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Lifecycle Funds Evolve To Meet Needs

By: Simon Segall

For Canadian Defined Contribution pension plan sponsors, target date lifecycle funds are a new idea. However, south of the border they have been evolving for the past decade. Simon Segall, of ABN Amro Asset Management, looks at these funds from a Canadian perspective.

In the last year, a popular new investment option has become available to Canadian capital accumulation plans – the target date lifecycle fund. These funds offer CAP members a simple way to select an appropriate investment fund for the whole time that they participate in the plan. For this reason, CAP sponsors hope that offering target-date lifecycle funds will help members obtain the intended benefits of their plans while also helping the sponsors themselves meet their obligations under the CAP guidelines.

Because the funds appear new to Canada, some sponsors may not be aware that lifecycle funds have actually progressed through three generations of development over the past 10 years, with each generation trying to overcome the perceived shortcomings of the previous one in order to better meet member and sponsor needs.

Life Cycle Funds Evolve

The Purpose of Lifecycle Funds

Many CAP members had no desire to be in the position of making investment choices. They simply wanted a job and ended up being enrolled in their employer’s CAP. Employers and providers, with encouragement from the regulators, responded to this situation by developing ever-improving education and communication programs for CAP members.

However, both experience and research have shown that education and communication programs are not a full solution. Even the best employee education programs only successfully reach about 50 per cent of CAP members.1 Nearly half of Canadian CAP members are 100 per cent invested in their plan’s default option2 – usually a money market fund or other conservative investment which is unlikely to deliver the long-term growth needed to provide an adequate retirement income.

Finally, as many plan sponsors saw during the 2001-2002 ‘tech wreck,’ many CAP members react to sharp market declines by abandoning their previous choices for the perceived ‘safety’ of the money markets or GICs. When members take this step, they forfeit the future gains they would have achieved by remaining invested, severely damaging their longterm growth prospects and their ultimate retirement income.

Lifecycle funds were developed by fund managers in an attempt to meet the needs of CAPmembers and sponsors for a simple way to select an appropriate investment without onerous education.

In addition, managers of lifecycle funds have tried various means to encourage members to stay invested properly through the inevitable bad markets so that they will benefit when the markets recover. Each generation of lifecycle funds has taken a different approach to satisfying these needs.

Generation 1 – Asset Allocation Funds

The first attempt to provide a simple approach to fund selection was through asset allocation funds. These funds have been available in Canada for many years now and in other countries, such as the United States, for even longer. Most readers of this article will be quite familiar with them.

Asset allocation funds are families of pre-packaged balanced funds, or balanced funds-of-funds, in which each fund in the family is designed to have a relatively static risk profile and asset mix ranging from ‘conservative’ through ‘moderate’ to ‘aggressive,’ possibly with additional variations in between. Members are instructed to select the one fund from the family that best fits their own risk profile, which they can determine by answering a questionnaire of some sort.

As a member’s risk profile is likely to change with time, the education program will encourage each member to re-take the risk assessment test every few years and adjust the fund selection accordingly.

Education and communication are also the primary tools for keeping members from making rash decisions in bad markets.

Asset allocation funds work quite well for members who are willing and able to take the risk test at regular intervals and to act on it when they do so. When bad markets hit, asset allocation funds require members to have a degree of faith in the long-term behaviour of the markets and the overall design of the funds in order to stay true to their investment decision.

Unfortunately, these conditions don’t hold for many CAP members. As we have already seen, education doesn’t reach 50 per cent of plan members. And CAP members and other investors, including sophisticated investors, have been shown by behavioural finance studies to overestimate their risk tolerance in rising markets and then underestimate it in falling markets3, resulting in the panicky behaviour that was so apparent during the last bear market.

In an attempt to deal with the first of these problems, fund managers developed the second generation of lifecycle funds.

Generation 2 – Target Date Lifecycle Funds

The second generation of lifecycle funds has been available outside of Canada for a decade, but only entered Canada in 2005 when a number of fund managers introduced them. This generation aims to make fund selection a simple, one-time exercise for the plan member by matching fund selection and management to the member’s retirement time horizon.

Specifically, the manager of the targetdate lifecycle funds offers a family of balanced funds, each with a specified target year – for example, one fund family offers funds with target years from 2010 through 2045 in five-year intervals. Each of these balanced funds has an asset mix that is based on the time remaining to the target year, with funds that have further to go to their target year having higher equity content than funds that are closer to their target year. As time goes by, the fund manager automatically adjusts the asset mix of each fund to reflect the time remaining to the target year, gradually making the funds more conservative as the target date draws near.

