Pension investment strategy: Are Target Date Funds the future for UK DC scheme members?

There are now more active savers in UK DC pension schemes than in DB pension schemes, according to recent stats from the Pensions Policy Institute. It also estimate that in just 15 years there could be as many as 17 million members enrolled in DC workplace pension schemes*.

Based on current experience it is expected that typically around 80-90 per cent of these members will “end up” in default funds, which means for scheme managers and their advisers, ensuring that the investment default options available offer the most suitable investment option is really important.

In the UK the majority of assets in default funds are invested to support lifestyle strategies that are an investment option designed to lock in investment growth as members reach their chosen retirement age. While some providers offer specific “lifestyle” funds, others will have a lifestyle option that uses their mainstream funds to achieve the same process. In the US, Target Date Funds are one of the most popular options for DC pension savers. They are investments, often in a mutual fund or a collective trust fund, where the portfolio asset allocation mix becomes more conservative as the target date approaches. They offer a lifelong managed investment strategy, so should remain appropriate to an investor's risk profile, even if not reviewed. Age is often the most important determinant in setting an investment strategy, so Target Date, or age-based funds, are particularly attractive as default investment funds.

This article looks at the merits of Target Date Funds, compares them with the more common lifestyle strategy approach used in the UK and reviews whether the derisking that is required over time is appropriate.

Default investment solutions

Advocates of TDFs claim that a lifestyling investment strategy is a much more rigid approach to investment derisking. The reality is, however, that both deliver a means of reducing risk by moving from one asset mix to another over a period of time; both diversify the asset mix based on current market conditions and the term to a preset date, which is often the scheme retirement date, and both are suitable for members who are unwilling or unable to make investment decisions.

Active management

There is some debate about the level of active management required across the two approaches. There is a misconception that lifestyle strategies are static and not able to adjust to market movements. The reality is that while the investment charge cap has meant most of the underlying funds, or building blocks, tend to be passively managed to reduce costs, there are some lifestyling investment options available which are actively managed. Most strategies now benefit from an active asset allocation overlay, where the level of investment risk can be increased or reduced by exposure to various assets within a risk defined framework. So while the structure is different, both TDFs and lifestyle funds can benefit from active management.

Delivering outcomes

Delivering good member outcomes is a requirement for all schemes and the quality of the default fund is a key contributor to achieving this. Before the introduction of pension freedoms, the investment strategies for default funds were set to target annuity purchase but schemes are now offering more flexibility and alternatives are available which target ongoing investment or capital preservation.

It is impossible to know exactly what members will do at retirement and while it is likely many will leave their pensions savings invested, they will still be looking to preserve their fund from big losses, particularly at a time when they may have stopped making contributions. This means derisking is still a key requirement, albeit the end goal is not annuity purchase. Having clear investment objectives means that default funds can be designed to deliver to member expectations and are appropriate in terms of outcomes and risk profile. Being able to measure how defaults are delivering against the objective is much more important than how the fund is structured. Default does imply a common approach, however, there are wide variations in terms of objectives, target outcome and the level of risk taken which makes it difficult to draw industry comparisons.

Ongoing review

Whichever solution is chosen, the default fund needs to be reviewed regularly. The Pension Regulator is showing an increasing interest in the level of governance of default funds and the review process should include examples of the level of income in retirement a member could expect. This is helpful in identifying the differences in risk and return for various default funds and how the return may change over time.

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Royal London, like other providers, offers a range of risk-graded lifestyle default funds, with strategies targeting cash, annuity and drawdown. All are actively managed, benefit from monthly switching, are reviewed on a regular basis and are within the charge cap. So rather than debating whether Target Date Funds are better than lifestyle funds, the focus should really be on getting under the bonnetof the chosen default solution to understand all the investment components to establish whether the default fund will truly deliver the required mix of investment and risk to achieve the best income outcomes for members.

*The Future Book: unravelling workplace pensions, 2015 Edition