By: Vartkes Rubenyan & Oma Sharma
Three new investment trends are slowly making their way to Canada. Now is the time for plan sponsors to consider them as part of their defined contribution investment lineups.
The level of uncertainty in the markets has significantly increased. Gone are the multi-year bull markets of the mid-2000s. Investors are facing the potential for more volatile and lower expected returns. Investment product trends for the DC markets are in some ways a reflection of these economic times. Many of the emerging trends involve ways to reduce risk and to better meet participant needs through improved diversification and greater customization.
With respect to investment products, Canada has a long history of following the U.S. For example, target date funds (TDFs) grew in popularity and numbers in the U.S. starting in 2006 when the Pension Protection Act included them as a safe harbour option for plan sponsors to use for participants who do not make an investment election for their salary deferrals and/or company match. As a result, these funds have become a huge part of the 401(k) market – the U.S. equivalent of a capital accumulation or defined contribution plan – as the preferred default option for participants.
Canada followed suit. In the past two to three years, DC plan sponsors have added TDFs to address concerns around member disengagement with investment decisions and members not de-risking as they approach retirement. Pre-packaged or ‘off the shelf’ TDFs are dominating the Canadian landscape.
How might the trends in DC investing continue to evolve based on developments in other markets? This article addresses some of these areas of evolution.
Target Date Funds
A typical off-the-shelf TDF will have exposure to Canadian and global equities, fixed income, and cash. Some can also include modest exposures to alternative asset classes such as infrastructure, real estate, and commodities.
In the U.S., TDF design is evolving in two new directions.
The first is a newer trend and entails moving beyond typical alternative exposures seen in Canadian TDFs and into:
- Long-short strategies – to benefit from a wider array of opportunities to add value
- Bond market futures contracts – to increase exposure to bonds more efficiently
- Unconstrained bond funds ‒ to give managers greater latitude to explore market conditions, such as a potential rising interest rate environment
The second is a trend towards customizing TDFs to better meet the need of DC plan participants. Very few Canadian plan sponsors are currently using a customized approach.
So why customize TDFs?
First, a customized approach provides the ability to leverage managers used in other asset pools (such as defined benefits plans). This can potentially reduce fees and ease the investment manager oversight burden for the plan sponsor. Second, a customized approach enables the sponsor to truly optimize the asset classes used, the managers chosen, and even the management approach (active versus passive). Third, a customized approach would enable DC plan sponsors to tailor the glide path to reflect unique characteristics such as demographic profile of the DC plan participants and other sources of retirement income that may be available to participants and may impact the level of risk they are able to bear.
Diversified Growth Funds
Many DC plan sponsors offer a balanced fund in Canada. An interesting alternative to a balanced fund may be a diversified growth fund (DGF). Popular in the UK, DGFs or real return funds, aim to deliver meaningful target returns in excess of inflation or CPI while at the same time attempting to avoid meaningful declines in market value.
To make them work, DGF managers use dynamic allocations across multiple asset classes with the aim of achieving a defined return objective (typically CPI plus ‘X’ per cent or inflation plus ‘Y’ per cent).
The managers are permitted high levels of flexibility in the tools and strategies to achieve their targets. When an asset class appears overvalued, the manager has the ability to significantly lower the exposure while increasing exposure to an undervalued asset class. Through the use of multiple asset classes, the managers have a far wider array of risk and return drivers at their disposal.
The ability to protect investors in declining markets and generate above inflation or CPI returns makes DGFs an interesting alternative to balanced funds. DGFs could also be used as a component of a custom TDF.
Low Volatility Funds
The final trend is low volatility funds. A key consideration in a DC plan is to offer downside protection. Traditional DC plans offer exposure to core or style biased equity funds which follow, to various degrees, the market movements.
The idea of low volatility funds is to generate capital appreciation with an emphasis on absolute (positive) returns. They are designed to have low market sensitivity and low volatility compared to the broader markets.
Traditional finance theory would suggest that higher risk assets generally command higher returns. However, there is now a large body of empirical evidence suggesting that high volatility stocks have not earned superior returns relative to low volatility stocks over long time periods.
A low volatility fund can be used as an offset to a typical equity fund in a DC line-up or used as the equity component of a custom TDF.
DC sponsors should keep an eye on these solutions as they present interesting ways to improve the overall effectiveness of DC plans.
About the Authors
Vartkes Rubenyan is a principal in Mercer's investment consulting business and Oma Sharma is defined contribution consulting leader for Mercer Canada
This article originally appeared in the December 2015 edition of Benefits and Pension Monitor