A smooth flight for TDFs?

Target date funds may answer many of the questions posed by the new pensions paradigm but they still have a way to go to replicate their US dominance in the UK, says Philip Scott

Target date funds may dominate the massive US market but, when it comes to cracking the UK, apart from Nest’s own giant version they still have their work cut out.

Providers, however, are banking on the new pension freedoms and the expanding universe of automatic enrolment to help them break through.

TDFs, much like lifestyle strategies, move pension members from higher- to lower-risk investments as they progress towards a set retirement date.

Presently, more than 85 per cent of UK plan members are enrolled in a default strategy, the most common of which is lifecycle. But TDF providers claim their products are far more suited to the needs of savers and retirees under the UK’s new pension regime because they are designed to be a ‘to and through’ retirement solution and, rather than applying a completely mechanistic de-risking strategy, they are able to adapt asset allocation strategy on an ongoing basis to meet market conditions.

Their success across the pond has been well documented. Of the millions saving into so-called 401(k) plans, more than half are invested in a TDF, according to Vanguard.

Slow UK take-up

But in terms of the inroads being made in the UK, State Street Global Advisors senior defined contribution investment strategist Alistair Byrne acknowledges that, while he is seeing an increasing interest, the pace of take-up is “steady but not rapid”.

JP Morgan Asset Management head of UK defined contribution Simon Chinnery agrees that, to date, TDFs have made “a relatively small impact”.

While research from actuary group Spence Johnson forecasts that TDF strategies should snap up around 20 per cent of the UK’s default fund assets
by 2024, currently a number of obstacles seem to be impeding the progress of TDFs.

Industry conservatism appears to be one such headwind. AllianceBernstein pension strategies group managing director Tim Banks says: “Traditionally, the industry has adopted innovation very slowly. Innovation needs to prove its worth before it becomes widespread. But I think target date funds have proved their worth and more will launch.”

Chinnery believes the evolution of TDFs is set to accelerate. He says: “In light of the new pension freedoms, target date funds are the natural next step for UK default design. Unlike lifecycle, they can quickly adapt to political, economic or behaviour changes and provide one solution, whether members choose cash, income drawdown or a partial/deferred annuity.”

Byrne agrees. “The pension changes mean that advisers and their clients must review their default strategies. One issue that comes up is how to make the default options future-proof.”

He firmly believes TDFs can more than meet this need. 

Nest endorsement

Since the introduction of auto-enrolment in the UK, more than five million employees have been placed in workplace schemes and, by 2018, when the rollout is complete, it is hoped that up to nine million workers will be saving.

A major validation of TDFs came when the Government-backed Nest scheme opted for the strategy in its own default plan. As a result, more than a million pension savers are in a target date strategy.

Birthstar head of research Henry Cobbe says: “Nest selected a target date fund approach for flexibility, fiduciary oversight and economies of scale. Likewise, a growing number of defined contribution schemes are selecting target date funds for the same reason. So yes, the inroads are clear to see – but it is a slow market.”

Cobbe asserts TDFs are “cradle-to-grave strategies” and believes they could be the panacea to the workplace default conundrum.

He says: “They are flexible: they can adapt to changing market, economic and legislative conditions. Broadly, lifestyle strategies are ‘to’ retirement and assume 100 per cent immediate annuity conversion, which is clearly no longer fit for purpose. By contrast, most target date strategies in the UK are ‘through retirement’ strategies – they continue to offer an increasingly cautious multi-asset strategy at and after the target date.”

While the workplace TDF market is dominated by asset managers including AllianceBernstein, BlackRock, Fidelity, JP Morgan, State Street and Vanguard, the latter firm’s European defined contribution proposition manager, Steve Charlton, notes that in addition to the known providers there are a number of players set to join.

He says: “All indications are that target date funds will become the default of choice given they are inherently more flexible and simpler to administer than the complex lifestyle matrix used in the past. With Nest using target date funds, a greater proportion of defined contribution members will have some knowledge of target date funds than of any of the alternatives.”

