Target-date funds are continually evolving, but how will they change moving forward?
Charles Darwin believed evolution is the result of survival. Those who survived, adapted and succeeded were the ones most fit for their environment. While it may seem unusual to view target-date funds (TDFs) in an evolutionary context, it is relevant as it relates to the shifts taking place within the retirement industry and how TDFs will continue to change to meet plan member needs.
TDFs began as a convenient way for DC plan members to get exposure to a multi-asset class strategy that automatically reduces investment risk over time. Since their introduction in the ’90s, TDFs have gained tremendous popularity with DC plan sponsors as a retirement savings vehicle for their members. One reason is that TDFs require little ongoing effort from the investor. As the DC industry matures, catalysts for change will cause not only the investment design but also the investment structure of TDFs to evolve.
The rise of TDFs is closely linked to the dramatic rise of DC assets as many organizations move away from traditional DB plans. The assets of Canadian DC plans have soared, reaching nearly $53.2 billion at the end of 2013, according to Statistics Canada. As a result, TDFs have received increased attention from DC industry stakeholders.
There are three main aspects of TDF investment design: underlying funds, asset mix and glidepath.
1 | Underlying funds – These are the actual investment funds used for each asset class within a TDF. Variations can occur through features such as active or passive management, value or growth investing biases, and market capitalization tilts (i.e., those investors who diversify their equity asset classes by capitalization).
2 | Asset mix – This is the combination of asset classes used and the constraints that will impose limits on asset class weights. Experience shows that the asset mix has a significantly bigger impact on the return—and volatility—than the underlying funds (see Figure 1 below).
3 | Glide path – The glide path is the most important element of the TDF, as it indicates how the asset mix will change over time. Since asset mix has the greatest impact, how that mix changes over the member’s lifetime should be a significant focus for plan sponsors.
The Evolution Begins
When TDFs were first introduced, they consisted of only three or four traditional asset classes. The pioneers of TDFs introduced a solution that helped plan members de-risk as retirement approached without requiring their intervention. The novelty of this approach overshadowed any considerations about the sophistication of the design.
As more TDFs came to market, the laws of competition came into play, and investment managers looked for design aspects where they could make a meaningful improvement to the solution. The first two elements—underlying funds and asset mix—began evolving as new products appeared. Multi-manager approaches offered a different type of underlying fund diversification. Slowly, TDFs were beginning to include new asset classes such as alternative investments.
While these evolutions were necessary, by focusing on only two aspects of TDF design, they overlooked a critical piece of the puzzle: the glide path. The next major evolution anticipated is glide path design.
This expected change is based on a similar evolution of thinking that occurred in the DB industry. For years, DB plans focused on achieving an efficient asset mix—one with the best blend of risk-adjusted returns. Over time, DB plan sponsors began to understand that their objective was not to build the most efficient portfolio but rather to fund plan liabilities. DB plans therefore moved from an “asset-only” investing framework to an objective-based investing framework: liability driven investing.
In the DC industry, this shift is beginning to emerge, as the industry starts to understand that it needs to pay attention to more than just the risk- adjusted returns of plan members’ assets. It needs to focus on the true objective of DC plans: to help fund members’ retirement. This objective-based investing mindset is resulting in the evolution toward retirement-driven investing (RDI).
RDI takes into consideration retirement factors such as costs (of both employee needs and wants), government benefits, longevity and inflation. These retirement factors can be combined with how plan members save over time to design an investment solution that will give the greatest probability of members reaching their retirement objectives.
With an RDI approach, the simple de-risking glide path can evolve to a robust and powerful tool. From here, the efficient frontier analysis can be mapped to the glide path by optimizing the overall objective of members reaching their retirement goals.
Another area where TDF design is evolving is risk management. With the increasing robustness of the glide path and the addition of new asset classes, methods for evaluating and measuring risk—which are focused on the objective—need to be determined. The future of risk management is not the evaluation of member risk tolerances but ensuring that risk is taken and mitigated in the right ways, in the right places, at the right time. Risk management evolutions will help ensure that TDF solutions are using RDI and achieving the objective so plan members can comfortably prepare for retirement.
While risk management and an RDI approach to a TDF’s glide path design may be the next major evolution, there are other expected changes at the asset mix level.
In recent years, alternative asset classes have started to gain traction within TDFs. Commercial real estate, commodities, private equity and mortgages are typical examples of alternative assets—all of which offer diversification benefits such as lower correlations to traditional asset classes. At present, some TDFs provide exposure to alternative assets through listed products (e.g., real estate investment trusts and listed infrastructure, which are traded on a stock exchange). But these listed products, while they do improve asset mix characteristics, do not fully capture the benefits of alternative assets due to their equity-like volatility. Going forward, the asset mix component of TDF design will likely evolve through the use of alternative assets, particularly direct alternatives (i.e., those not listed on an exchange).
Your Customized TDF
Another evolution that has already started is the introduction of customized TDFs. Customized TDFs can provide greater flexibility compared with the one-size-fits-all pooled solution. By using an RDI approach, DC plans can have their own customized glide path built on their specific plan design, member demographics, savings patterns and member retirement needs. In addition, TDFs could be customized at the underlying fund and asset mix levels by choosing different asset classes, underlying funds and investment styles. While not every DC plan has the need or desire for customized TDFs, some plans with unique characteristics or circumstances (e.g., a younger employee population) may find them useful.
Further evolutions in the structural design of TDFs are yet to come. Could each member have a fully customized glide path based on his or her unique personal situation, age-earnings profile and retirement goals, with the flexibility to adapt over time? By using an RDI investment solution, this structural evolution is in sight. Technology is improving in terms of both cost and design, and administrative barriers continue to be knocked down. In the years to come, the individual plan member glide path has the potential to make its way to the forefront and be the next TDF breakthrough.
Unlike the evolution of species studied by Darwin, which took place over countless generations, TDFs are evolving rapidly— and their proliferation is expected to continue. This gives all DC industry stakeholders the responsibility to continue upgrading TDFs to better help plan members reach their objectives. And members will benefit: only those TDFs that are fit to adapt to the changing environment will ultimately survive.
Jonathan Jacob is senior vice-president, portfolio risk solutions, and Zaheed Jiwani is senior vice-president, client strategy, with Greystone Managed Investments Inc.
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