Elston Research Series | Page 2

Feature | Professional Investor Key questions for pension plan sponsors and trustees to ask QUALITATIVE QUESTIONS TO ASK A MANAGER WHEN CHOOSING A DEFAULT FUND 1.  What is the goal of the fund at maturity (annuity purchase, drawdown, income stream)? 2.  What is the TER of the fund, and what is the Total Cost of Ownership (all-in cost to investor including TER, platform and advisory fees)? 3.  What is the theory underpinning the strategic and tactical asset allocation policies? 4.  How does expected return and expected volatility of the fund evolve over time? 5.  the asset allocation glidepath managed or automated? Is 6.  How is volatility managed? 7.  How will the fund overcome: a) inflation risk; b) market downside risk; c) shortfall risk; and d) longevity risk? 8.  What are the underlying constituent funds, how are these selected, and what is their impact on TER? 9.  What experience does the manager have of designing and running TDFs? 10.  How does the default fund measure up to each of the DWP eligibility criteria? QUANTITATIVE QUESTIONS TO ASK A CONSULTANT WHEN CHOOSING A TDF 1.  How do the risk and return graphs look for a TDF vs individual asset classes: is it successful in delivering returns on a risk-adjusted basis? 2.  How do different TDF glidepaths compare to get a snapshot of the manager’s current investment strategy across all maturities? 3.  How has the glidepath changed compared to the previous 3 to 5 years? 4.  How does asset allocation compare for TDFs of the same maturity? 5.  Will a Monte Carlo simulation illustrate how different funds with different asset allocation glidepaths are likely to perform? equity allocation at maturity (for example, to fu nd an annuity purchase), others argue for a moderate 0-20% equity allocation (to fund annuity and/or drawdown). This is known as the “to or through” debate. We believe that the increasing number of choices at retirement aside from annuitisation, plus increasing life-expectancy justify a moderately “flat and conservative” allocation to equities as appropriate insurance against longevity risk (Cohen, Gardner & Fan 2010). WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF A PACKAGED INVESTMENT STRATEGY? The advantages of TDFs are fourfold: First, they offer a life-long age-appropriate investment strategy in a single fund. While investors should review their investments regularly regarding suitability, behavioural research suggests that the majority of savings plan participants (for example Figure 2: Four generations of default fund 1980s Default v1.0 Equity fund Equity return Equity risk 1990s Default v2.0 Balanced fund Target return Variable risk 2000s Default v3.0 Lifestyle fund Target risk Static risk 2010s Default v4.0 Lifecycle fund Target date Dynamic risk Source: Elston Consulting Figure 3: Old and new approaches to derisking the default fund OLD Default v3.0 (Lifestyling) NEW Default v4.0 (Target Date Fund) Derisking Traditional Enhanced Oversight None: automated Constant: managed Derisking timeframe Rapid (5-10 years) Gradual (25 years) Asset allocation Heuristic: straightline Researched: strategic & tactical Market conditions No regard With regard Equity allocation at target (retirement) 0% 0-25% Longevity risk Higher Lower Inflation risk Higher Lower Shortfall risk Higher Lower Drawdown risk Substantially lower Partially lower Source: Elston Consulting 44 | The Journal of the CFA Society of the UK | www.cfauk.org