Target date funds: investing for retirement
For all the complexities of the pensions industry, effective retirement planning really boils down to a single question: what is the best way to hit your target?
Enter target date funds, which aim to answer exactly that question. These funds automate the process at the heart of most pension planning strategies: when you're younger they invest in assets such as equities with a higher risk and return potential so as to maximise capital growth; as you move closer to your planned retirement date, they gradually move your money into less risky assets, such as bonds and property, to ensure your capital is at increasingly less risk of a collapse, from which there will be no time to recover.
This is effectively a packaged version of the de-risking process you might otherwise implement for yourself when planning for old age or with the help of an independent financial adviser (IFA).
Different target date funds mature on different target dates in the future – so if you're hoping to retire in, say, 2030, you would pick a 2030 target date fund; if your aim is to retire 10 years after that, you would go for the 2040 target date fund option.
In the US, target date funds are huge. Of the millions of US savers with 401(k) pension plans – the American equivalent of a private pension with no guaranteed payout – more than one in two now hold their savings in some form of target date fund, according to research from Vanguard, the retail fund management giant.
By contrast, target date funds haven't yet captured significant market share in the UK – and only a handful of providers offers them. But supporters of the concept say there are several reasons why target date funds have a big future.
One of these supporters is Henry Cobbe, managing director at financial services consultancy BirthStar, which has been working with fund managers Architas and Alliance Bernstein to offer a suite of target date products.
Cobbe believes the potential target market for these funds is enormous. "This is a simple and low-cost way to have your money professionally invested without you having to pay for independent financial advice," he says.
What you need to consider
BirthStar's argument is that a combination of several factors will persuade more savers to consider target date funds.
Not least, the auto-enrolment reforms, which require every employer in the country to offer workplace pensions to their staff – and to sign all workers up for the schemes unless they opt out – is dramatically increasing the number of people with pension savings. At a stroke, auto-enrolment adds as many as 9 million to the number of savers wondering about how to invest a pension fund.
Also, the retail distribution review (RDR) reforms of two years ago have polarised the independent financial advice sector. Whatever you think about the fact that advice must now be paid for upfront, rather than through ongoing commission charges, RDR has meant that fewer people are now able and willing to access IFAs; everyone else has to make their own decisions or find products and services that effectively make decisions for them.
In addition, the pension freedom changes that came into force in April are likely to mean many more people will choose not to buy an annuity when they reach retirement age. Instead, they'll need new investment products and services that enable them to draw an income from their savings while preserving their capital, potentially over three decades or more.
Target date funds meet all three imperatives, supporters claim. They could give members of work-based pension schemes, as well as individual savers, a default investment option that ensures their money is invested with the same regard to time horizons that an IFA would advocate.
Over time, they offer exposure to a diversified range of assets including domestic and international stockmarkets, bonds and property, as well as more exotic options in some cases, with the proportion of the fund allocated to each of these assets set appropriately on the basis of investors' ages and when they're due to retire.
Why are they not popular in the UK?
So why has the concept not gained more traction in the UK? One problem, suggests Patrick Connolly, a certified financial planner at independent financial adviser Chase de Vere, is that with relatively few providers spreading the message, many people have not yet understood how they differ from conventional 'lifestyle' fund options, which have been available for many years in the UK.
"Target date funds allow people to select a retirement target date which is specific to their own requirements rather than the one-size-fits-all approach of lifestyle funds," he explains.
A more fundamental problem, Connolly adds, is that a target date fund requires an act of commitment that a sizeable proportion of people don't feel able to make. "Many people won't know exactly when they will retire and how they will take pension benefits, so it is difficult to select the right fund for them," he warns.
However, BirthStar's Henry Cobbe argues that some criticisms of target date funds are based on a misunderstanding of how the products work. "There is a common misconception that target date funds just stop at the target date," he says. "In the US, it is understood that these are funds for life and that the target date is simply a turning point when you move from a strategy of accumulation to one of drawing down your assets."
In fact, Cobbe argues this is an area where target date funds can play a crucial role. As more people ponder the tensions of managing pension assets in retirement so as to produce an income without depleting their savings too quickly, target date funds can provide a strategic response to this challenge that will help people unwilling or unable to pay for financial advice to avoid the pitfalls of a DIY approach.
That's fine, says Connolly, as long as investors are in target date vehicles with the right asset allocation models. "If you will remain invested after you retire, potentially for decades, it makes little sense to move too much money into lower-risk assets such as cash and fixed interest because longer-term investment growth will still be required," he warns.
This is why, for example, BlackRock, another provider of target date funds in the UK, relaunched its range earlier his year. It now offers three different versions of its funds, aimed respectively at savers planning to buy an annuity on retirement, those planning to take their pension pots as a cash lump sum, and those planning to draw an income directly from their savings. Each fund moves towards different types of asset as savers get older.
One area where Cobbe does concede target date funds face a potential difficulty is on performance analysis. Since each vehicle is a bespoke creation for the investors within it – with an asset allocation designed for those set to retire on a certain date – comparing the performance of one target date fund to another (let alone to a conventional fund) is problematic. Only comparisons with funds targeting the same date make any sense.
This means it is difficult for investors to hold their fund managers to account. With only a tiny universe of funds to compare, investors have little idea about whether the returns generated are good, bad or indifferent.
Still, such criticisms are by no means an issue only for target date funds. Many other multi-asset funds suffer from a similar problem – particularly those designed to achieve a particular outcome. As fund managers and other investment providers innovate in order to respond to meet to the changing landscape for financial planning, this is likely to become more of an issue and the Investment Association has already begun a consultation to make meaningful performance comparison data available to investors.
That will be important if target date funds grow in popularity. And despite adviser scepticism, there is good reason to think they may. While Architas, BlackRock and Fidelity have been blazing a trail, another significant player in the market is Nest, the pension scheme through which thousands of employers are complying with the auto-enrolment service. Its default investment option for new members is a target date fund strategy, which should mean thousands of savers become accustomed to the idea – and boost awareness of these products.
At Wingate Financial Planning, Cunningham's view is that more people should take independent financial advice on an ongoing basis and that "the idea of fixing an investment, never reviewing it and expecting 'auto-pilot' de-risking is somewhat flawed".
He may have a point but for those without the means to secure good-quality advice, target date funds at least offer a professionally managed approach to saving for retirement that is based on well-established financial planning principles. And that is likely to appeal to many people.
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