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Target date funds on the wayby Stuart Fowler Commentary
In an FTfm article on Monday, I explore the parallels between target date funds, a new import from the USA, and our Defined Outcome Portfolio approach, which was derived from a home-grown innovation in occupational pension funds, Liability Driven Investing or LDI. I suggest target date funds can make mass customisation feasible in the retail market, which would be a huge improvement in capital allocation and risk management.
To read the full article click here (you may need to register for ft.com). I summarise the arguments below.
Target date funds are the basis of the default fund in the government-sponsored NEST auto-enrolled pension scheme, which is an important boost to their credibility. The next step in putting them on the retail investment map will be product launches from private providers. We expect Vanguard, a target date fund market leader in the US, to be amongst the first. This will allow anyone with a personal pension to match their capital and contributions to a specific retirement date or, if they plan to draw down in retirement, to a sequence of dates.
Target date funds make the risks taken by an investor and the expected payoffs specific to age, stage and the manner in which they expect to take pension benefits, whether as an annuity (with or without inflation protection) or drawdown. It can also make risk-taking activity specific to ‘utility’ or the way in which they value different attributes of the payoffs from risk taking. In personal retirement planning, utility or welfare is significantly defined by the adequacy of real purchasing-power outcomes at distant horizons and the consequences for spending of shortfalls in adequacy. Volatility does not explain utility well in pensions saving. Correctly defining utility, and allocating capital to maximise expected utility at the right time, represent important gains relative to the failed ‘balanced management’ paradigm that dominates investment management today.
In the article I examine whether these benefits can be delivered without the time-intensive personal financial planning or segregation of portfolios that we can achieve, working with very wealthy clients. I believe this is exactly what is enabled by our adoption of the technique or ‘portfolio separation’: the separation of portfolios into a risky segment and a risk-free segment – risk free in terms of the nature of the outcome (real or nominal) and its date (or duration) supports. It will require, as it does for us, very high orders of systematic decision processes. It is scalable to the mass market and target date funds supply the basic chassis if not the engine.
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