‘Difficult market’

For some, however, a long road still lies ahead before TDFs become mainstream. Previously, they have been criticised for being too reliant on fund managers.

Towers Watson head of UK DC investment consulting Nico Aspinall believes TDFs are “a very difficult market”. He notes that most providers try to manage all the assets in house and, naturally, employers can be nervous of committing to one investment manager.

He says: “Where we have seen some take-off is in small to medium-sized schemes, where trustees do not want to be overly engaged with the advice process. But this rise has been relatively limited.”

Given that no member interaction is required, these funds may appear a perfect solution for the unengaged investor who has been automatically enrolled into a workplace pension. However, Hargreaves Lansdown head of corporate pension research Nathan Long asserts that member engagement with both their pension and wider finances is crucial when planning for retirement and TDFs do not nurture this involvement.

Decisions made at the point of taking benefits are rarely straightforward and can be heavily influenced by emotive factors. “It is therefore impossible to create a one-size-fits-all de-risking strategy,” says Long.

He adds: “Income drawdown is a high-risk way of taking pension income. Members are, in a sense, forced to be their own insurance company by managing capital withdrawals over their lifetime. A more sustainable way of drawing income can be to take the ‘natural yield’ – that is, only the income generated by the underlying investments. As yet, I have not seen this available on any target date strategies.”

Company pension schemes

Chase de Vere certified financial planner Patrick Connolly says that, while TDFs have limitations, nevertheless he expects the market to grow.

He says: “We are already seeing and will continue to see an increasing number of target date funds being used as the default choice in company pension schemes in preference to lifestyling funds.”

On the plus side, he says, TDFs enable investment managers to have more flexibility in how funds are managed, particularly from an asset allocation perspective, rather than the “more rigid approach adopted by lifestyle funds”.

 However, Connolly adds that, while TDFs have a role to play, it is far more about accumulating pension assets than taking income. He argues this is because “people will have a much better idea of when they are going to retire than when they are going to die” and adds: “If target date funds are used sensibly, they should at least stop people from going too far wrong.”

Although income drawdown is certain to be more popular than it was before the pension freedoms, Long believes using a target date default fund to take members ‘to and through’ retirement is “a step too far”. 

He says: “Doing so normalises income drawdown when it should be a strategy used for those happy to take the extra risk with their pension in retirement.” 

However, early indications of retirees’ choices show that drawdown may not be as popular as many had anticipated. Numbers from the Association of British Insurers show that, in the first months of the freedoms, 11,300 people chose an annuity versus 10,300 who chose income drawdown.

Long says: “Clearly, annuities still have a key part to play in the new retirement landscape. Therefore over-reliance on default funds of any sort stores up issues at the point of retirement.”

But City Asset Management head of financial planning Chris Green believes the future for TDFs in the UK is bright, chiefly because, for the workplace market where default investment funds are required, flexible TDFs “are a stronger default investment strategy than the old lifestyle strategies”.

He says: “They are easier for members to understand and can be easily updated – without disrupting members – when things change. They could soon become the rule rather than the exception in pensions.”    

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The US backdrop

In the US, more than 90 million Americans are covered by defined contribution accounts, with assets in excess of $700tn.

According to Vanguard, 88 per cent of plan sponsors offered TDFs at the end of 2014, up 17 per cent from the end of 2009. The fund manager claims that an important factor in driving this growth is the role of TDFs as an automatic or default investment strategy.

Vanguard European defined contribution proposition manager Steve Charlton believes that TDFs are the answer to the UK default scheme issue.

He says: “We have seen the adoption of target date funds in the US defined contribution market grow enormously over the past 10 years. Some of this has been driven by legislation but that alone cannot explain their popularity. They are simple to explain and meet members’ expectations without any need for member intervention – just what a default option should do on both sides of the Atlantic.”

State Street Global Advisors’ Alistair Byrne observes: “The fact that we no longer have to buy an annuity in the UK has brought the two markets closer together.”

JP Morgan Asset Management’s Simon Chinnery notes that the US has addressed its own investment and behavioural challenges by increasingly using TDF default structures.