Although not yet widespread in Canada, target-date funds are playing an increasingly larger role in defined-contribution retirement plans in the U.S.

A TDF portfolio typically holds a mix of stocks, bonds and cash that is considered appropriate for a client with a particular time horizon. The portfolio grows more conservative as the target year approaches; the target date usually matches the inves-tor’s expected retirement date.

There is, however, a lack of consensus about how these TDFs should be constructed. Variations exist in the degree of risk assumed, in asset allocations and in how the “glide path” — the rate at which the fund sponsor changes the mix of equities and fixed-income over the life of the fund — will operate.

Although each TDF provider has its own methodology in glide path design, most Canadian TDF manufacturers follow a similar trajectory, looking to achieve a 30%-40% equities exposure and 60%-70% in fixed-income assets upon maturity. In contrast, U.S. providers tend to maintain a more aggressive equities exposure throughout, generally maturing with something closer to a 40%-50% tilt toward stocks. Some also include alternative investments such as global real estate.

Either way, Zvi Bodie, a finance professor at Boston University, urges caution when it comes to TDFs because so many of them still hold lots of stock on the unitholder’s expected retirement date.

Some investors will clearly be retiring when the markets are producing losses, he says, and the consequences of this timing could be severe. The problem is that not everyone with the same target retirement date shares the same risk tolerance or investment goals.

In Bodie’s study, Making Investment Choices as Simple as Possible: An Analysis of Target Retirement Funds, he analysed a cross-section of TDFs available in the U.S. at the end of 2007.

The study found that there was no agreement about how fast the asset shift should occur, or about the optimal asset mix when a participant reached the all-important target date. Some funds would be as much 60% invested in stocks on the target date, while the percentage in stocks in other funds might be closer to half that. The TDFs also differed on what they expected investors to do with their money after their target dates. As well, some TDFs’ glide paths were steeper than others.

Bodie’s follow-up study, entitled Making Investment Choices as Simple as Possible, but Not Simpler, noted that TDFs are probably a good choice for clients who are in the middle to late stages of their careers and work in stable industries, or who can tolerate risk. The study referred to this group as “natural” TDF holders.

But a TDF strategy could fall short of the mark for employees who — although of the same age — differ from the natural TDF holder in their risk tolerance or job security, the later study cautioned.

Instead, Bodie suggests, these workers could benefit from having a more secure default investment option in their plans, such as Treasury inflation-protected securities, which mature in a certain year and pay interest based on the rate of inflation.

On the other hand, the adoption of TDFs does eliminate the extreme allocations that can hamper employee success, suggests a research team led by University of Pennsylvania professor Olivia Mitchell in a recent study entitled The Dynamics of Lifecycle Investing in 401(k) Plans.

The introduction of TDFs can produce changes in participant portfolios that benefit their retirement goals and are consistent with the objectives of plan sponsors, Mitchell believes. More than 35% of plan participants who later opted for a target-maturity option had initial extreme equity allocations of 0% or 100%, she says.

Mitchell suggests employees are definitely more inclined to participate in and benefit from TDFs when plan sponsors influence the process directly.

The speed with which behaviour changes will depend on the menu offered by the employer, as well as the degree of outreach to new entrants and low-literacy employees. Currently, for every 10 months that TDFs are on offer in a plan, participation rises by an additional 2%, she says.

The Penn study also found that already having a static-allocation or balanced fund in the mix has the largest influence on whether a participant will adopt a TDF. IE