A spin on the traditional target date fund offers greater flexibility and simplified governance for CAP sponsors.

When it comes to investing, people are always wondering, What’s going to be the next big thing? For capital accumulation plans (CAPs) and member investments, target date funds (TDFs) are it. But there is no need to wait: the next generation of TDFs is already here.

There are as many different types of TDFs as there are fund managers and service providers offering them. A TDF allows an investor—in this case, the CAP member—to invest in a balanced portfolio that adjusts the asset allocation over time as he or she approaches retirement (the target date). TDFs are typically offered as part of a series, with five-year intervals between target dates (e.g., 2015, 2020 and so on). The adjustment in asset allocation is referred to as the glide path, since the equity component in these funds, when plotted on a graph, often looks like a plane coming in for a landing. Many traditional TDFs are managed by a single investment manager, and returns are calculated in a single unit value.

While traditional TDFs offer many benefits, there are a few issues that plan sponsors should consider before offering them to plan members.

Time is just one element of the investment decision- making process. The member’s ability to assume a certain level of risk is another key consideration— one that becomes even more important when he or she is expected to invest in a particular fund for a prolonged period of time. As the recent market turmoil has shown, members who stay the course and do not liquidate their investments at the wrong time are likely to do well over the long term. However, depending on the equity content of the TDF, members may be uncomfortable if they see negative returns in their retirement accounts. Many traditional TDFs don’t account for this risk element.

Governance of TDFs can also present challenges. Plan sponsors need to consider aspects such as the fund’s track record, benchmarking the fund and dealing with chronic underperformance. As many of these funds are relatively new to the market, their track records are rather short, or even non-existent. When selecting funds, plan sponsors should take a careful look at the manager from both a quantitative and a qualitative point of view. However, quantitative measurements become difficult when there is little data to rely on, so the fund manager’s reputation will take on increased importance.

Benchmarking of TDFs is another issue, as there are currently no recognized Canadian benchmarks. No doubt these benchmarks will develop as TDFs become more widespread; however, it can be difficult to objectively measure performance today.

Finally, since many of these funds are presented as single unit value funds and are offered in a series, dealing with the underperformance of a particular component or fund within the series is problematic.

The next generation of TDFs may help overcome these challenges. This new type of TDF takes advantage of the existing fund composition within the retirement program. Designed in a matrix, these TDFs take into account different investor profile options and several different time horizons, allowing them to account for both the member’s target retirement date and his or her investor profile.

Based on a predetermined asset allocation model, the plan sponsor can choose the particular component funds that make up each of the funds offered, allowing the sponsor to tailor the funds and customize the glide path to meet specific demographic needs. There may also be advantages from a plan governance perspective. Since these funds are composed of the individual funds within the plan, measurement is already been done on them, which allows for more detailed and transparent reporting and makes it easier to swap out any underperforming components.

Plan sponsors looking at the next generation of TDFs should carefully consider how these funds will fit into the overall menu of investment options available to plan members. They’ll also need to investigate other options for retirement and payout, as these products are currently limited to the accumulation phase only.

CAP sponsors now have more ways than ever to help their members accumulate retirement income. The next generation of TDFs offers one possible solution to this ongoing challenge.

Anthony Cardone is senior vice-president, group savings and retirement, with Standard Life Canada. anthony.cardone@standardlife.ca

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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the May 2008 edition of BENEFITS CANADA magazine.