Why TDFs are a different way of preparing for retirement

The funds are run on a multi-asset basis, moving between different asset classes as the member gets older, starting off in higher risk equities and moving towards a more risk averse asset class, such as bonds, as the member approaches retirement.

The National Employment Savings Trust, which uses Target Date Funds (TDFs), describes the three different phases of investment that its funds will go through, throughout the period of investment: a foundation phase - the first five years to get the member in the habit of saving; a growth phase when the fund invests in growth-seeking stocks over 30 years; and finally the last 10 years, which it calls a 'consolidation' phase, when the fund is invested in more risk-averse stocks.

The proponents of TDFs say they have numerous advantages over lifestyling because they have the flexibility of a conventional multi-asset fund, which means the manager can move in and out of different asset classes whenever the occasion suits.

This can be as much to respond to changes to market conditions, as it can for the member approaching retirement.

It’s a much more flexible way of running a strategy than lifestyling, which you can’t change as easily.Henry Cobbe

Henry Cobbe, a director of Elston Consulting, says the defining characteristic of these funds was the retirement age or end point at which the member wants to cash in the fund.

He explains: “The funds are managed on an ongoing basis throughout the life of the fund.

“Life expectancy is 85; let’s say life expectancy moves to 95, you’ve got to fund your retirement for longer, the fund manager will say: ‘Let’s adjust the allocation’.

“It’s a much more flexible way of running a strategy than lifestyling, which you can’t change as easily.”

Different approaches

Target Date Funds can either be statically managed or dynamically managed; statically managed TDFs look similar to lifestyle options, in that as the member approaches retirement, the asset allocation glidepath is pre-set according to the individual's approach to retirement.

A dynamically-managed TDF takes a much more active approach, taking account of changing market conditions that might have a material impact on the investment fund.

They can use passive or active funds, depending on the preferences of the fund manager, where the usual rules apply: passives tend to be cheaper and therefore keep costs down, while active funds might achieve a superior performance.

TDFs in the UK are used mainly in the institutional market, managing assets generated from auto-enrolment. 

Mr Cobbe notes: “It’s up to the trustees to decide what is the glidepath for the default fund for the pension scheme.

“By grouping members into different categories based on their age they will experience a different journey. 

“There is this whole idea of a cohort where you’re grouping members of a pension scheme by their age, and it’s being run in the best interests of that cohort based on life expectancy.”

Membership appropriate

In the US, where the vast majority of pension saving is done through TDFs, a huge amount of research has been done to ensure that the scheme allocates its funds correctly based on lifestyle and life expectancy of that cohort.

For example, employees in a professional occupation will be on a different glidepath from workers in a steel plant.

Mr Cobbe explains: “[In the UK], Nest has designed their default strategy based on the Nest target group. 

"These are people who wouldn’t be in a private scheme, and they’re not high earners. It’s a catch-all, and they have to make sure the investment strategy is appropriate for that group - they have an obligation to make sure it’s appropriate to their membership.”

As the rules have changed over what one can do with one’s pension fund at retirement, so the way TDFs are sold have changed.

Emma Douglas, head of DC at Legal and General Investment Management, says: "The old style target date funds, you would have one target date for each year, and that would be aligned to 25 per cent tax-free cash and focusing on buying an annuity, and you would have the same process in terms of aligning these TDFs to the outcome.

"Given the pension freedoms, generally people aren't buying annuities at 65. They might be taking some tax-free cash and leaving some invested.

"A lot of research is done around pension freedoms, which just shows people don't really know when their retirement date is going to be."

This means that most of the retirement dates are done in three-year blocks or five-year blocks.

"You will be retiring around that date rather than you will definitely be retiring in that year," she adds.

This does affect the investment strategies.

Ms Douglas says: "You have one main pathway which leads to a typical outcome at retirement, and that outcome will vary.”

For example, it may need to keep funding the member into retirement. More people are looking at drawdown, she adds, but the TDF manager needs to keep the endpoint in mind.

“We can change the asset allocation in the fund and can change the glidepath pretty quickly.”

How TDF funds can be used will be covered in the next feature.

melanie.tringham@ft.com