximize the risk-adjusted return. Effectively, we’re combining the best of the target-risk and TDF solutions,” says Duane Green, vice-president, strategic alliances, with Franklin Templeton Investments.
And these are just a few of the many products on the market. But when it comes to delivery, Green points out that most TDF products in Canada tend to be available through recordkeepers. Investment managers work with the recordkeepers—which in Canada tends to be life insurance carriers—to maintain their funds on the insurer’s DC plan solution platform. The investment fees are negotiated between the recordkeeper and the investment management house rather than directly with plan sponsors. Alternatively, several of the large life carriers have their own proprietary investment funds. “The insurers are the gatekeepers, and we work with them to broaden our representation of investment solutions,” he adds.
The bundled approach in Canada is largely due to the need to curtail expenses and the limited size of the CAP marketplace. DC plan and TDF investment customization is rare in Canada, says Mike Sandrasagra, regional director of DC services, private client group, with Russell Investments, as the largest DC pension plans tend to fall into the mid to smaller category of plans in the U.S.
One Size Fits None?
The reduced interaction required from the plan member over the course of the investment can benefit all parties, but as one observer illustrates, “a TDF is a bit like walking into a clothing discount store and buying a suit from the rack where the sizes only come in even numbers.”
Most TDFs are age-based and mature every five to 10 years, meaning that plan members have to select the funds closest to their retirement target dates. But the difference in asset allocation and glide path can vary greatly from one fund to another within the same family. And these differences can be even more profound when comparing different providers’ options. “TDFs can cover a wide variety of solutions,” says Green. “When you peel back the onion, [TDFs] can be very complex—the products out on the market differ substantially in terms of investment management, the asset mix, as well as the glide path methodology.”
There’s also the issue of passive versus active management. TDFs that are passively managed tend to be index fund-based and offer lower costs (possibly at the expense of investment return), as they track the performance of investment indexes. Actively managed funds (which can be single manager or multi-manager) invest in other pooled products—essentially becoming a fund of funds, where the active management applies to the set periodic shift in a TDF’s asset mix.
The downside of off-the-shelf TDFs is that they do not take into account individual member risk tolerance or lifestyle expectations. “One size fits all is rarely ideal for anyone,” says Joan Johannson, president of retirement services, with Integra Group Retirement Services. But, she notes, it is better to have a product available that delivers a higher return than the inadequate returns of pure money market funds.
When viewed against the U.S. market, TDFrelated fees in Canada seem high, observes Loder, “but, in general, when compared with the cost of retail investment solutions, the Canadian institutional TDF fees seem competitive.” On most recordkeeper platforms, the total bundled costs for TDFs are a combination of investment management fees and asset-based recordkeeping fees, she notes, and separating these fees is not that simple. But in her opinion, the bundled costs of TDFs are competitive and comparable with other balanced fund options. Bundled money market fees, on the other hand, may or may not be reasonable depending on the plan.
“Overall, I think the costs associated with institutional TDFs are reasonable…I think TDFs are appropriately priced when compared with [static] balanced funds; [TDFs] are only at a slight premium,” agrees Lee. Furthermore, she points out that the heightened disclosure required under the CAP Guidelines has improved transparency around management fees and plan operating expenses.
Sandrasagra says that from Russell Investments’ perspective, the objective is to establish a fee structure over the course of a TDF based on a 60% equity to 40% money market balanced fund ratio. “So, in the early stages, the member benefits from a much higher equity managed fund. Products in the market are typically priced like this. However, the cost issue becomes important in terms of how fast the asset allocation rolldown takes place,” he adds.
And cost structures may change in the future. Janice Holman, a principal at Eckler Ltd., notes that in the early innovation stage of product development, the record-keepers and investment managers tend not to compete on price. “We’re at that stage in Canada, but when the market matures, I think there will be greater attention given to price,” she adds.
Regardless of the option they choose, plan sponsors should be aware that the TDF is not a panacea for member disengagement and inertia. As many consultants observe, the growth in CAPs in both the U.S. and Canada is linked with plan sponsors’ desire to shift the onus of retirement saving to the individual member, thereby reducing the potential for litigation and the administrative overhead. TDFs have been marketed and sold in the U.S. on the basis of their automated simplicity and flexibility in design.
