Why target date funds work better for all

Lifestyle approaches don’t recognise the reality of modern work says Tim Banks, head of DC sales and client relations, AllianceBernstein

Tim Banks

We think flexible target date funds (TDFs) meet the standards by which “best” should be judged. When measured against the current “default default” offering – lifestyle – we believe they offer more robust governance, allow greater investment sophistication, provide improved risk management, have the potential for superior performance and give much greater simplicity for both employers and members.The arrival of auto enrolment means that millions of people will soon be saving in defined contribution (DC) pension schemes. All the evidence suggests that by far the majority will go straight into the default offering and stay there. That puts a responsibility on DC pension providers to make sure that the default is the best solution available.

The secret of TDFs is that they start with the saver. Our research clearly shows that the single biggest factor affecting savers’ risk capacity is their age. So TDFs put people of a similar age in a single fund. The asset allocation of this fund is then proactively managed as these savers advance through their working lives.

But, given that people could be saving for 40 years or more, even the most sophisticated asset-allocation “glide path” cannot anticipate everything. So, in our flexible TDFs, a professional fund manager is put in
charge of overseeing the glide path. This mean that changes are made in anticipation of events, be they market movements, new legislation, better investment ideas or tightened regulation, rather than afterwards, when it is often too late.

More than that though, this professional manager also has the responsibility for ensuring that the fund meets its objectives. We think this is a major advance in governance. Helped by their advisers, many trustees and employers currently set the scheme’s objectives and the asset allocation and then also decide whether the aims are being achieved. With flexible TDFs, the trustees and/or employer (plus their advisers) still set the objectives, but a professional is charged with ensuring they are met. We believe separating these two key functions creates a much more robust recipe for governance.

The results are already starting to come through. For the year to December 2012, our TDFs performed well where performance was needed, ie in the early years of saving, and provided lower volatility when the priority needed to shift towards lower risk, ie in the run-up to retirement. It is early days as yet, given that our range was only launched on 1 October, 2011, but we are encouraged by these results.

By contrast, to our eyes the lifestyle approach looks cumbersome, seems blind to events going on around it, and often fails to embed good governance. It is true that lifestyle reduces risk in the key period before savers retire, but the investment approach lacks sophistication and the mechanism used typically requires each
saver to own a separate fund for each asset owned. The result is a multiplicity of purchases and sales in the member’s account, none of which can happen quickly or easily. The scope for expensive and potentially litigious mistakes is clear.

Meanwhile, adjustments – if they take place at all – are inevitably done only with the benefit of hindsight. This is steering by the rear-view mirror and is hardly likely to be consistent with a member’s reasonable expectations for an investment strategy into which they have been defaulted.

But then neither is the fact that lifestyle relies on assuming that the member’s retirement date can be predicted precisely. We don’t think that recognises the reality of modern work. Most people are unlikely to know when they are going to retire 40, 30, 20 or even 10 years away from the date. And even when they do, “retirement” may still involve an element of paid employment and much more choice as to how retirement income is taken. Unlike TDFs, lifestyle arrangements cannot accommodate this sort of flexibility, usually assuming instead that everyone will buy an annuity on the day they give up work.

So we believe offering the best default DC arrangement means providing a future-proof solution that grows and evolves with its members, while delegating the day-to-day driving to a professional fund manager. We think that only TDFs meet those requirements, providing better governed pension arrangements which should provide superior returns to what’s traditionally been offered by lifestyle approaches.