Target Date Funds: The One Fund You Need for Retirement?
The Canadian Retirement Dilemma
As a matter of public policy, Canada has built several safety nets to help mitigate poverty for retirees. Among the most well-known are the Canada Pension Plan (CPP) and Old Age Security (OAS). Lesser known, but available to lower-income Canadians is the Guaranteed Income Supplement (GIS). Nevertheless, these programs are not intended to fully replace the income needs of Canadian retirees. Ideally, employers are providing one of several options, such as Defined Benefit (DB) Pension Plans, Defined Contribution (DC) Pension Plans, Group Registered Retirement Savings Plans, and Deferred Profit-Sharing Plans (DPSPs). Beyond these, we also need to consider personal efforts, primarily Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs). Lower-income persons will want to focus on the TFSA, while those with annual incomes approaching $60,000 and higher will probably want to prioritize the RRSP.
These sources of retirement income are good to have, but they do not promise every Canadian the entirety of the income they will need in retirement. Someone who has worked at a low-income job all their life will not have maximized their CPP payments regardless of their diligence in holding down a job. A Canadian who arrived in the country after age 30 will not be able to maximize OAS payments even if they wait until age 70 to collect. Having said that, GIS can help pick up this slack.
Furthermore, not all jobs come with employer-sponsored pension plans. Often, the bulk of the responsibility lies in our hands as individuals or households. As a further challenge, we need to consider that many Canadians lack sufficient knowledge and understanding to live up to that responsibility. Naturally, we then go to financial institutions, mostly our neighbourhood banks, for guidance. It may be surprising to know that, except in certain specific circumstances, banks have no obligation to act in their customers’ best interest.* Rather, that bank account, mortgage, or mutual fund is sold on a much lower “suitability” standard. In other words, “caveat emptor”: “let the buyer beware,” because the onus is on the buyer to exercise due diligence before agreeing to go ahead with the offer.
In addition to this challenge of low levels of financial literacy (although, on average, Canadians tend to do better than the residents of other countries), other issues also challenge us to prepare for retirement. Among them are rising life expectancy, which means we may have to save for a retirement of 30 years or longer, and volatile market conditions that don’t sit well with our desire for certain, steady, and risk-free income.
Introducing Target Date Funds (TDFs) as a Solution
Target Date mutual funds have been offered for many years as a solution, often the default, for defined contribution pension plans and group RRSPs. The employee only needs to estimate the year of their retirement and then pick the fund that fits that estimate. For example, a 50-year-old who expects to retire at age 65 would probably pick a 2040 TDF, which is approximately 15 years into the future. These funds typically have maturity dates set in 5-year increments.
Target Date Fund Definition
The following is the category definition of Target Date Funds per the Canadian Investment Funds Standards Committee (CIFSC):
Funds in the Target Date fund group comply with the Balanced fund category criteria but have specific, pre-determined maturity dates and a stated mandate to adjust their target asset allocation weightings over time as they approach their maturity dates. Upon maturity, funds in the Target Date fund group will be moved out of the Target Date group and included in the appropriate Fixed Income or Balanced fund category.
Target Date Fund Examples
TDFs address the challenges through a structured investment approach. The fund management team gradually reduces the risk of the fund by reducing the equity allocation in favour of the fixed income allocation. For example, here are two of the biggest players among retail TDFs, Fidelity and RBC:
You will notice that the two fund companies provide similar equity (stock) allocations for the years 2025, 2030, and 2035. However, from 2040 onward, there is considerable divergence. Fidelity takes a much more equity-heavy approach than does RBC.
A 55-Year-Old Who Wants to Retire at 65
A person in such a circumstance would find that a 2035 TDF would be the most suitable. The equity allocations would be 61% for the Fidelity fund and 64% for the RBC fund. After five years, these funds would have their risk reduced to the equivalent of the current 2030 funds, and after five more years, the equity allocation would be around the current 2025 funds. The closer to retirement, or in other words, the shorter the “time horizon,” the less risky the asset allocation. Despite the recent inflation-fueled drop in the prices of bonds, the tendency is for fixed income to be a less volatile investment, which is an often desirable trait when you start to withdraw from your portfolio.
