CAP advice: Client may misuse lifecycle funds

Lifecycle funds are fast becoming the default investment option for capital accumulation plans (CAPs). If your client is in a CAP, there is a role for the advisor to play in assessing whether the client even needs a lifecycle fund and, if he does, whether it meets his investment objectives.

There is always a role for an advisor to play, even with clients who hold the bulk of their assets in a CAP (also known as a defined contribution plan). Investment options offered through a plan sponsor are usually well-managed and cheaper products than what is available in the retail sphere. While a plan sponsor can offer sound investment solutions, that does not mean a CAP member will implement those solutions appropriately.

Most lifecycle funds are de facto all—in—one retirement portfolios that use a strategic glide path to transition a client’s asset allocation to more conservative investments and fixed income as the client ages. This simplicity of use has helped lifecycle funds to become the default product offering for many CAP members in the U.S.

The U.S. Securities Exchange Commission and the Labor Department’s Employee Benefits Securities Administration recently held hearings into target date or lifecycle fund usage in employee benefits plans to get feedback on whether new regulation is in order to improve target date fund usage.

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The recent downturn in the stock market highlighted that many 401(k) members were inappropriately invested in lifecycle funds and, more alarming, that some lifecycle funds had inappropriately high equity allocations for relatively short retirement horizons.

Boston—based research and consultancy firm DALBAR outlined in its submission to the hearing that asset allocation theories behind lifecycle funds work, but the investment strategies that fund providers employ — such as strong equity bias — can be flawed.

“DALBAR has developed norms for asset allocation in target date funds based on current industry practices. Funds were compared to these norms and showed a strong bias to equities. In other words, funds erred on the side of having too much equity. While this test shows a bias to equities, it does not explain the magnitude of the failure of short—term target date funds experienced in 2008,” DALBAR’s submission says.

DALBAR believes that lifecycle funds, or the plan sponsors that offer them, need to create better risk metrics for plan members beyond simply using their age, which is the primary trigger for initiating changes within a lifecycle fund’s glide path.

“Theories that fail to distinguish between participants with $100,000 for retirement and those with $100 million are fundamentally flawed. Theories that use a single variable (age) to determine a lifetime investment strategy cannot be in the best interests of the participant,” the submission says. “To simply base a lifetime investment strategy on age makes little sense. This ignores variables such as retiring early or later, personal obligations, accumulated wealth and health.”

DALBAR also found in its research that the literature offered by lifecycle fund providers to CAP members was complex and would be difficult for a member with no investment knowledge to understand. In the absence of financial advice, it suggests that providers simplify their literature.

“Disclosures and notices that are suitable for the average investor are incomprehensible to a new employee with no investing experience or training. A new employee is often confused by basic investment terms like appreciation or return and has absolutely no idea what terms like ‘CUSIP’ or ‘beta’ mean,” DALBAR’s submission says.

Of course, an advisor acting as a fiduciary on behalf of a CAP member should help the client sidestep some of these problems. A good advisor would likely help a client understand how a lifecycle fund could be used for her broader financial needs.

Lack of communication and understanding is the biggest factor in lifecycle misuse in Canada, according to Idan Shlesinger, managing partner with Morneau Sobeco’s integrated CAP services department.

“A lot of them aren’t being used properly right now. Largely, this misuse revolves around communication and education,” Shlesinger says. “Lifecycle funds are prepackaged, and they can be very opaque — plan members can’t really see what is inside them; they don’t know what they actually cost; and they can’t compare them from one to another.”

Shlesinger says a common mistake, then, is that a CAP member chooses lifecycle funds as she would a variety of mutual fund mandates — not realizing that lifecycle funds are essentially an all-in-one portfolio.

“Diversifying amongst lifecycle funds is really defeating their whole purpose, which is that they [provide] the total strategy that allocates money in your investments in an efficient way that matches your investment style and your time horizon,” he says. “We’ve seen examples of somebody who has got half their money in a 2020 fund and half their money in a 2025 fund,” Shlesinger says.

Shlesinger believes greater transparency within lifecycle funds would help both plan sponsors and clients understand how the product works as a core portfolio and which time horizon best matches their own personal retirement goals.

“The plan sponsor has the fiduciary responsibility for picking the right funds for their members. When it has got these opaque funds, it’s difficult to do that because you can’t compare them from one to another,” he says. “They are popular as an investment default option — quite frankly, they’re fantastic as a default option compared to money market funds or even balanced funds. They are far superior. The problem we find is that plan sponsors take whatever lifecycle is available through their provider because it can’t benchmark them to other lifecycle funds — they can’t really test them.”

Plan sponsors are not really in a position to determine whether a particular lifecycle fund works for the member’s retirement goals. It is, after all, viewed as a default solution for unsophisticated investors. Shlesinger says an advisor could add value by determining whether it’s the right solution for an individual client who may have other core asset holdings outside of the CAP, such as non-registered assets, insurance, real estate or even her own RRSP.

“Plan sponsors can’t really keep track of all that. Lifecycle funds only make sense as somebody’s primary savings plan,” he says. “If you’re offering employees a DC pension plan as their primary source of income, that’s a very good place for a lifecycle fund. If you’re offering them a DB pension plan with a small voluntary RRSP on the side, maybe that’s a little inappropriate for a lifecycle fund. The fund is going to be a very small proportion of their retirement savings.”

For more on capital accumulation plans, read BenefitsCanada.com.

(07/07/09)