TDFs evolve and grow

Target date funds (TDFs) are an important component of capital accumulation plans (CAPs) for employees who lack investment expertise. As TDFs become more dominant in the market, they continue to evolve and grow, offering the opportunity for better outcomes for plan members.

Jafer Naqvi, vice president and director, lead of institutional asset allocation team at TD Asset Management, says there is a continued shift from defined benefit (DB) plans to defined contribution (DC) plans. As employers move away from guaranteed pension plans, the onus of retirement savings increasingly falls on employees. Most employees do not have investment expertise, so this necessitates simplified investment solutions, such as TDFs, which automatically adjust the investment mix over time based on the employee’s age and proximity to retirement.

TDFs were introduced into the Canadian market in the early 2000s. TDFs are structured to maximize the investor’s returns by a specific date. Generally, funds are designed to build gains in the early years by focusing on riskier growth stocks; then they aim to retain those gains by weighting toward safer, more conservative choices as the target date approaches.

No more guarantees

“TDFs are important because of what’s going on in Canada and around the world,” says Naqvi. “We’re seeing less DB plans where the pension is guaranteed by the employer and more DC plans where an employer provides a plan where it offers a matching contribution up to a certain amount without any guarantees.

“That money goes into an investment pool and grows as the employee’s retirement nest egg.” However, Naqvi says, “whatever that pool of money amounts to when the employee retires, that’s their retirement income.”

Unfortunately, data shows individuals need help with retirement savings. “If you give them a bunch of investment options, most people aren’t investment experts to the point where they can create an optimal retirement savings portfolio for themselves.

“TDFs aim to simplify the retirement saving for members down to one easy question: [at] what age do you expect to retire? From the answer, TDFs will create an investment portfolio over time that adapts to their savings horizon.”

In simple terms, when investors are young, they have a longer time horizon, and they will potentially have a lot of contributions over that time. They can afford to take more risk, and then, as they approach retirement, they’ve built up their nest egg. As the fund grows over time and the investor moves closer to retirement age, the TDF allocation settings will change along a glide path to a more conservative mix.

“TDFs try to reduce the risk of the portfolio so that the capital is preserved to some degree,” says Navqi. “Studies show that plan members invested in TDFs tend to end up with better outcomes than those who are left to their own devices to try and navigate the ups and downs of the stock market.”

He adds that TDFs also benefit the employer. “One of the challenges with DC plans is getting members engaged in making their investment selections. So, if members aren’t engaged, the plan sponsor can default them into an appropriate TDF based on their age. TDFs have improved outcomes and make life simpler. For these reasons, they are getting a lot of traction, and now they tend to be large portions of DC programs.”

A broader range of investment options

Naqvi says TDFs have evolved over time to include a broader range of investment options. For example, along with stocks and bonds, many now include alternative investments (e.g., infrastructure, private real estate). These alternatives provide inflation protection and potential for higher returns.

“Traditionally, TDFs have been in the realm of investing in stocks and bonds. Stocks are the riskier investments but can provide more returns. Bonds are what stabilize the portfolio and derisk it over time.

“If we look at DB plans, for quite some time the largest institutional investors with DB plans have opened their degrees of freedom beyond just stocks and bonds to include alternative investments. Particularly in Canada, private real assets have played a big role in DB plans.

“Alternative investments, such as infrastructure, private infrastructure, private real estate, and different private credit strategies, give investors many characteristics that are a great complement to their asset mix and can enhance the portfolio when included alongside stocks and bonds.”

Alternative investments can offer inflation protection, which has been particularly demonstrated over the last few years.

“Portfolios that didn’t have good inflation protection really struggled,” says Navqi. “In 2022, stocks and bonds both decreased by more than 10 percent. They didn’t have that traditional diversification where if one goes up, the other goes down and smooths the ride out. In 2022, everything went up and down at the same time, which can be quite difficult for investors, as we saw.”

Alternative investments are a good option because of their inflation hedging characteristics. They did quite well in 2022 by providing additional diversification to stocks and bonds.

A way to incorporate alternative investments

DC plan sponsors were looking for a way to integrate alternative investments into their plans, and TDFs provide a good way to do this.

“For DC plan members, complexity is not a good thing. TDFs are simple for the member because they offer professional money management that can integrate some of these more complex levers. TDFs have managers who provide proper due diligence and who can transmit the value, navigate the liquidity, navigate some of the operational complexities with coming in and out of these strategies, and can integrate them into a holistic TDF alongside the stocks and bonds. DC plans can integrate alternative investments with TDFs that have integrated them.

“These investments have shown an ability to deliver attractive returns often above the average TDF. But, just as important, they are able to do that with a lot less risk while smoothing out the ride.”

Simplifying investment choices reduces the psychological burden on plan members who might otherwise be overwhelmed by the complexities of investment decision-making. As TDFs evolve, they offer smoother investment returns over time, contributing to better long-term financial outcomes.