How they work
TDFs are divided into vintages or ‘buckets’, essentially denoting the retirement date to be targeted by the investment manager and are often split into buckets between two and five years long. For example, a fund manager might offer a TDF dated 2050.
But what does it mean to target a specific retirement date when investing?
Generally, when members are further from retirement they can afford to take on more risk, since they have longer time horizons, in exchange for capital growth. This is called the ‘growth phase’. Similarly, when members are approaching retirement they often can’t afford to take on too much risk in case of a downturn in the market when they are trying to cash out. This is the phase in which a member would normally de-risk their portfolio, switching from volatile to historically more stable assets.
TDF managers generally take the same approach. How the asset allocation changes over time towards retirement can be visualized in a ‘glidepath’, like the example below. The glidepath will show a heavy tilt towards riskier assets such as equities and high-yield credit 20+ years from retirement. These allocations would gradually be decreased by the TDF manager as members approach retirement. At retirement, the TDF would favour less risky assets like investment-grade corporate and government debt (gilts).
Different TDF managers may have slightly contrasting processes and asset selections. Therefore, it is important that trustees undertake the necessary due diligence when selecting a TDF manager to ensure they are comfortable with the approach taken.
Growing in popularity
Since auto-enrolment began in the UK in 2012, defined contribution schemes have quickly overtaken traditional defined benefit (DB). According to the IFS, half of all employees were contributing to a DC scheme in 2021, with only one in ten private sector employees contributing to a DB scheme.
In the US, the 401k defined contribution plan is the most common form of retirement saving. A great proportion of these are invested in TDFs, likely due to their convenience and relatively low costs. Over recent years TDFs have begun to attract more attention in the UK too.
Potential benefits and drawbacks
TDFs offer a range of benefits for trustees and members. The convenience of selecting one fund and having a professional actively manage the strategic asset allocation throughout a member’s career up to retirement is certainly a huge advantage. The typically low cost, with some expenses as low as 0.18% per annum, is another. Additionally, there is a significant reduction in administration requirements relative to ‘lifestyling’ since switches between investments are done within the fund.
However, trustees have less control relative to constructing a lifestyle strategy themselves. Decisions like deciding when to de-risk and which asset classes to use are delegated to the investment manager, which may not align with trustees’ views. Another concern might be that, although TDFs are diversified in assets, members’ investments will be concentrated with one investment manager and therefore reliant on the skill of the manager to some extent. Also, the TDF that a member is placed into may not align perfectly with their target retirement date, for example.
Conclusion
Overall, it is easy to understand why TDFs have grown in popularity, particularly as a result of the simplicity, ease of understanding, lower administration requirements and relatively low costs.
When considering TDFs as an investment option, trustees will need to carefully consider their investment objectives, the membership profile of the scheme, preferred/expected retirement choice of members and other manager specific factors such as the level of ESG integration, past performance and the approach each TDF manager takes.
Conor Pinnington – Investment Analyst at Quantum Advisory
