Confronting the less-discussed downsides of TDFs

The simplicity of the concept is compelling – pick a date to retire, buy the appropriate fund and then sit back. Your manager then provides exposure to return-seeking assets in the early years when risk capacity is higher, and becomes increasingly conservative as time progresses.

TDFs are designed to provide a simple and convenient way to manage member assets up to retirement, in an area previously dominated by lifestyle options.

The key advantage that TDFs offer over a lifestyle profile is an element of discretion. Instead of automatically swapping equities for bonds on set dates, a TDF is managed by an investment team allowing them to make asset allocation changes at opportune times. But there are drawbacks to this approach.

Providing a comprehensive range of TDFs, for example, means creating a significant number of funds.

If we assume that any DC scheme has school leavers as well as those about to retire, a scheme looking at its members today would have a range of retirement dates from 2014 to 2063. This means 49 different funds.

Naturally, this can be reduced using three or even five-year bands. This reduces the number of variants but would also mean members losing some of the 'targeted' exposure that is one of the key reasons to use such funds.

This is not an insurmountable problem, but does mean trustees need to be sure the provider has the appropriate infrastructure in place alongside the required investment expertise.

Does one size fit all?

Different schemes will have different views on risk, particularly during the growth phase. Using a TDF typically means accepting the provider’s idea of a suitable risk profile. We believe that schemes will have varying needs.

Schemes may wish to offer a low-risk foundation stage investment strategy for their younger employees. Creating customised TDFs is possible, but with up to 49 new funds needed for each bespoke strategy, the appetite to deliver these options may be limited.

The aim of any DC strategy is to provide the best retirement income for the members. To meet this objective, members need to obtain the best results from both growth and derisking phases.

A traditional TDF will aim to provide both of these components within a single structure. The convenience this offers could ultimately mean compromising on the quality of each element.  

There is a way to keep the benefits of TDFs, while still delivering investment flexibility and therefore advocate addressing growth and derisking assets separately to maximise the potential benefits of each.

Growth  solutions: The aim is to maximise the returns at an acceptable level of risk, whether by buying an off-the-shelf diversified growth fund, or other multi-asset funds, or creating a more bespoke solution with a client-specific blend designed with help from a consultant.

Dynamic derisking funds: These funds are TDFs that are used for members’ investments in the 10 years before retirement only. They are in effect mini-TDFs with a glidepath that will move members’ assets from the growth solution into a suitable pre-retirement investment mix that aims to match annuity prices as closely as possible.

This disaggregation of strategies combines the simplicity of TDFs with greater flexibility. A scheme can give the manager of its derisking funds the discretion to alter the pace of the derisking process, thus still giving the member a managed, rather than automatic glidepath to a specific retirement year.

Asking members to choose a retirement date when they are much closer to retirement is preferable, as by this point in their career they are more likely to know whether the selected date is realistic or not.

This can easily become a 'good or bad' debate, but that misses the point. The principles behind TDFs are good. But we expect them to evolve towards a model that will allow for even better outcomes.

Emma Douglas is head of defined contribution at Legal & General Investment Management