WIXLIB

DESIGNSOPHISTICATIONFOR THE MASSMARKETHow target date funds are gaining traction asa better way to deliver good retirement outcomes.By Sahil Sethi,DC Strategist,State Street Global AdvisorsThere have been seismic changes in the UK’sdefined contribution market over the last fiveyears. The introduction of auto-enrolmentforced companies to review their sometimesneglected DC schemes. A raft of policy decisions has furthershaken up the market, especially the government’s decisionto relax the requirement to buy an annuity at retirement.These changes have radically re-shaped the market.Companies, trustees, consultants and insurance companieshave had to re-think their investment strategies. Theincrease in the number of master trusts has introduceda host of new players to the workplace pension market.Previously held assumptions about the best way to design aDC scheme are being challenged. Target date funds (TDFs)are gaining traction as a better way to deliver pensions than‘lifestyle’ products. Consulting actuary Harry Taylor says:“Target date funds can bring institutional sophistication tothe mass market at low-cost and with good governance.”18State Street Global Advisors DC StrategyThe Anatomy: TDFs vs LifestyleTo explain the difference between the two, let’s take a closerlook at how a DC pension is built. During the course of anemployee’s working life, salary contributions are put into adefault investment strategy. As the employee approachesretirement money is switched out of riskier assets, such asequities, and into more secure assets, like bonds. This helpsto protect the value of the pot from any falls in the valueof financial markets.This switching is traditionally carried out by a lifestyleprocess. A proportion of each individual scheme member’spot is switched between different funds in a mechanisticmanner. But target date funds can do this in a moreefficient manner.In the run up to retirement, a TDF can take advantageof market movements as a manager is overseeing thesechanges rather than just switching a set ratio of assets.Robert Holford, partner at Spence Johnson, says: “Thisallows TDFs to get the best deal for the scheme member.”

A Challenging Growth MarketDespite the fact that TDFs dominate the US pensionsmarket, uptake in the UK market has been relativelyslow. The structure of the UK market has made itparticularly difficult for providers of TDFs to gaintraction. Most schemes rely on the advice ofemployee benefit consultants.Holford says: “There has been significant consultantopposition to the product as it’s a competitor to theirlifestyle model.” This resistance, however, appearsto be waning. Holford says: “Aon Hewitt, for example,has adopted TDFs for their delegated DC offering.”Perhaps the biggest impetus for the growth for TDFswill come from the rise of master trusts, particularlythe National Employment Savings Trust (NEST)Corporation. Taylor says: “The scale of NEST meansthe TDF structure is becoming mainstream andmembers will expect a similar approach and advantagesfrom other pension schemes if they change jobs.”Low Costs and FlexibilityFor the MassesNEST was established to ensure small companies and lowincome savers would have access to a low-cost, transparentsavings scheme when auto-enrolment was introduced in2012. Building a DC scheme from scratch enabled NESTto select the most efficient tools available. Mark Fawcett,chief investment officer of NEST Corporation, says:“A target date fund is the best vehicle for us to providepensions for millions of members.”The TDF structure considerably reduces the administrativeburden. Fawcett says: “It’s much more effective to changethe asset allocation of a cohort of members rather thanindividuals.” The structure also reduces the likelihood ofmaking an error and the expense of fixing the mistake.A TDF structure, where the glide path is managed fromwithin the fund, also tends to be easier and less disruptive toadapt than administratively-led lifestyle fund approaches.This adaptability is crucial when we consider the needto adjust asset allocation according to evolving memberneeds, or when regulatory changes like freedom and choicenecessitate refining the glide path.04“But perhaps the biggest impetus fortarget date funds will come from thegrowth of master trusts, particularlythe NEST Corporation.”TDFs also make member communications muchmore straightforward. Each member is included ina fund which targets a retirement date. For smallerschemes each cohort might target a five-year window– for example, 2060 to 2065. But for a scheme as largeas NEST it’s a specific year. Fawcett says: “The purposeof each fund is clear from its name. It is easy for us tosay: ‘We are managing your pension as you approachretirement and these are our targets.’”In contrast, a lifestyle member will simply receive anannual statement showing their funds have been switchedbut with no understanding of why the changes havebeen made.Forming retirement age cohorts also makes it much easierfor members to change their target retirement date. Taylorsays: “Members can select to move from one cohort toanother if they decide to work for longer.”TOP 5 ADVANTAGES OF TARGET DATE FLEXIBILITYCOSTFund managerguides strategicasset allocationand riskreductionStructure allowsasset allocation andfund selection to bechanged with nooperational impacton membersMember communicationsare more straightforward– funds target a specificretirement date and thepurpose of each fund isclear from its nameDifferent assetallocations are setfor different agegroups, with theability to changeallocations asmembers matureTransaction costskept to a minimumContribute Design Sophistication for the Mass Market19

