Target date funds not a cure-all

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Left to their own wits, employees often exercise the same acuity in investing as they do in boosting their favourite hockey team. The stakes are chump change in a hockey pool. With a retirement fund, however, they are the stakes of a lifetime.

With a defined benefit pension plan, that’s all taken care of. Almost. There is no guarantee that the company will survive to pay its pension promises. Even before the Great Recession, companies that once stood at the commanding heights of industry were shifting from DB plans to defined contribution plans and Group RRSPs.

We’re all at the risk of market forces. Either employers bear these costs, or employees bear them.

For employees, there’s still the question of what to buy—whether it’s a DC plan or a Group RRSP. Service providers offer a range of options—from money market and bond funds to balanced funds or straight-up equity funds. But such choice, even if limited to five funds, can overwhelm investors. They might just follow the lead of the inventor of modern portfolio theory, Harry Markowitz, and simply put equal amounts in each option.

Increasingly, the default choice is a target-date fund. Also known as a lifecycle fund, it is classified as a balanced fund, but is a fund of funds with moving parts—the investment mix changes from aggressive to conservative as the target date approaches. They are popular not just in Group RRSP accounts but also in RESPs.

But major market upsets can disturb the “glide path”—the way the asset mix is managed to maturity. Dismal results on American 2010 target date funds in 2008 prompted the Securities and Exchange Commission to call for greater disclosure about the glide path. This after Senate hearings.

Says SEC chair Mary Schapiro, “It has been reported that the average loss in 2008 among 31 funds with a 2010 target date was almost 25%. Perhaps even more surprising were their widely varying performance results. Returns of 2010 target date funds in 2008 ranged from minus 3.6% to minus 41%. “These varying results should cause all of us to pause and consider whether regulatory changes, industry reforms or other revisions are needed with respect to target date funds.”

In Canada, there hasn’t been the same degree of scrutiny. Of course, target date funds are still small, with $4 billion in assets versus $270 billion in the U.S. Nevertheless, a couple of funds in Canada were forced to lock in guarantees earlier than the target date. Guarantees offer a whole other layer of complexity and fees. And, as should be expected: someone has to earn the risk premium.

With a non-guaranteed target-date fund, the danger is the classic mismatch in the timing of assets and liabilities. While, over time, equities provide superior returns, those returns may not come to fruition in an investor’s timeline. The timeline could be a little as a year. For example, someone who cashed out of the equity market in 2007 is in the cat-bird seat compared to one who exited in 2008.

There are a few reasons for that. The most obvious is that a 2010 target date fund would have had a higher notional equity allocation in 2008 than it would have had in 2009, depending on its glide path. So there’s the question of systemic risk. Second, the fixed income component might include corporate bonds, which were also whacked in 2008, regardless of quality. So there’s also the question of idiosyncratic asset class risk—when the only safe asset is government bonds.

Volatility is the wild card—as it is for all investments. In Canada, some target-date funds are offered as segregated funds, or they have guarantees similar to principal protected notes. With a seg fund, the insurer guarantees either the principal or the highest value achieved. Should the fund fail to perform, the insurer is on the hook. With a guaranteed fund, the guarantee is secured by a strip bond, and locks in either the highest daily or monthly close. But should the fund fail to perform, the portfolio could be monetized. In other words, it converts entirely to a strip bond for a duration of perhaps 10 years.

With or without guarantees, it pays to know the product. While a target-date fund appears made for one-stop shopping, that doesn’t mean it’s a buy and forget investment. (Not that any investment actually is.) Nor are all intended for a specific target date. Some simply start with a high equity allocation and winnow it by the target date, but the fund itself doesn’t mature. Instead, investors who stay with the fund have a 30% to 40% equity allocation—as a hedge against inflation—and can stay with the fund or cash out.

Those ranges have provoked a debate in the U.S. since target-date funds have become vehicles of choice on 401(k) plans—the U.S. equivalents of DC and Group RRSP plans. The SEC is recommending greater disclosure, including a graphic plotting of the glide path.

But critics have noted that may not be enough. Do investors also need to be warned about longevity risk—they may retire at age 65 but then live another 20 years. Inflation risk could be a factor too (though it hardly seems a factor now).

The CFP Board, for example, is calling for better disclosure when a fund’s asset allocation differs significantly from its peer group. Then there’s a whole other question that hasn’t even been asked in Canada: whether a target-date fund is designed to get a participant to retirement, or through retirement. In other words, does the unitholder have enough to annuitize at age 65 or buy an income fund, or is the target date fund intended to provide income past retirement.

Disclosure can’t prevent market volatility. But forewarned is forearmed.

Despite being an auto-pilot solution, target-date funds require the same due diligence—and attention to risk tolerance—as any other investment does.

This Advisor.ca Special Report is sponsored by: