What is a target date fund?
A target date fund is an investment fund whose assets change to suit the risk and return needs of defined contribution pension savers. Our research shows that these needs – how fast they should build up their savings and the risks they should take in doing so – are closely linked to a saver’s age. Each target date fund is therefore designed to gradually adjust its mix of assets as a saver gets older and closer to when they are likely to retire. This retirement window will be reflected in the name of the fund (e.g. the 2023 to 2025 Retirement Fund).
How does a scheme decide which fund is right for an individual?
This is based on a saver’s expected retirement date. A 33-year-old in 2013 who expects to retire when they are 67 has about 34 years left before they retire, meaning their expected retirement year is 2047. So their target date fund might be the 2046 to 2028 vintage.
Who looks after the saver’s interests in target date funds?
We believe that target date funds are designed from the beginning with the saver’s best interests in mind. The way the assets change to suit their needs means their fund should eventually provide the best savings pot for them, taking into account the risks they can afford to take at any given age.
Our flexible target date funds are overseen by a professional manager, who can take any necessary action if stock market conditions look difficult, or regulations change or new investment ideas emerge. That manager is responsible for making sure that the fund meets the objectives that have been set by the pension scheme. Effectively, that means the manager has to make sure that savers’ best interests are being looked after.
Do target date funds make life easier for trustees?
Because a professional manager takes on the responsibility for setting the long-term asset allocation and overseeing its day-to-day management, a big burden is lifted from trustees. They can concentrate on the really important things, like making sure that the scheme is on course to meet its objectives and that employees are saving for the future and/or saving enough.
What are the benefits for employers?
As with trustees, we believe target date funds lift many of the traditional burdens carried by employers running DC pension schemes. Because the professional manager takes on the responsibility for setting the asset allocation, governance in a contract-based scheme can therefore be much more robust. It means that the setting of the asset allocation – on which most of the investment returns depend – and the monitoring of its effectiveness can be separated. That should help improve both performance and oversight.
All this is available at a competitive price on an open-architecture platform. The employer can choose the components they want, whether assets, managers or administrators, and still reap the other benefits.
In addition, because target date funds operate on a single-fund basis, all subsequent changes happen within that fund. It means that switches of fund components can be made with much less disruption, fewer errors and at substantially lower cost than with rival approaches, such as lifestyle.
A target date fund sounds complicated: do the savers have to get involved in all the changes that affect the fund?
The beauty of target date funds is that each saver (scheme member) only needs to own a stake in one fund. Indeed, if they are happy with the arrangement and stay with the scheme, they need never own another fund until they retire. All the asset changes (and any others, such as those involving investment managers) all happen within the fund. The member can be kept informed, but doesn’t need to get bound up in the bureaucratic detail.
Are target date funds risky?
All investments are risky and a saver may not get back the money they invest in a target date fund. However, target date funds are designed to limit risks. The asset allocation glide path is set to automatically reduce risks as people get older, when they are less able to withstand losses on their savings. And, because a professional manager is involved in managing the funds, they can take much speedier evasive action if market conditions look like they will get worse. We would argue, therefore, that target date funds are less risky than alternatives, such as lifestyle funds, which are often used in DC pension schemes.
Will a saver in a target date fund have to pay extra for the service?
Charges are very competitive. Although there is an additional cost involved in providing professional oversight of the funds, it is also possible to negotiate lower fees for the underlying funds. The all-in cost, therefore, can be substantially less than charged by certain rival approaches, such as diversified growth funds.
How does the asset allocation work?
Known as the “glide path” of the fund, the planned asset changes are proactively managed through time in our target date funds. When savers are young, their fund will own a lot of shares. This is because they are likely to have only small savings and shares, whose value can rise substantially, can help them grow their savings fast. Of course, shares also carry higher risks, but younger savers can make up for any losses by saving during the many years they have ahead of them. People at the start of their saving career are likely to use a target date fund with a higher concentration in shares.
As people get older, they will not want to take so many risks as they generally have more to lose, since they usually have larger savings “pots”. Therefore the amount of “safety assets”, such as bonds, will increase in their target date fund. By the time they are within a few years of retirement, their fund’s mix will mostly be made up of safer assets, although there will still be some shares involved. This mix reflects the use most savers will want to make of their fund. Many, for instance, will want to take a tax-free cash sum from their savings, while the bonds will match quite closely the sort of assets that will be used to create an income for them in retirement. This might be done by purchasing an annuity, or by using another approach that keeps their money invested for a little while longer. They could then use their investments to pay themselves an income while they wait for a better time to buy an annuity.
Where else are target date funds used?
They are widely used in the US and they have been adopted by NEST (the National Employment Savings Trust), the UK-wide scheme set up with government backing to provide a fall-back option for employers that don’t have their own employee pension arrangements. Under the new “auto enrolment” rules, any worker who doesn’t have access to a suitable scheme will automatically start saving in NEST, unless they ask not to be involved. If they do end up in NEST, the “default” fund they go into will be a target date fund based on their age.