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Left to their own devices, employees are often as diligent in investing as they are in supporting their favorite hockey team. Small changes in the hockey pool are at stake. In the case of a pension fund, however, these are lifetime rates.
With a defined benefit pension plan, everything is taken care of. Almost. There is no guarantee the company will survive to pay off its pension promises. Even before the Great Recession, companies that were once at the top of the industry were transitioning from DB plans to defined contribution plans and group RRSPs.
We are all exposed to market forces. These costs are borne by either employers or employees.
For employees, the question is still what to buy – whether it’s a DC plan or a group RRSP. Service providers offer a range of options, from money market funds and bond funds to balanced funds or straight stock funds. But this choice, even if limited to five funds, can overwhelm investors. They can simply follow the example of the founder 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 – as the target date approaches, the investment structure changes from aggressive to conservative. They are popular not only in group RRSP accounts, but also in RESPs.
However, severe market disruptions can disrupt the “tracking path” – how the mix of assets is managed to maturity. The dismal performance of U.S. 2010 target-date funds in 2008 prompted the Securities and Exchange Commission to call for greater disclosure about the path forward. This is after the Senate hearings.
Says SEC Chair Mary Schapiro: “Reports suggest that the average loss in 2008 among the 31 funds with a 2010 target date was almost 25%. Perhaps even more surprising were their widely varying performance results. Returns for 2010 target date funds in 2008 ranged from minus 3.6% to minus 41%. “These mixed results should cause us all to pause and consider whether regulatory changes, industry reforms or other changes are needed for target-date funds.”
The same degree of scrutiny has not been done in Canada. Of course, target-date funds are still small, with $4 billion in assets compared with $270 billion in the US. However, several funds in Canada were forced to lock up guarantees earlier than the target date. Warranties offer a completely different level of complexity and fees. And as you might expect: someone has to earn the risk premium.
In the case of an unguaranteed target-date fund, the danger is the classic time mismatch of assets and liabilities. Although stocks provide higher returns over time, these returns may not be realized within the specified time period by the investor. The schedule can be a maximum of one year. For example, a person who left the stock market in 2007 is in a no-win situation compared to a person who left the stock market in 2008.
There are several reasons for this. The most obvious is that a fund with a 2010 target date would have a higher nominal capital allocation in 2008 than in 2009, depending on its growth path. So the issue of systemic risk remains. Second, the fixed income component may include corporate bonds, which were also affected in 2008, regardless of quality. So there is also the issue of specific asset class risk – when the only safe asset is government bonds.
Volatility is the wild card – as with all investments. In Canada, some target date funds are offered as segregated funds or have guarantees similar to principal protected bonds. In the case of a seg fund, the insurer guarantees the principal amount or the highest value achieved. If the fund underperforms, the insurer will be on the hook. In a guaranteed fund, the guarantee is backed by a strip bond and covers the highest daily or monthly close. However, if the fund fails to perform, the portfolio can be cashed out. In other words, it converts completely to strip binding for a period of approximately 10 years.
With or without a warranty, it’s worth knowing the product. While a target-date fund may seem like a one-stop shop, that doesn’t mean it’s a buy-and-forget-it investment. (This does not mean that any investment actually is). Not all of them are intended for a specific target date. Some people simply start with a large allocation of capital and sift through before the target date, but the fund itself does not mature. Instead, investors who remain in the fund have a capital allocation of 30% to 40% – as a hedge against inflation – and can stay in the fund or withdraw.
These ranges have sparked debate in the US as target date funds have become the preferred tool within 401(k) plans – the US equivalents of DC and Group RRSP plans. The SEC recommends broader disclosure, including graphical representations of the glide path.
However, critics have noted that this may not be enough. Should investors also be warned about longevity risk – they could retire at 65 but then live another 20 years? Inflation risk may also be a factor (though this does not appear to be a factor at this time).
For example, the CFP Council calls for improved disclosure when a fund’s asset allocation differs significantly from that of a comparable group. Then there’s a completely different question that hasn’t even been asked in Canada: whether a target-date fund is intended to provide for the participant’s retirement or retirement. In other words, does the unitholder have enough to annuity at age 65 or buy an income trust, or is the target date fund designed to provide income after retirement.
Disclosure cannot prevent market volatility. But prudent is prudent.
Although they operate on autopilot, target funds require the same due diligence and attention to risk tolerance as any other investment.
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