Do TDF’s traditional glide paths still make sense in Canada’s retirement landscape?
The use of target-date funds is on the rise in Canada, with more members of capital accumulation plans being offered the investment option every year. Half of plan sponsors with defined contribution plans (50 per cent) and group registered retirement savings plans (51 per cent) allocated target-date funds as their default option in 2016, according to research by the Canadian Institutional Investment Network and Great-West Life Assurance Co. That’s up from the previous year, when 43 per cent of DC plans and 44 per cent of group RRSPs included the option as their default fund.
Despite this rise in popularity, most target-date funds have yet to reach maturity so it’s difficult to assess how well they’re preparing Canadians for retirement. In the meantime, what options are available to plan sponsors to improve the offering?
Context and customization
While glide paths differ between target-date funds, they’re designed to start off riskier and become more conservative as the target date — retirement — approaches. Commonly, this means more exposure to equities for younger investors and more exposure to fixed income as they close in on retirement. As well, they’re inherently customizable as they allow members to estimate their retirement year and then choose the corresponding fund. But many considerations come into play, including an individual plan member’s broader savings context, which may affect their capacity for risk.
50% of DC plan sponsors and 51% of employers with group RRSPs allocated TDFs as their default option in 2016.That compares to 43% of DC plans and 44% of group RRSPs that did so in 2015.
Source: 2016 CAP Benchmark Report, the Canadian Institutional Investment Network and Great-West Life Assurance Co.
The Office of the Superintendent of Financial Institutions raised this point in its March 2018 guidance on DC plan default options. “A target-date fund . . . does not take into account the individual risk tolerance of any particular investor or any investor’s individual circumstances, including whether the investor holds investments outside of the default fund,” it noted.
In some cases, a CAP member will also be in a closed defined benefit plan, says Tommy Perron, an associate partner and financial risk consultant at Aon. Since that DB plan will still play a major role in providing retirement income, it may be beneficial for employers with a large population of members in both plans to offer a suite of funds that takes this into account, he says.
“For this population you might want to design a glide path or a custom target-date fund that recognizes this, because if you have DB benefits, these benefits can be seen as very secured investments,” says Perron. “That might be a good reason to put a little more risk into your target-date funds.”
As well, plan sponsors should be considering plan members’ longevity, he adds. “When you’re dealing with a population that, on average, might live longer than the rest of the population, then you need more returns,” he says.
Mark Betcher, human resources, pay and benefits manager at the University of Winnipeg, agrees it’s worth considering adding more customization to the traditional approach to target-date funds.
“We have had our provider come in, and we’ve talked about it on a board level as well, that it’s possible that someone who is really close to retirement might want to choose a target date that is way beyond their retirement date because they wanted to be more aggressive . . ..
“We certainly don’t dissuade individuals if they want to be a little more risky, a little more aggressive in the market,” he adds.
Can’t win if you don’t play
With equity markets climbing higher over the past decade, younger plan members who are joining target-date funds for the first time are inevitably putting their money into the asset class at some of the highest prices ever. The traditional glide path, which puts people with longer time horizons into riskier assets at the outset, is commonly criticized because it doesn’t account for the market environment.
On the other hand, acting in a market-neutral capacity, regardless of conditions, can be a safeguard for less savvy investors, says Mohamed Karmali, a consultant at Accompass Inc. He notes target-date funds are designed for people who are either uninterested or unengaged in the selection of their retirement fund.
“So for those people, it keeps them invested even in times of a downturn,” he says. “And it takes away that emotional bias that may have otherwise resulted in people reducing their equity allocation at a bad time.”
To illustrate this point, consider the effects of de-risking a portfolio at an inopportune time, says John Croke, head of multi-asset product management at the Vanguard Group. “We have a pretty good stress case for that: we have 2008/09. And we found that when we’re de-risking the portfolios along our glide path, we’re not doing big five, 10, 20 per cent trades. We’re de-risking gradually over decades in a methodical, month-to-month, quarter-to-quarter fashion. So there is no big trade in March 2009, just like there is no big trade today when we might be close to the top of the market.”
