Is a TDF approach right for your scheme?

TDFs work on a similar basis to a conventional lifestyle, but instead of being a combination of separate funds, a TDF is a single fund with various asset classes underneath, where the fund’s investment manager makes decisions on the asset allocation between them. 

As a TDF matures, derisking occurs within the fund itself, and not at an individual member level. 

TDFs have one big disadvantage, namely the inability of DC schemes to customise the allocation specifically for their members

Members’ investments are aggregated into various TDFs based on their anticipated retirement year. A member expecting to retire in 2040 would usually invest in the ‘2040 fund’, for example.

This would have an internal switching mechanism and would start to switch into less risky assets in say, 2030, so that the fund is well-positioned for retirement in 2040.

This differs from a lifestyle method, where pension scheme administrators are responsible for implementing the switches for each member.

TDF efficiencies can limit admin costs

Elevating the switching procedures from member to fund level significantly reduces any potential administrative errors and omissions.

In addition, there is usually a considerable saving on scheme administration costs, because all investment switches are executed by the fund manager; economies of scale also improve the efficiency of trading, further reducing costs.

While lifestyle switching is always done on a mechanistic basis, most TDFs allow investment managers a degree of discretion to consider the timing of the switches, thus allowing them to respond to market conditions with a view of adding value.

From a member communication perspective, TDFs can be easier to understand and help members focus on the final outcome, hence this could make their choice more straightforward.

A TDF default arrangement can also assist with planning a phased retirement by allowing savers to invest in more than one fund with different maturity dates.

One step ahead of traditional lifestyle

The TDF concept is also consistent with behavioural finance theory: by evolving the investment strategy with the passage of time, these funds help with the status quo bias of default investors who rarely, if at all, make any choices.

The reduction of risk in the financial portfolio over time also reflects the importance of this portfolio in the overall wealth of a saver, whose human capital is declining through the years while financial capital is accumulating.

In fact, traditional lifestyle strategies attempt to do the same, but they tend to be more clunky, particularly when changes are required. 

TDF popularity in the US is often linked to the 'safe harbour' rule, which provides protection for pension scheme sponsors by essentially saying that such investments are a prudent choice and so sponsors are not liable for any potential litigation that members may wish to engage in.

However, as we have explored here, there are many more benefits that make these investments attractive even in the absence of a similar provision in the UK.

The turning point was the introduction of DC pension freedoms in April 2015, a move that prompted TDF managers to implement changes very quickly to realign their investments to the new landscape.

Not only did this showcase the speed of strategic adjustment that TDFs enjoy, but also highlighted the future-proofing benefits of this approach: as member behaviours and preferences change, and regulations develop, TDFs will always stay one step ahead of a traditional lifestyle.

Too good to be true?

If you think that this sounds a little too good to be true – you are correct. TDFs have one big disadvantage, namely the inability of DC schemes to customise the allocation specifically for their members.

The majority of TDF solutions are 'off-the-shelf', meaning that different clients will get the same allocation versus what most DC schemes are used to with a lifestyle strategy, which is an infinitely customisable offering.

To decide which approach works best for your DC scheme, you should get to know your scheme membership and estimate whether you can afford the additional costs that come with a lifestyle arrangement.

Moreover, you must decide what is more important to you – keeping control of investment decisions, or outsourcing the process to ease the governance burden.

Maria Nazarova-Doyle is head of DC investment consulting at JLT Employee Benefits