Recent regulatory reforms have introduced a lot more freedom and transparency to savings and investment decisions.
The announcement of greater pension flexibility from April 2015 will enable individuals to take greater control of their finances, and choose from a wider range of retirement options. As a result, the demand for conventional investment vehicles such as annuities is declining, and more than 150,000 people have delayed pension income decisions. With UK interest rates hitting record lows, individuals are looking towards non-cash investment products to help them achieve their investment goals.
For those lacking the experience or confidence to manage their own investments, savers looking to invest £100,000 or less may seek out simpler, cheaper forms of investment advice or go down a self-directed route. Part of that solution might include ‘do it for me’ multi-asset funds that make investing easier. There is a lot of buzz around creating innovative solutions that are simple but engaging, offer good value for money, and create better customer outcomes. One type of multi-asset fund option is target date funds (TDFs), which are becoming increasingly popular in the workplace pensions space, and are also gaining renewed interest in the retail funds sector.
TDFs have already emerged as a popular ‘all in one’ investment solution in the US because they offer a whole savings journey inside a single fund. From a small portion of retirement savings a decade ago, today, over half of defined contribution plan participants are using TDFs to deliver their savings journey over time. As chart 1 shows, this has driven TDF assets under management from US$9bn (£5.7bn) in 2000 to US$621bn (£396.1bn) in 2013, according to ICI and Morningstar reports. TDFs are now essential to delivering savings outcomes in the US.
TDFs are the next generation of multi-asset funds that are designed to deliver an investment journey over time where the underlying mix of diversified assets shifts from a growth objective to an income objective on approaching the ‘target date’. The target date could be retirement, or any other goal at which withdrawals are expected to commence. In this respect, using TDFs to target different events fits neatly with cashflow planning tools. Importantly, money is not locked up, units can be sold at any time just as any other multi-asset fund, and if you change your target date, you just switch from one TDF to another.
Rather than focusing on ‘risk attitude’, TDFs focus on ‘risk capacity’, which increases with longer time horizons, and decreases when time horizons are shorter. This is simply a professionally managed version of a common sense approach: the closer you are to needing your money, the less volatile you want it to be.
Chart 2 illustrates how a TDF glidepath might look like based on the expected median and actual equity allocations (as at the end of June 2014) of the four IMA Mixed Asset sectors reaching IMA Mixed Asset (0-35 per cent equity) by the target date. The elegance of TDFs means that instead of having to pick and mix different allocations of different funds along your savings journey, you can use one fund to do it for you. This creates cost efficiencies as well as consistency.
In the US, there are different types of TDF: some are ‘static allocation’, in which the glidepath is fixed. This is a bit like a traditional lifestyling strategy, but delivered using a single fund. Others are ‘dynamic allocation’, where there is a strategic glidepath, but scope for tactical deviation around that glidepath for risk management purposes to enable the manager to adapt to changing market and economic conditions. This dynamic approach is a material improvement on the traditional lifestyle strategies, as it is more ‘future-proof’. The funds for each asset class inside a TDF can be active or passive, which naturally has an impact on price. As TDFs focus on asset allocation as the main driver of returns, some of the largest TDF providers in the US use an active allocation approach, but using mainly passive funds for exposure to the various underlying asset classes.
The fund technology of TDFs has interesting features which offers the promise of overcoming at least three investment decision barriers that non-advised investors face when investing in instruments other than cash deposits.
Firstly, given that capital is at risk in any investment instrument other than a cash deposit (which is instead subject to inflation risk), individuals are inclined to feel nervous about investing their retirement funds in non-cash instruments. When making a retirement decision, investors look for some certainty that they will have access to an adequate pension pot. Compared to other multi-asset funds, TDFs are purpose-built to manage a changing level of risk towards that outcome. By not rebalancing to a fixed risk level but de-risking gradually over time towards a stable value/income objective, TDFs are designed to mitigate the impact of less predictable market risks. The approach optimally balances anticipated needs for future withdrawals from the target date and the remaining time horizon available to achieve returns. This managed approach to capacity for loss improves the likelihood that investors will stay on track with their original investment objectives. If they change the target date of their goal, they can switch to a different TDF.
Secondly, when taking charge of their investment decisions, most individuals are unable to tell which of the thousands of funds, or combination of funds, is suitable for them. Often the primary criterion for picking a fund is a personal assessment of attitude to risk. Risk appetite is a complex phenomenon which depends not just on the psychological tendencies but also investment time horizon and need for returns as well as economic factors, such as affordability and the purpose of investing. The architecture of TDFs shifts the focus from fuzzy notions of psychological risk attitudes to the more tangible concept of risk capacity, driven primarily by time horizon. This is an important and much-needed simplification of investment decisions faced by individuals.
Finally, there is growing demand from advisers to have solutions in their toolkit that embed the ongoing asset allocation decisions at a reasonable price to their clients. TDFs offer the potential to reduce overall cost to consumers by amalgamating fund management for individuals with similar investment time horizons. The efficiency and convenience of professionally managed funds with inbuilt consideration of risk capacity and time horizon in the asset allocation mix fits neatly with cashflow and holistic financial planning tools that allow advisers to help their clients in achieving better outcomes. In this way, TDFs appear to have the ingredients of a ‘cheap and cheerful’ investment service recently highlighted by pensions minister Steve Webb.
The application of TDFs goes beyond retirement savings solutions. They can serve as a managed investment solution by becoming an age-based ‘fund for life’ (target date set to retirement age), or wherever a time horizon is a key consideration: savings for future life events such as a first home, children’s education costs, or holidays. In short, TDFs can be used to plan for any major future expenditure an individual may undertake. They help deliver an intuitive, goal-based approach to investing.
Key Points
Individuals are looking towards non-cash investment products to help them achieve their investment goals
Target date funds are the next generation of multi-asset funds designed to deliver an investment journey over time
When taking charge of their investment decisions, most individuals are unable to tell which of the thousands of funds is suitable for them
Shweta Agarwal is head of behavioural insights for The BirthStar® Project, set up in 2012 by Elston Consulting
