Target-date retirement funds miss the mark

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Some financial products don’t live up to their potential

Many popular target-date retirement funds might not suit the modern UK market, says David Prosser.

The financial-services industry has a long history of inventing seemingly clever products that turn out to be anything but smart. Now it looks like target-date funds, aimed at millions of people saving for retirement, could be yet another example.

The premise is appealing. Target-date funds group together savers who plan on retiring at roughly the same time, and promise an asset-allocation strategy built accordingly. When people are younger, the fund invests in assets deemed higher risk, but potentially higher return – predominantly shares.

As the group of investors nears its target retirement date, the fund is gradually shifted into bonds. These are supposed to be less risky, reducing the danger of investors’ money plummeting in value shortly before retirement. They also pay a regular income, which may be useful for those considering withdrawing money direct from their pension funds, rather than cashing in to buy an annuity.

Problems across the pond

In America, assets invested in these funds have increased 15-fold over the past decade or so, to more than $1.1trn today, and they are now being aggressively marketed to savers in the UK. But there is a potential snag.

A team of researchers from Princeton University in the US and EDHEC, the French business school, have published a study warning that the bond portfolios that target-date funds use are riskier than widely thought. These portfolios are typically composed of short-term bonds that are exposed to market risks (eg, changes in interest rates) and do not offer the long-term certainty about income that many retirees expect.   

It should be possible to manage this shortcoming by designing bond portfolios that are less exposed to market risks, say the researchers. However, there is little sign of the industry rethinking its current approach.

The suitability of target funds for today’s retirees is also questionable. Many people don’t want to set a specific date to take their benefits – they’d prefer to leave that choice until later. And now that the requirement to buy an annuity has been removed, many savers see no need to shift all their money into low-risk assets as they near retirement – they’d rather keep some invested for capital gains. An all-bonds portfolio will generate some income, but it won’t deliver much growth. So a multi-asset portfolio that includes both shares and bonds may be better for people who want to take advantage of the flexibility that today’s pensions rules can offer.