Global financial and economic crises, low interest rates, longer life expectancy are spelling tough times for capital accumulation plans, predominantly consisting of defined contribution pension plans offered by insurers. In these plans, participants rely on the return on their contributions to enjoy a comfortable retirement. They also hope to outlive their savings.  

Target date funds (TDFs) are one solution for investors. Offered by several industry players, these funds target a pre-determined retirement horizon and rebalance the investors’ asset allocation as they approach their chosen retirement date.  

For example, Manulife will launch a target date fund called “Manulife CI LifeCycle 2060 Portfolio Fund” in March  2021. The fund's aligns most closely with the expected year of retirement for anyone born in 1995, assuming retirement at age 65, the insurer’s website explains. In 2020, seven of its target date funds had reached maturity.  

Growing popularity, overperformance and disparity  

Often used as a default investment option in capital accumulation plans (CAPs), target date funds attract more than 35 per cent of member contributions, according to a Sun Life white paper entitled Maturity Date Funds in CAPs from capitalisation:Building and constructing portfolios for the next decade. “TDFs have grown from representing 7% or CAP assets in 2010 to 29% at the end of 2018,” the insurer says.  

As they become the default choice of a growing number of plan members, the success or failure of TDFs is likely to play a more prominent role in the retirement prospects of millions of Canadians, Sun Life says in its report.  

Investors who used target date funds exclusively earned a higher average return than investors who did not invest in such funds, i.e. 1 per cent per year over five years, including fees. Sun Life derives this data from the results provided by its client plans.  

Target-date funds’ outperformance has increased over shorter time horizons, the insurer’s report points out. For example, participants who invested in target-date funds had an excess return of 2.12 per cent from May 1, 2018 to April 30, 2020 compared with other investors.  

In its report, the insurer attributes these superior returns to asset allocation, a tool that reduces risk by diversifying investments. It cites research by Brinson, Hood and Beebower that found that 93.6 per cent of the variation in total return for large pension plans is related to asset allocation policy, and 6.4 per cent is related to security selection and investment timing.  

What’s more, the COVID-19 pandemic revealed a wide disparity in TDF performance. “As at March 31st, following the initial shock to global markets following the outbreak of the coronavirus, the dispersion in 3-month returns of Canadian 2020 target maturity funds ranged from +0.6% to an -11.5%, a return differential of over 12%,” the report states. Sun Life says it observed a much smaller spread in the five-year period ending Dec. 31, 2019, at 3.3 per cent based on an average quarterly return.  

TDF managers need to seek higher risk-adjusted returns, which implies a shift toward non-traditional equities, Sun Life continues. While allocations to traditional equities decreased by 12 per cent in Canadian defined benefit plans from 2008 to 2018, allocations to specialty equity, including real assets and private equity, climbed nearly 18 per cent. Sun Life attributes this trend to the increased return enhancement opportunities of specialty fixed-income securities. Beyond returns, these investment choices also allow asset diversification.  

“In light of the ongoing evolution of capital markets, opportunities and constraints, TDF managers should consider whether their strategic asset mixes remains optimal to provide the anticipated long-term returns for different levels of risk taken,” Sun Life says.