When the US introduced auto-enrolment in 2006, Target Date Funds (TDFs) were popularised as the Qualifying Default Investment Alternatives (QDIA), which offered corporate advisors and pension trustees “safe harbour” that a suitable default fund had been provided. TDF assets mushroomed from $71bn in 2005 to $340bn in 2010 and the pace of growth led to a rush of TDF launches by fund managers. But after the 2008 crisis consumer groups became increasingly concerned about the discrepancy of asset allocation glide paths and disparate returns for TDFs of identical vintages. This led to a SEC and Department of Labor joint public hearing on Target Date Funds in 2009, and SEC recommendations in 2010. The story offers some valuable lessons as auto-enrolment commences in the UK this year.
The dynamic nature of these funds means that a single fund should remain appropriate to a typical investor even if left – unadvisably – unreviewed. Their continuous appropriateness makes TDFs appealing as a default fund under auto-enrolment. Whereas the DoL explicitly referenced TDFs as a suitable default, in the UK, the DWP has defined eligible default fund criteria, which TDFs meet or exceed, in my view. Furthermore TDFs have received specific endorsement from Nest. Importantly, the DWP’s criteria are applicable to new and existing pension arrangements alike, with the FSA referencing them as a benchmark for fiduciary best practice. Thus advisers and trustees who fail to review default options, or who leave ineligible arrangements in place – for example tracker funds, balanced-managed funds, static-risk lifestyle funds – may find themselves under FSA scrutiny with regard to suitability, and could ultimately become liable to scheme participants.
The key advantages of TDFs were outlined in the SEC/DoL hearings. Firstly, they offer a life-long age-appropriate strategy in a single fund for a typical investor thereby designing out behavioural aspects than can impair investment outcomes. Secondly, the asset allocation models are professionally researched and managed. Thirdly, grouping investors by objective creates substantial scale benefits in terms of TER. Thus, in the SEC’s words, target date funds “are designed to make it easier… to invest for retirement by providing the simplicity for which many investors yearn”.
In terms of design, the disadvantages of TDFs are no secret: they are intended for typical, not individual circumstances. However, investors who prefer a bespoke approach will pay a premium for that, and this will become explicit post-RDR. In terms of construction, the disadvantage of TDFs is that funds of identical target date can have very different glide paths from manager to manager, and therefore very different risk-return profiles.
Glide paths differ firstly because investment managers are not homogenous in methodology and outlook, and secondly because the specifics of the target group may differ. In the UK, Nest’s glide path is conservative, with equity allocation peaking at approximately 40 per cent for a 35 year old, and declining to 4 per cent at retirement. This is consistent with the typical risk capacity of Nest’s low-income target group, or “new savers”. By contrast private-sector TDFs have more familiar glidepaths with equity allocation peaking at 70 to 90 per cent for a 35 year old, and declining to 0 to 15 per cent at retirement. This is consistent with the typical risk capacity of the mediumto high-income target group, or “existing savers”. Clearly understanding the different glide paths of two funds with the same target year is crucial, hence disclosure is key.
Target date funds are designed to make it easier… to invest for retirement by providing the simplicity for which many investors yearn
Following the 2009 hearings, the SEC/DoL concluded it was not their place to intervene in the design of TDFs glide paths. Instead the SEC issued guidance in 2010 mandating suitably robust and consumer-friendly glide path and risk disclosures so that investors and intermediaries can make an informed choice. The SEC also updated antifraud guidance clamping down on any misleading descriptions of TDFs, such as the suggestion that TDFs were a simple investment plan that requires little or no monitoring.
While these safeguards were created after the event in the US, the UK has a unique opportunity to establish similar safeguards in advance to mitigate any risk of intentional or unintentional mis-selling and to ensure that the strategies TDFs offer to consumers are sufficiently transparent, and the harbour that TDFs are designed to provide to advisers and trustees is genuinely safe.