However, the high concentration of future retirees in a single strategy does mean many people will be exposed to the same set of risks, he says, noting both the Canadian and U.S. industries are becoming very concentrated. “In the U.S., there are about six target-date fund providers that represent about 90 per cent of the assets. And it’s been perhaps the highest organic growth area of retirement growth assets, certainly in the U.S.”
Updating the menu
As target-date funds continue to grow in size, many now have the scale to invest like much more sophisticated entities, with some even gaining the capacity of a mid-tier DB fund, says Mazen Shakeel, vice-president of market development and group retirement services at Sun Life Financial Inc. Many have the depth to start adding more complexity, he adds.
Indeed, the inclusion of infrastructure, commodities, real estate and less traditional types of fixed income is now on the table, says Perron. “Especially if you look at the inflation protection that is usually associated with commodities, you might see, for instance, a custom target-date fund or even off-the-shelf target-date fund with an allocation to commodities, especially as we get closer to the retirement age or within the retirement phase.”
Within a target-date fund, fixed income is meant to provide downside protection and should also provide at least some return, so investment managers are being more creative in the current low yield environment, says Perron. This includes using investments in return-seeking bonds, as well as relatively liquid strategies like bank loans, emerging market debt, corporate bonds and mortgages, “to make sure that basically, yes, you get a risk/reward profile that is more efficient,” he adds.
Further diversification within TDFs into alternative assets such as private equity, real estate and hedge funds could significantly increase their overall success, according to a study by Georgetown University’s McMourt school of public policy.> Private equity can improve median retirement income by between 6% and 13%, depending on its weighting and the retiree’s income level.
> Real estate can provide between 2% and 3% of extra downside protection.
> Hedge funds can boost retirement income from 2% to 8%.
While it was once common for a single investment manager to oversee operations, many target-date funds are taking on a multi-manager approach as their universe of assets expands, says Michelle Loder, vice-president of DC solutions at Morneau Shepell Ltd. “We’re seeing much more of a broadening of the asset class spectrum that is being employed, moving away from the traditional and employing more non-traditional types of asset classes into the mix. And I think we’re going to start to see more evolution and re-thinking of the glide path that has been employed.”
One of the reasons to implement this change is that the usual structure of the glide path has been reasonably successful in the past decade or so, but today’s forecasts are a little gloomier, says Shakeel. “In order to deliver the same dollar of wealth 10 years from now, the asset mix has to look a little bit different.”
It’s difficult to measure how well target-date funds are working since very few pension plans have used them long enough to evaluate whether they’ve helped their members to a comfortable retirement, says Perron. “We are still relatively early in Canada to be able to assess that.”
But from a qualitative standpoint, the funds are still an efficient way to ensure plan members are invested in what’s broadly accepted to be an excellent mix of assets for their goals, he says.
However, with so many offerings on the market, it can be difficult to benchmark whether the target-date funds that one plan is providing to members are performing as well as any other, says Eileen Holden, vice-president of human resources at Tarion Warranty Corp.
“The funds are not consistent,” she says. “You are able to benchmark, but it’s not as clear as benchmarking Canadian equity funds against other Canadian equity funds.”
In Tarion Warranty’s DC plan, as in any other CAP, it’s important to ensure members are educated, says Holden. But since target-date funds are designed to allow plan members to disengage, how involved do they need to be?
Failure by members to engage with communications can cause problems, says Bletcher, noting people can misinterpret the information they’re given. In the University of Winnipeg’s case, one member in their early 20s chose a target-date fund meant for members who’d already retired. “So we did advise them, ‘That’s not for the age group that you’re in.’”
Understanding the full picture can be difficult for many plan members, so employers must be prepared to translate complex language, says Karmali.
Janice Sidney, senior director of total rewards and payroll at Sodexo Canada Ltd., says her organization has been broadly successful in ensuring its plan members are in appropriate investments, noting it reviews this with its target-date fund provider, which shows the company whether there are any significant instances of members misusing the funds.
“It’s more of a soft coaching because, if the employee only has five per cent of their money [in a less appropriate fund] and they have the rest in other funds that are appropriate, you’re not going into too much,” she says.
Among about 500 employees in Tarion Warranty’s DC plan, just five appear to be doing something unusual with their target-date funds, which is encouraging, says Holden.
Martha Porado is an associate editor at Benefits Canada.
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