A Benefits Canada CAP Member Survey found that 79% of plan members wished they could follow a set-it-and-forget it approach to their retirement investments.* Indeed, getting employees to be more actively engaged in their plans is perhaps one of the most common challenges cited by plan sponsors. As a result, Target Date Funds (TDFs) were developed in response to this growing demand. Under this arrangement, an employee would provide the year in which they expect to retire and select a TDF with a corresponding target date. Following a preset formula, the TDF would gradually de-risk as the employee approached their retirement date.
Unsurprisingly, TDFs appeal to many employees as well as plan sponsors. On one hand, this model caters to the widespread preference among plan members for a set-it-and-forget-it strategy. At the same time, plan sponsors saw TDFs as a solution to addressing financial illiteracy and member inertia. Many organizations adopted this seemingly well-rounded investment mechanism as the default option in their DC pension plans.
Yet closer scrutiny of TDFs reveals a far less rosy picture. While it cannot be denied that TDFs partially address some of the challenges facing plan sponsors and members, there are many gaps and inherent flaws in this model that should prompt employers to reevaluate their reliance on TDFs.
One size fits all
One of TDFs’ biggest limitations is the fact that they are fundamentally age-based. Rather than taking into account other factors such as retirement goals, risk tolerance, and changing life circumstances, TDFs assume that all investors ought to follow the same investment strategy as that of a ‘mostly equity’ portfolio in youth that becomes more conservative over time. In this scenario, a risk-averse 30-year old would be placed in a very aggressive portfolio which does not match their profile. Conversely, a 55-year old that is still quite far from attaining their goals would be placed in a relatively conservative portfolio when they are in fact willing to take on more risk.
While TDFs are often able to outperform balanced funds over a long-term period, their premium price tag more often results in net returns that are lower than what non-retail balanced funds generate. Where large corporations are generally capable of leveraging their buying power to negotiate lower pricing, plan members in small and medium sized organizations far too often end up paying unduly high fees which offset the benefits offered by TDFs.
Conflicts of interest
As a fund of funds, a TDF usually contains a wide variety of investments from different asset classes. The intent of this, in theory, is to unburden plan members from having to select the investments themselves and rebalance periodically. Unfortunately, this very feature is quite often abused by providers who use it as an opportunity to include proprietary funds within the TDF. Governance-minded sponsors should be on the lookout for poor performing investments (that do not sell well on their own merits) in TDFs. It is absolutely essential to regularly look under the hood of a TDF and assess the underlying funds.
Another feature of TDFs is their unresponsiveness to changing market conditions. When faced with an increasingly volatile market, most TDFs will maintain an equity weighing that is in-line with the predetermined glide path. This partly explains why TDFs, against expectations, fared quite poorly in 2008. This was particularly the case for equity dominated TDFs. This inflexible structure also prevents the more conservative (near-retirement) TDFs from making the most out of a market recovery.
The formula that determines asset allocation over time, is referred to as a glide-path. It is a universal element in TDFs that can vary significantly from one to another, unbeknownst to plan sponsors. A 60-year old employee who expects to be placed in mostly fixed-income investments might be shocked to discover that his TDF still has 60% equity exposure. It is imperative that plan sponsors communicate clearly to members the variance found in different TDFs.
In the desire to provide plan members with a more managed investment strategy, TDFs are a step in the right direction. However, this model has many intrinsic flaws that make it a suboptimal investment option as well as a challenge to sound CAP governance.
There are certainly many factors to consider when choosing a group retirement plan for your employees. So, how can plan sponsors provide their employees with quality investment management that is free of conflicts of interest, responsive to markets, and accommodates a range of risk profiles?
Open Access’ answer to this question is to provide plan members with discretionary management done on a fiduciary basis. This means assigning investors to actively managed portfolios that correspond to their profile and ensure a conflict-free model by not utilizing any proprietary funds. It also means providing this service cost-efficiently so as not to offset the superior returns this model yields.
*source: Benefits Canada, 2016 CAP Member Survey