New realities spark substantial changes

Target date funds (TDFs) have seen more substantial changes in the past four years than in the past two decades since their introduction in the early 2000s. Significant market upheaval, impending regulatory changes, and new ideas about how and when to retire are making TDF managers take a closer look as to how these funds can benefit Canadian employees/investors on their path to and through retirement. 

“There’s a whole reset of the philosophy,” says Jillian Kennedy, partner, wealth with Mercer. She says target date managers are revisiting objectives and how they approach retirement readiness.

“There are a lot of philosophies that are starting to change as we see market changes. Glide paths are changing and now we have to look at how much risk is appropriate. Our money has to work harder, and, when plan members do start to derisk, what is the best way to derisk? We’re seeing people hold onto equities longer, and we’re seeing different approaches as to when the derisking would occur.”

The ‘to’ vs. ‘through’ retirement concept

Kennedy, who leads the strategy for DC savings and financials for Canada at Mercer, says a primary reason driving much of this change is the “to” versus “through” retirement concept. Some plan members will stop changing allocations once retirement is reached (to retirement glidepaths), while other continue to change allocations past the point of retirement (through retirement glidepaths).

“As little as five years ago, most organizations would add a TDF for the purpose of helping people save when they get to retirement. Now, we’re seeing a shift – and we’re waiting for regulatory guidance that will cement this shift – where managers have to think about this whole concept of transitioning into retirement.”

Typically, the glide path is the strategy that dictates asset allocation changes as investors move closer to retirement. Traditionally, these paths have become more conservative as the retirement date approaches. Kennedy suggests that glide paths should continue throughout retirement and not stop when someone is ready to turn their savings into retirement income.

People have become more accepting of risk in their portfolios, “and we think that may be what’s driving the change,” she says. “People have a lot more going on as they transition to retirement, so our first strategy is to help people to not worry about how they’re invested.”

Changes in asset classes

Another change in TDFs is the level of asset classes being used. “The overall asset classes are playing a more important part now. We are starting to see more tactical engagement with target date managers where they want to optimize risk and return.”

Tactical investing responds to market conditions. It looks at the present and the near future. A tactical investor attempts to shift the composition of a portfolio to manage risk exposure or to take advantage of new opportunities.

TDFs have typically invested in equities with investment in bonds to “give the right amount of risk and the right amount of time.”

Kennedy says the TDF market has also seen the introduction of alternatives and that now “the newest asset class on the block is the introduction of private equity.”  And, while the alternative asset class is a small component of the TDF portfolio, “you can see why an investment manager would need to have better diversification across different sources if they’re taking that equity risk and their risk premium goes up.

“Similarly, we historically used to cash in universe bonds to derisk, but that’s not going to give us the duration that we want to match up to the liability. Managers are getting smarter and starting to look at alternatives as a class like they would do in an asset mix study for a defined benefit pension plan. 

“They are getting really creative on the instruments they’re using to derisk, including things like emerging market debt or alternative sources of private debt that actually allows the diversification on the derisking side as well. They will have to manage their cash flow and rebalancing better because they still have liquidity to worry about.”

Kennedy says all these changes are happening together and, in some ways, go hand in hand and affect the glide path, because with private equity, investors want longer holding periods. She admits there are many more changes to come in this space, but, in the meantime, “we can rely on investment strategies and leverage tools that are already working in the retail markets. That might actually be where we need to focus our attention.”

Bringing ESG to TDFs

Another significant development is the increasing integration of environmental, social, and governance (ESG) factors into TDFs.

“We see the majority of target date managers now have some ESG integration. Roughly 80–90 percent of TDFs have integrated ESG somehow, but some are doing it differently than others. How ESG is implemented will tie back to what the organization’s ESG beliefs are and how they want to manage that risk. Everyone will be a little bit different, and this is causing us to see a lot of new product coming into the market. There are differing flavours of investment style (i.e., passive vs. active), and organizations are asking for a mix instead of having to choose between styles.”

When it comes to adding ESG products, Kennedy says managers have to care about how products are designed and look at it through a fiduciary lens. “You have to care about fees and past performance like financial outcomes. You also have to care about how those portfolios are being managed.”

As the TDF industry adapts to new realities, Kennedy’s insights suggest that both challenges and opportunities lie ahead. The ongoing adjustments in investment strategies, coupled with a proactive response to impending regulatory changes and an increased focus on ESG, are setting the stage for a new era in retirement planning – one that promises greater flexibility and responsiveness to the needs of tomorrow’s retirees.