But the key benefit of a TDF is its flexibility. Fawcettsays: “It allows us to have different asset allocations fordifferent age cohorts and to change those allocations as themembers mature.”It also allows NEST to change asset allocations for otherreasons, such as risk management, changing the strategicasset allocation or adding a new asset to the portfolio.“It’s very cost effective as it keeps transaction costs toa minimum,” says Fawcett.Holford agrees: “These government changes could providefurther impetus for target date funds as they underline howmuch easier it is to radically re-haul the investment strategyin this structure.”NEST is able to invest in a wide range of assets becauseof the target date fund structure. In particular, it can investin illiquid assets, such as property. Fawcett says: “Thisstructure enables us to establish an internal market forthese assets.”Members close to retirement sell their stake in the propertyfund to those still in the growth phase. “We avoid the needto sell these assets in the market which would be muchless efficient and more expensive,” adds Fawcett.Flexible Fund Structure ForVarying Retirement NeedsMore fundamental changes to investment approach arealso made much easier. When the government decided toabolish the requirement for pensioners to buy an annuityon retirement, the DC industry needed to re-think itsinvestment strategy for the latter stages of the defaultfund. Before this change, it made sense to switch members’portfolios entirely across to fixed income assets as thesewould provide a good match to annuity pricing. But thatstrategy is no longer valid.SMALLBEGINNINGS According to Spence Johnson, lifestyle continuesto be the dominant approach in the UK institutionalmarket – those trustee and contract-basedschemes with more than 1,000 members. Lifestyleproducts in the UK have assets of 76 billion,equivalent to 84% of the total. In contrast, TDFshave assets of 1.9 billion.This contrasts with the US, an early adopter ofTDFs, where growth has been more vigorous. Theproportion of US plans offering TDFs grew from29.1% in 2006 to 69.6% in 2012 .Data from Cerulli alsoprojects that by 2020 US target date fund assets arelikely to be more than double their level of 2014, withover 70% of contributions expected to be directedtowards Total Institutional DC Assets.20State Street Global Advisors DC StrategyChanging the investment strategy of a lifestyle fund can becomplicated and time consuming – an investment consultantor provider needs to come up with a new strategy, get thetrustee board or governance committee to agree to thestrategy and then implement it. Fawcett says: “Oncewe had determined that our at-retirement strategy shouldtarget inflation rather than annuity pricing, we couldeasily implement it without having to go back to thedrawing board.”The Future is Unpredictable,Adaptable Products Are VitalNot only is it easier to overhaul a TDF investment strategybut it’s also a much easier vehicle in which to provide anat-retirement fund. Fawcett says: “The TDF allows a fairlyseamless transition into an at-retirement product. For thisto happen, however, the fund would have to have a new targetas it would no longer be retirement.” An alternative targetcould be an annuity at the age of 85, which is when schememembers need the longevity protection only an insuranceproduct can provide, he adds.Taylor adds: “The inherent flexibility of the TDF structureallows the manager to set up the investment objectiveaccording to customer needs and time horizons.”Much of current research indicates members wantflexibility because they have little idea of their futureUK InstitutionalDC Schemes*Total undsTarget DateDefaultFunds 91 bn 81 bn 76 bnUS DC SchemesOffering TDFs69.6 %29.1 % 1.9 bnSource: Spence Johnson,January 2016*Master Trusts & DC Schemeswith more than 1000 members2006Source: Brightscope,December 20142012