Professional Investor | Feature
Target Date Funds:
will the UK follow the American revolution?
Regulatory developments in the pensions and advisory markets are prompting
a fresh look at age-based multi-asset funds, known as lifecycle or Target Date
Funds (TDFs), says Henry Cobbe, CFA. As part of a broader move towards
packaged investment strategies, investment managers may need to reassess
their product offering to become a wealth manager, a fund factory, or both.
WHAT ARE TDFs AND HOW DO THEY WORK?
Target Date Funds are multi-asset funds pioneered in the US in
the early 1990s. TDFs do not have guaranteed returns, and are
not structured products. They are a “packaged investment strategy”
that aim to discard behavioural tendencies that could potentially
jeopardise savings objectives, for example: excessive choice, naïve
diversification, performance extrapolation, market timing, status
quo bias, and asymmetric loss aversion (Benartzi and Thaler 1995,
2001, 2004 and 2007).
In contrast to “static” target-risk funds, target date funds
have a “dynamic” risk profile which, in early years at a time
when risk capacity is high and volatility is affordable relative
to potential returns, allocates more to return-seeking assets
(equities) and diversifiers (property, alternative assets). This is to
counterbalance the bond-like characteristics of “human capital”
represented by future career earnings (Chen, Ibbotson, Milevsky
& Zhu 2007). In later years, as risk capacity decreases, TDFs
allocate more to capital preservation assets such as cash and
bonds. The expected pace of derisking over time is known as a
“glidepath”, and can be visualised by looking at a snapshot of
asset allocations for a range of maturities of target date funds.
Executive summary
• Target Date Funds are gaining increasing traction in
the UK DC pensions market as the next generation
of default funds, driven by auto-enrolment.
• TDFs are a low-cost lifelong investment strategy
packaged to be a simple alternative to those who will
not or cannot pay for bespoke advice.
As continuously managed funds with diminishing risk
profiles, TDFs are ideally suited as DWP-compliant default
pension funds. With auto-enrolment due to commence in the
UK in October 2012, take-up of properly designed TDFs,
similar to those used by NEST, may increase rapidly.
TDFs represent the “fourth generation” default fund, and
offers an evolving investment strategy appropriate to a typical
investor, within a fund whose objective, or target date, makes
them intuitive to understand.
Target Date Funds are continuously managed with regard to
market conditions and are therefore an improvement on the
automatic derisking techniques of their predecessors.
While TDFs’ primary application is age-based funds (for
example, someone born in 1970, wishing to retire aged 65
might select a 2035 Target Date Fund), TDFs can use the
same underpinning liability-driven investment theory (Chang
2007; Ruth 2007) to build a savings pot towards any future
liability such as school or university fees, where the timing and
size of the future liability is estimable. This opens up potential
applications for TDFs outwith the pensions context.
Glidepaths vary from manager to manager, depending on
their investment approach. The main differences are the asset
allocation mix of the glidepath, the pace of derisking, and the
equity allocation at maturity. Some managers argue for a 0%
Figure 1:
Illustrative TDF strategic allocation
• RDR is creating demand for similar funds for the
non-pensions market as intermediaries segment
their client base, and investors seek out affordable
savings solutions.
• TDFs may force fund managers to decide whether
to design and manage packaged strategies, or be
commoditised as a provider of constituent funds.
Source: Elston Consulting, for illustrative purposes only
The Journal of the CFA Society of the UK | www.cfauk.org | 43