However, the Canadian legal environment is very different, consultants caution. “The slippery slope for employers/plan sponsors [in Canada] is that many [pension plan professionals] in the industry are selling TDFs on the basis that they are simpler to administer and involve less legal risk than a CAP where members select investment options,” says Paul Litner, a partner at Osler, Hoskin & Harcourt LLP, specializing in pension law. Not only does Canada not offer protective legislation such as the PPA, he adds, the CAP Guidelines do not expressly support the implementation of a mixed asset allocation investment fund such as a TDF as an appropriate plan default option.
The CAP Guidelines emphasize the need for ongoing and regular member communication and education on the plan options, as well as recurring review of the performance of the available fund options, Litner observes. “Employers really need to realize that if they take up this option [TDFs], they need to understand their ongoing responsibility and expense in being in constant contact with their plan members.” Furthermore, he adds, “no legislation or regulator has indicated that TDFs are a prudent investment choice in Canada.”
Stephen Lewis, a senior consultant with Towers Perrin, concurs that in Canada, TDFs offer no protection against future plan member litigation. “Litigation is a concern out there; it’s only over more recent years that plan sponsors have taken their plan governance responsibilities more seriously,” he notes. “Plan sponsors should focus on the CAP Guidelines rather than thinking that TDFs are a ‘silver bullet’.”
The view that a plan sponsor can “select and forget it” in choosing an autopilottype fund such as a TDF is deceptive, says Loder. “There is a need for greater member education—and a shift from what plan sponsors have done in the past. Past education has leaned heavily on providing investment market knowledge; with products like TDFs, there is a greater need to focus on retirement planning.” Holman agrees. “Without the protection of the safe harbour provision in the U.S., Canadian plan sponsors are grappling with their duty to communicate and keep members engaged in their retirement savings versus a product that can be selected at enrollment and be allowed to run on autopilot,” she adds.
Without a legislative safe harbour, the advice that Watson Wyatt offers to its Canadian plan sponsor clients is to “document, document, document.” “It’s much easier to be sued if you don’t document your decisions,” says Janet Rabovsky, practice leader, investment consulting, with Watson Wyatt Worldwide. “Although there aren’t any legal precedents in Canada, I think there will be plan member lawsuits eventually. All we have for support is the best practices set out in the CAP Guidelines. The concept of risk transfer really hasn’t taken place.”
When envisioning the future of TDFs in Canada, the U.S. market once again serves as a guide. Looking ahead, the “DB-tization” of CAPs—and TDF products in particular—is the most likely future market development, according to industry consultants, recordkeepers and investment managers. Sometimes known as “DB guilt,” plan sponsors that have switched to CAPs are seeking ways to achieve a level of security in post-retirement benefits that members would have enjoyed under a DB plan. Consequently, much of the current development of TDFs in the U.S. involves a post-retirement component addressing the need for ongoing income security during the de-accumulation stage. “I think the future will see providers introducing a post-retirement component addressing the need for fixed income as well as capital growth,” says Johannson.
Rick Headrick, vice-president, International Investment Centre, with Sun Life Global Investments, agrees that future development will see providers building a de-accumulation component into the TDF structure. “TDFs were created because they are simple to implement. Therefore, the extension of the product through an automatic transfer to something like a variable annuity that provides a guaranteed retirement income for life combined with a capital growth element is just one step further in convenience.” An added benefit to such fluid structuring, he notes, is that longevity risk (the risk of the plan member outliving his or her assets) is addressed.
Chiappinelli also foresees greater competition between investment managers in more diversification of the asset allocation of TDFs. “There’s a move in the U.S. to invest in non-traditional asset classes such as emerging markets, real estate and commodities.” He, too, believes that much of the future innovation of TDFs will be at the “back end” relating to the payment of an income similar to a DB plan.
“In the U.S., there is talk of creating a DB-type “annuitization” to TDFs. This will be the next evolutionary step in the TDF market,” says Lee. Such development will advance rapidly to the Canadian marketplace, she predicts. And the issues of managing money after retirement and longevity risk will drive the need to create a simple product such as a TDF with an annuity component, Lewis adds. “This would be the simplest solution.”
Sean van Zyl is a freelance writer in Toronto. email@example.com
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