A 25-Year-Old Who Wants to Retire at 65
If we look at someone who is 30 years younger and doesn’t anticipate retiring until 40 years from now, a 2065 TDF is likely the most appropriate. Using the Fidelity fund as an example, since RBC does not have one, it will start with an aggressive equity allocation of 84%. Over the next 20 years, it would stay at a fairly aggressive 81% in equities before dropping to the 72% level when the fund holder gets within 15 years of retirement.
You can see that this is a great tool for simplifying the complexity of investing for retirement. The aggressiveness of the fund diminishes over time providing the investor with a single fund that does all the work. All you need to do is keep contributing.
Pros and Cons of Target Date Funds
No doubt I will be accused of the Appeal to Authority Fallacy, but one person who, rather surprisingly, speaks well of Target Date funds is Ben Carlson, author, blogger, podcaster, and Director of Institutional Asset Management at Ritholtz Wealth Management, a Registered Investment Advisor (RIA) in the U.S. While not everything he says will apply in our Canadian context, much of it does so I include the links for those who want to expand their understanding of the investment landscape.
Pros
- I think it is clear that the benefit of using a TDF is its simplicity and convenience. As mentioned, they are an easy and frequently offered solution for employees of businesses that offer DC pensions or group RRSPs.
- Employees who make this choice, as well as retail investors who directly select these funds, benefit from the global diversification that is a part of the design of these funds.
- Inherent in the design of these funds are the lifecycle adjustments that are made throughout the years that you own it, saving you the responsibility and challenge of adjusting your asset mix as you near retirement.
- Also inherent in this design is the risk management aspect of TDFs. That is, they grow more conservative as you near retirement and have less time to use your “human capital” (your ability to work and earn an income) to keep on contributing during a down market and wait for the underlying assets to recover.
- A final pro I will mention is that investors have professional management taking care of the fund, determining what should go in and what the equity versus fixed income balance should be as time marches on.
Cons
- Fees are an issue with TDFs. To my knowledge, none of the underlying assets are index funds. Furthermore, the active management that goes into making the adjustments, although essential, is an added expense. A company called Evermore created a group of Retirement ETFs with a target date approach. They used portfolios of the leading index ETFs available in Canada, adding lifecycle adjustments to the management of the portfolios. Although not as low-cost as a straight index ETF, they were significantly less costly than the mutual fund versions. Sadly, the timing of their public launch, just as COVID was getting underway, exacerbated the challenge of creating a new fund company, and they terminated their funds about a year ago.
- While simplicity is a meaningful reason for going the Target Date route, the downside is that you have limited ability to customize your investment. You have to take the options that are available to you, especially if you are selecting for your employer-sponsored retirement plan. If you are more aggressive, you could always choose a target date that is five or ten years further out than your planned retirement, or conversely, if you are more conservative, you can choose a target date closer to the present, but there is little more that you can do unless you want to pick individual funds and create your own mix. This, of course, defeats the very advantage of these funds in that you must then assume more responsibility for the management of the fund.
- TDFs focus on the retirement date – that is their purpose, after all – but if held in a personal RRSP or TFSA, this focus can become an overemphasis on the retirement date. Many Canadians are taking a more gradual approach to retirement. My dad, for example, retired at around age 63 but then kept on working part-time into his 70s. These sorts of individual factors are not accounted for in the rigid scheduling of TDFs. Investors can address this situation by using a longer-dated fund, but it puts the onus on the investor to make the decision.
- A final problem is the limited choice of funds available. This is different than limited customization in that customization refers to the ability to adjust the asset allocation or the timing. Here I am referring to the sheer limited range of available funds. While the overwhelming range of choices available in each of the mutual fund categories comes with its problems, when you are choosing an option within your pension or group RRSP, you may have only one series of funds to choose from. Even in the retail space, there are only a few to choose from, and as the two examples above show, their asset allocations can vary significantly.
Final Thoughts (Held Loosely)
While a Target Date fund can be a useful tool, I’m not sure it is a suitable one-fund solution for every Canadian. Granted, if your only savings for retirement are in your employer-sponsored plan, then it could very well be the best solution available; however, if you have accumulated more retirement savings, I would encourage taking the opportunity to broaden your holdings a bit so that you are less constrained by the predefined limits of these funds.
*As a member of the Financial Planning Association of Canada, I have signed onto a “fiduciary pledge,” a duty to act honestly and to put the needs of my clients first.
This is the 238th blog post for Russ Writes, first published on 2024-03-04
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.