Which pension schemes do target date funds suit?

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• Like lifestyle funds, target date funds de-risk as the member nears retirement by switching into cash and bonds.
• Their structure allows the pool of investments to be tactically managed.
• However target date funds have few providers in the UK, no performance track record and an assumption that members aim to buy an annuity.
• Nest is using target date funds but its huge scale will allow it to reap additional benefits from the structure, such as reduced transaction costs.

Target date funds may be an ideal default option for Nest, but do they suit other pension schemes? Ceri Jones reports

The national employment savings trust’s (Nest) use of target date funds as the default option for the UK’s new pension scheme has thrown such arrangements into the spotlight.

Like lifestyle funds, these are heavily invested in growth assets when the member is young and progressively switch to safer assets, such as cash and bonds, as retirement age approaches. The common aim is that individuals are not penalised if they happen to retire when the financial markets are poor.

However, the focus of target date funds is squarely on the retirement year selected. The member’s assets, which are pooled with everyone else retiring at that date, can be invested tactically in line with current thinking about the economic cycle. By contrast, the switching in a lifestyle fund generally happens automatically using a fixed formula, and as switching occurs, it is the individual’s fund that sells units in one asset class and buys units in another.

Brian Henderson, head of defined contribution (DC) in Mercer’s consulting business, says: “Target date funds are like lifestyle with whistles. In lifestyle, if you want to change the asset base, the assets must be bought and sold at a member level. In target date funds, this is done at a fund level, and there is potential for adding value in the investment of assets. They will not be actively managed so much as adjusted to take advantage of investment views on a threeto five-year horizon. In a traditional lifestyle arrangement, to manage the funds more tactically, a governance committee is required.”

However, UK fund managers have no track record in adding value in the investment of target date funds. Mark Jaffray, senior investment consultant at Hymans Robertson, says: “Although asset allocation in target date funds can be moved around, it is not clear if anyone has managed to add value by doing so. It makes sense theoretically, but there is evidence that fund managers are not that brilliant at timing the market.”

Trustees will also be wary that there are only two providers of target date funds in the UK BlackRock and Alliance Bernstein although others plan to enter the market.

Nest default choice

Nest is using target date funds for its default choice and is constructing 46 funds to match every possible year of retirement, but it can only do this because of its huge scale. No UK scheme will be big enough to do so and would have to use five-year groupings, which may be less effective. Gail Philippart, principal consultant at Aon Hewitt, says: “Lifestyling with some exposure to diversified growth funds can achieve the same thing.”

Some advisers will consider target date funds for new pension plans, but say that where a scheme already has lifestyle funds, a revamp is not necessary.

So, target date funds are well suited to Nest’s potential membership but are not a good fit for the better-off parts of a workforce who might choose income drawdown. Like lifestyle, target date funds de-risk because they assume the objective is to buy an annuity at retirement. Nest has a cap on contributions and will be populated by the less well-off, for whom an annuity will remain the best course of action.

Read more on target date funds for pension schemes