The evolution of Target Date Funds: A call to action for plan sponsors
Compound Interests - Issue Five
October 31, 2024
Welcome to the fifth issue of Compound Interests - Mercer’s perspective on capital markets, asset management, and how you can get the most out of your investment portfolios.
In this installment, we’re looking at Target Date Funds (TDFs) – how they are continuing to evolve and how new Canadian Association of Pension Supervisory Authorities (CAPSA) guidelines are changing what plan sponsors are expected to do to fulfill fiduciary responsibilities.
Over the last 20 years, TDFs have become a cornerstone of retirement planning in Canada, and today account for over 70% of Capital Accumulation Plan (CAP) assets. The “set it and forget it” nature of these funds helped simplify investment decisions for Canadians, leading to their increase in popularity. However, the investment landscape is constantly evolving, and plan sponsors have a fiduciary responsibility to enhance their oversight of TDFs to meet the changing needs of plan members.
The evolution of TDFs – changing investment landscape
In the early 2000s, TDFs emerged as a solution to help members manage the complexities of retirement planning. Instead of worrying about picking individual investments, members could rely on a pre-determined investment strategy that adjusts over time as they approach retirement. While originally focused primarily on equity and fixed income, over time TDF managers have enhanced the asset mix of TDFs beyond traditional asset classes.
Today, several TDF managers incorporate real estate, infrastructure and commodities within their TDFs, and a number are also considering the addition of private markets, along with other types of alternative investments. While the addition of these asset classes offers the potential for enhanced diversification and portfolio efficiency, TDF managers need to balance these benefits with liquidity requirements.
The need for due diligence
The evolution of the TDF landscape reinforces the need for ongoing due diligence of TDFs. A decision made by a plan sponsor years ago to select a particular TDF manager for a group retirement and saving plan, may no longer reflect the optimal selection. Plan sponsors need understand if their TDF has kept pace against an evolving TDF backdrop.
Proper monitoring and oversight goes beyond a review of performance. The recently released CAPSA Guideline for Capital Accumulation Plans (CAPs), Guideline No.3, makes it clear that plan sponsors are responsible for reviewing plan options including default investment choices. The new CAPSA guideline provides a helpful framework for sponsors to consider when reviewing plan options, which includes:
- Purpose of the CAP and intended member outcomes: Does the default option of the TDF align with the plan’s objectives and goals of its members?
- Competitiveness and reasonability of fees: Are the fees charged by the TDF competitive and do they provide appropriate value for members?
- Demographics and observed behaviour of CAP members: Has there been a change in demographics or member behaviour that requires a change to the default options?
- Degree of diversification: Does the default option of the TDF offer adequate diversification across asset classes to mitigate risk effectively?
- Liquidity of default option: Does the default option of the TDF provide sufficient liquidity to meet member needs?
A call to action for sponsors
As the investment landscape continues to change, TDFs will also evolve. This means that sponsors must be diligent in reviewing the TDFs they offer to ensure they remain relevant and effective. Also, the recent revision of the CAP Guidelines highlights the need to review governance processes. This involves prioritizing the areas within a CAP that have a significant impact on member outcomes.
We are here to assist you in navigating the evolving landscape of TDFs and staying up-to-date with the changing expectations of regulators. Contact us today to get started.
Today’s capital markets
What a year this has been. Global equity markets wrapped up the third quarter on a high note, marking the end of a remarkable 12-month period. The S&P 500 stood out with an impressive year-over-year return of 36.0%1, largely fueled by advancements in artificial intelligence and the stellar performance of companies like chipmaker NVIDIA. Meanwhile, the S&P/TSX Composite also showed strength, achieving a return of 26.7%1 during the same timeframe.
In the United States, economic activity continues to demonstrate resilience, defying fears of an impending recession. The second quarter's GDP came in at a robust rate of 3.0%2, reinforcing the notion of a soft landing for the economy. In contrast, growth in other global markets has been more subdued. Canada, for instance, reported a Q2 GDP growth rate of 2.1%2, a respectable figure, but per capita GDP has been declining due to rapid population growth having outpaced growth of the overall economy.
On a more positive note, inflation rates across developed economies are moderating, as we had expected. In Canada, the Total Consumer Price Index (CPI) dropped to 1.6%1 year-over-year in September, aided by lower gasoline prices. This trend opens the door for additional rate cuts by the Bank of Canada, including the 50 basis point cut announced in October. In the U.S., the Federal Reserve initiated its cutting cycle with a 50 basis point reduction in September, as inflation approaches the 2% target.
A key factor contributing to the near-term disinflation and longer-term stability of inflation expectations is the belief that the Fed and other developed economy central banks will maintain policies aimed at achieving this target. Having maintained this commitment to credibility marks a crucial distinction between the current economic landscape in the U.S. and Canada and that of economies that have suffered from persistently high inflation.
Numerous uncertainties however remain on the horizon, including the upcoming U.S. presidential election and ongoing tensions in the Middle East. These factors could heighten market volatility, particularly before and after the election, depending on how policies are perceived in terms of their potential impact on the economy.
As of now, the outcome of the presidential election remains uncertain, as does the fate of various policies. The president will need Congressional support to enact most measures, although some actions - especially those related to tariffs - can be implemented through Executive Authority, which could have implications for global trade and for the Canada-U.S. relationship. As a further risk scenario, any significant political interference to the independence of monetary authorities such as the U.S. Federal Reserve could undermine credibility, potentially leading to more volatile economic growth and inflation expectations. The impact of such a shift, even if less likely, would certainly be felt in Canada and beyond.
2 Source: Bloomberg – October 2024, Quarter-over-Quarter Seasonally-Adjusted Annual Rate