Your IndustryJul 1 2015

Under the hood of target date funds

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The target date is when they expect to begin making withdrawals for a future goal – most commonly to quit work and enter retirement.

Mark Fawcett, chief investment officer at the National Employment Savings Trust, says each of the nearly 50 single-year target date funds his organisation handles has an asset allocation that is consistent with the expected amount of risk that is appropriate for that stage in a scheme member’s savings career.

The make up of the fund – and therefore the amount of risk taken by managers - reflects when the member expects to take their retirement benefits.

At Nest, Mr Fawcett says scheme members can change their fund at any time to reflect a different expected retirement year.

The glide path for the Nest retirement date funds – the allocation between return-seeking and income-seeking assets through time – is split into three phases; the foundation phase, the growth phase and the consolidation phase.

The foundation phase refers to the early years of younger scheme members’ working lives as they develop the savings habit. This phase typically lasts five years, according to Mr Fawcett. The objective for the foundation phase is to keep pace with the consumer price index (CPI) after all charges.

The growth phase is where the maximum growth in assets is being targeted through asset classes that are expected to grow in value relative to inflation more than other investments.

The objective for this phase at Nest is to outperform CPI plus 3 per cent a year after all charges over the long term.

The consolidation phase prepares a scheme member’s assets for retirement and at Nest typically begins 10 years before their Nest retirement date fund matures. Investments in this phase are progressively switched out of higher risk assets.

For Nest retirement date funds maturing through 2020, Mr Fawcett says the consolidation phase objective is to manage the risks associated with converting a member’s accumulated savings into a cash lump sum.

Mr Fawcett says the great benefit of this approach is how easy it is for pension scheme members to understand – and therefore engage with.

He says: “So if a member is due to retire in 25 years time, they’ll be saving in a 2040 target date fund.

“This illustrates one of the easiest-to-understand benefits of target date funds: they lend themselves to straightforward communication with members on what is happening with their money.

“For the member, being in the ‘2040 target date fund’, is a subtle but unambiguous way of nudging their imagination to more distant horizons than that of any short-term movements of their pot. We believe this is helpful for pension savers.”

In terms of the benefits for schemes, Mr Fawcett says target date fund providers are able to make judgments on how to manage money appropriately over the whole of an individual’s time saving.

Because target date fund managers can make judgments on what action will best keep the saver on track, Mr Fawcett says this can mean more thoughtful movement between assets.

This can also mean lower transaction costs, which in turn means savers should be able to keep more of their pots, he adds.

The fact that re-balancing the asset mix doesn’t happen automatically - on say the same day every month – means a target date fund manager can use cash in-flows from the target date funds further from maturity to buy the risky assets from the near-maturity target date funds, he adds.

This means the members’ pots can avoid being hit with the costs of, say, selling shares in a downward spiralling market.