Not all target-date funds are created equal

Published on November 26, 2024

Par : Éric Vachon
Senior Investment Strategist
Group Benefits and Retirement Solutions
iA Financial Group

Given that group retirement savings plan sponsors have a fiduciary duty to their members, which includes keeping their employees adequately informed and selecting and monitoring their intermediaries, service providers and investment options, it looks as though target-date funds can be an attractive solution.

These all-in-one funds provide diversification and automatic age-based rebalancing. What’s more, the simplicity of these funds helps to compensate for a potential lack of financial knowledge on the part of lay investors, thus reducing the burden on plan sponsors.

But not all target-date funds are created equal, and I advise sponsors to closely evaluate the range of funds available before choosing which one to offer.

Remember, target-date funds propose an asset allocation strategy that adjusts for the transition from the savings and accumulation phase to the retirement income and decumulation phase.

Each individual will have different needs in this respect. However, because they’re often designed to meet the needs of the typical investor, target-date funds may not take atypical investors into account.

Long-term investment glide paths

This is where the famous long-term investment glide path becomes important. Glide paths are determined using a strategy which automates the fund’s asset allocation to progressively reduce market risks as a plan member approaches retirement.

As an investor’s target retirement date nears, fund managers will increasingly emphasize the preservation of capital.

Every fund manufacturer will have their own asset-allocation strategies, each of which may deliver significantly different returns. Furthermore, certain strategies may not suit a specific type of clientele.

For example, within the same group of investors, some people may wish to pursue an aggressive approach after reaching their target retirement date, therefore reaping the rewards of an asset allocation that continues to favour equities. Others may rather choose to preserve their capital and limit risk to focus on generating income as of day one of their retirement.

The range of approaches to rebalancing strategy means that there can be a wide variation from one provider to another in the extent to which they adjust the focus on equities toward more conservative securities, such as bonds, past the target date.

Some target-date fund strategies involve retaining the equity portion of the fund past the target retirement date, enabling investors to continue gaining stock market returns even after they’ve retired. In this case, a certain level of risk and volatility remain.

Other strategies focus instead on gradually lowering the investor’s overall risk by continuing to reduce their allocation of equities for 10 to 15 years past the target retirement date, thereby minimizing the volatility of their returns.

Plan sponsors should be informed of the provider’s investment glide path strategy and discuss it with them.

Different ways of managing various risks

Also among the variables that I think plan sponsors ought to consider when choosing the best fund for their members is how providers manage risk in their target-date funds.

Target-date fund providers have strategies in place to balance not only capital risk, but longevity and inflation risk, as well. Longevity risk is the risk that a member outlives their savings, while inflation risk is their potential decline in purchasing power.

There’s no easy way for providers to optimally manage all these risks. On the one hand, providers who focus too heavily on limiting longevity and inflation risks may expose investors to elevated market volatility at a time when there wouldn’t be enough time to recoup losses, especially if they depend on their withdrawals to cover their expenses.

On the other, heavy-handed attempts to reduce capital risk may undermine investors’ long-term returns, leaving them with insufficient assets in retirement.

That’s why it’s essential that plan sponsors understand how risk and performance may vary among products with the same target date.

Time is money

In the end, sponsors deciding what kind of target-date fund to offer their employees need to assess their objectives, promote them with a financial contribution, if possible, and reiterate how important it is that their members start to contribute to their plan as soon as they can.

Because even as target-date funds are intended to simplify investing, there’s no substitute for long-term retirement savings. And this is all the more true if there are incentives in place to encourage employees to start saving as early as possible.

Remember, time is one of the more powerful elements of a group retirement savings plan investment strategy.