What this means for the member is very simple fund selection. A member can simply select the fund that is targeted closest to his or her expected retirement date and let the fund manager do the rest. No further action is needed on the part of the member – no tests, no reallocations, nothing at all if the member so desires.

For the CAP sponsor, target date lifecycle funds offer the reassurance that even those members who are not open to education programs can still readily choose a fund that has an appropriate asset mix and that the mix will remain appropriate throughout the member’s tenure.

One common concern raised in connection with target date lifecycle funds is that they imply that two people with the same age have the same risk tolerance, which may or may not be true in actual fact. However, research has shown that the variation between investors of similar age is much less than the variation between investors at different stages of life4, so this concern may be overstated.

Another concern that has been raised about target date lifecycle funds is that they do not address the issue of member panic in bad markets. In order to attempt to comfort CAP members, the fund manager may even be tempted to be more conservative at most ages than is really appropriate for the time remaining to retirement. Even then, the members for whom target date funds are specifically designed may still find it hard to resist the urge to ‘head for the hills’when markets fall. A couple of lifecycle fund managers, therefore, went on to develop a third generation to address this facet of member behaviour.

Generation 3 – Guaranteed Target Date Lifecycle Funds

The third and most advanced form of lifecycle fund was first launched in Europe in 2000, and has been available in the United States for about a year. This generation has been available to CAPs in Canada since mid-2005.

Like the second generation funds, the third generation also uses the target date concept, making fund selection simple for members. They also use the lifecycle asset mix concept, automatically moving from high equity content when the target date is far in the future to low equity content as the target date gets close.

However, the third generation funds also incorporate a maturity guarantee. Units held on each fund’s target date will be redeemed for the highest month-end unit value the fund ever reached during its lifespan. What this means for members is that they do not have to worry when markets fall; they can simply stay in the fund to its target date secure in the knowledge that they will then collect on the gains made before the markets dropped.

These funds have had a powerful impact on investor behaviour.

In Europe during the 2001-2002 bear market, asset allocation funds and second generation target date funds suffered heavy redemptions as investors panicked – as did many balanced funds in Canada. However, the third generation funds saw major inflows of capital in the same period as investors realized the value of the guaranteed approach.

This impact on investor behaviour means that it’s more likely the members using the third generation funds will remain properly invested through their careers, benefiting from the long-term growth of the markets.

For plan sponsors, the guarantee feature means less strain on their human resources departments due to employee ‘hand holding’ during down markets, and the reassurance that more members will remain properly invested.

Because the maturity guarantees of the third generation funds reduce members’ sensitivity to risk, this approach can be combined with higher equity exposure than first and second generation funds tend to use, enhancing the expected longterm returns for the third generation funds.

The combination of lifecycle asset mix and the maturity guarantee also makes the third generation funds an attractive alternative for use as CAP default funds. The maturity guarantee gives the security that plan sponsors want in a default fund, and the members benefit from the upside potential from the funds’ equity content.

Lifecycle funds represent the investment industry’s attempts to deal with some of the facts of life facing CAP sponsors and members. Many CAP members are reluctant and skittish investors who are not open to even the best educational programs. As lifecycle funds have evolved through three distinct stages of development, they have progressively improved in their ability to meet the real needs of these members and their plan sponsors.

The third generation – guaranteed target- date lifecycle funds – enables most CAP members to make an easy one-time decision and lets them face down markets in confidence. CAP sponsors using third generation funds are reassured that their members are investing appropriately and will stay invested wisely with minimal strain on their human resources departments even during difficult markets, thus achieving two vital goals towards having their CAPs meet their overall objectives.

Simon SegallSimon Segall is vice-president, institutional sales and client services, at ABN AMRO Asset Management.

1. Utkus, Stephen P. & Young, Jean A., ‘Lessons from Behavioral Finance and the Autopilot 401(k) Plan,’ The Vanguard Centre for Retirement Research, April 2004

2. Bak, Lori et al, ‘The Road Ahead: The Canadian Defined Contribution Plans Trend Report,’ Sun Life Financial, 2004

3. Shiller, Robert J., ‘From Efficient Markets Theory to Behavioral Finance,’ Journal of Economic Perspectives, 17(1), 2003

4. Fontaine, Thomas J., ‘Target-Date Retirement Funds: A blueprint for effective portfolio construction,’ AllianceBernstein Global Investment Research, October 2005

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