TDFs are extremely good for environmental, social and governance considerations in retirement planning as unless one has a lot of time and determination, constructing a balanced and evolving ESG retirement portfolio is an almost impossible challenge for both an adviser and an individual. 

The problem is compounded by the fact that ESG investment extends beyond the investment itself and applies to all participants in the process. For example, an investor may not want to purchase an ESG-compliant investment from a business that does not use similar ESG policies.

While there is increasing information on funds and an almost daily launch of a new ESG option, the reality is that trying to construct a glide path to retirement that includes retail investments that are ESG is almost impossible.

For this reason, ESG within retirement planning is arguably best served by the use of TDFs. And, for much of the insight, we need to look to the USA where they have been commonly used for almost 30 years.

TDF history

TDFs are not as new as people might have you believe. They date back to 1994 when Barclays Global Investors and Wells Fargo launched them to address 401k issues in the US. 

These issues remain today and fundamentally revolve around the fact that planning for retirement requires a strategy that includes using assets with different risk and rewards over the pre-retirement investment journey. It is also worth noting that similar issues exist in decumulation investment strategies, but this CPD only looks at TDFs and accumulation to retirement.

DIY retirement planning the problem

TDFs solve a problem that largely did not exist in the UK until relatively recently. Ignoring ESG for the moment, those who were lucky enough to be in a defined benefit or defined contribution workplace auto-enrolment scheme, often using a master trust structure, had their retirement planning managed for them.  

The relatively small number of people with personal pensions was fairly well catered for with their current provider or one of the DIY investment platforms, albeit they needed to manage their own glide path to retirement. It should be noted that in the US a good proportion of this DIY market adopted a TDF solution when it became available. 

However, the 5m self-employed workers in the UK (up from 3.2m in 2000) have largely been ignored. This problem is compounded by the fact that we have a burgeoning gig economy, where almost 4.5m people regularly find work through online platforms in England and Wales. I should stress that there is a huge overlap as 48 per cent of gig workers also have a full-time job.

TDF structure

TDFs’ core principle is often called a glide path to retirement. Quite simply, it is based on an investment manager ensuring an appropriate asset allocation given someone’s time to retirement. Within this, it is the need to ensure the balance changes over time. 

Having a professionally managed approach based on personalised parameters is plainly much better than the individual investor trying to do this themselves, unless we are talking about a very high-net-worth investor with adviser support.

Personal yet part of a cohort

Ignoring high-net-worth individuals, who often have significantly different risk budgets and profiles, most of us need support with our retirement investment planning.

Such support on an individual level would be prohibitively expensive, but when a cohort of people with the same objective, such as age 45 now and wanting to retire at age 67, are combined, then the problem becomes easier to manage. This is the basis on which almost all TDFs operate.

A personalised, yet collective approach also has other benefits, including:

• Providing an uplift for people with inadequate savings.  

Many people will be sufficiently far away from retirement age that they should be investing in assets that have a higher risk and reward ratio. Unfortunately, if you have inadequate savings the automatic approach is to invest in less risky investments, accepting the fact that it will most likely produce a likely poorer return. However, by pooling assets such an approach can be ameliorated over multiple participants, hence on aggregate a higher return is produced. The creation of a larger pension pot also helps reduce some of the longevity risks that an individual might face.

• Asset allocation. 

The recent 2020 study in the US by Mitchell and Utkus of 401k-focussed TDFs found that people using low-cost TDFs as the default fund option improved their asset allocation in several important ways. They increased their allocation to equities and bonds and decreased the allocation to company stock and cash. 

TDFs a popular investment among the young

Of particular importance if we are looking to close the retirement savings gap and help support the self-employed, gig workers and auto-enrolment workers is offering products that they understand and are easy to manage.

A March 2021 study by the US Investment Company Institute and the Employee Benefit Research Institute found that 62 per cent of 401k participants in their 20s held TDFs, compared with half of 401k participants in their 60s. On average, 401k participants in their 20s held about half of their 401k plan account assets in TDFs, compared with about 23 per cent for 401k participants in their 60s.

TDFs are also used at a higher rate among recently hired plan participants. Among those with two or fewer years of tenure, 57 per cent held TDFs, compared with 54 per cent of participants with five to 10 years of tenure, and 36 per cent of participants with more than 30 years of tenure. 

Charges

As you would expect, charges vary depending on the provider and the assets that they use within their TDF. As TDFs are a type of fund of funds, their structure makes them more expensive than other funds, but this must be viewed against their structural advantages in providing greater reward with lower risk. At the same time, TDFs benefit from better fees agreed by the asset manager; there are economies of scale with TDFs that might make it even more cost-effective than a DIY option.

Performance

Given the relative newness of TDFs in the UK, a performance analysis could be misleading. Once again it is best to look at the US as a benchmark, especially as TDFs were subject to considerable scrutiny after the recession of 2008-09, including a congressional hearing and a report from the General Accountability Office. The issue of more than a decade ago was that both long and near-term TDFs suffered large losses.

However, there has been a marked improvement since then, as shown by performance during the recent 2020 stock market crash. Between February 19 and March 23, the US stock market fell by about one-third and, while most of the long glide path funds did not do significantly better or worse than a pure equity fund losing between 30 and 35 per cent of their value, the short glide path funds, such as those with 2025 maturity, lost just between 20 and 25 percent of their value over the five weeks. 

What is probably more significant is that funds that reached the end of their glide path in 2020 ended the year up 10.8 per cent on average, according to data from Morningstar.

ESG and TDFs

Unless one has a lot of time and determination, constructing a balanced ESG retirement portfolio is a challenge. While there is increasing information on funds, this alone is not a full representation of ESG as most investors also want to know that the investment provider follows the same ESG policies as the assets that they select for their funds. 

Products and providers will be assessed going forward

Another issue is that, at the moment, it is clear that not all ESG financial products are being launched by providers with the most robust ESG policies.  

Recent research from GaiaLens showed that of the four most prominent ESG investing companies, one had four of its listed businesses in the third quartile of the sector and the other two were in the second quartile. In comparison, its three major competitors all had two or more listed entities in the first quarter.

Currently this disconnect is not a major issue as investors are primarily interested in the makeup of the ESG investments that the asset managers offer. But as greater regulatory scrutiny is likely, it would be hard for a pension fund or its trustees to justify sourcing compliant products from a manager that did not adopt similar policies.

In conclusion, TDFs are not only an ever-increasing part of modern worker retirement investments, but will certainly play a huge role in the shaping the future of retirement planning and investing. 

Eduardo Chazan is chief executive and co-founder of Collegia Pension