Elston Research Series

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