Over the last two decades, defined benefit (DB) pension plans have been replaced by defined contribution (DC) plans in much of corporate Canada. DC plans offer certain advantages for employees – chiefly, the fact that DC assets are portable and can be transferred more easily in kind if employees move to another organization. Nonetheless, studies in Canada and globally show that DB members consistently enjoy higher and more stable incomes in retirement.
This DC gap can potentially be closed through a well-diversified target date fund solution which includes exposure to private market assets. This is the core argument of a new in-depth article by TD Asset Management Inc. (TDAM) called Bridging the Gap: Delivering a DB-like Experience for DC Plan Members with Target Date Solutions and Alternatives.
The Power of Target Date Solutions
The main challenge to optimizing a DC plan's asset mix is that the plan's assets are fragmented across employees, who are required to make their own investment decisions. Individual plan members must select an optimal asset mix or put their retirement plans at risk. Over the last several decades, DC plan sponsors have responded to this challenge by introducing target-date multi-asset-class solutions that employees can invest in collectively.
A target date solution is a series of balanced funds whose vintages span a period of 35-40 years. Longer-dated vintages (for employees just beginning their careers) have a higher allocation to riskier assets, like equities, while near-dated vintages (for employees nearing retirement) have progressively lowered risk in favour of less volatile investments, like bonds. Each plan member is invested in the vintage of fund that aligns with their retirement horizon. The asset mix changes over the course of their career, optimizing risk/return characteristics in relation to their expected retirement horizon.
By providing a practical means to optimize the asset mix for all plan members, target date solutions could arguably offer a viable way to bridge part of the investment gap between DC and DB pensions.
The Importance of Alternatives
However, to the ability to optimize a single pool of assets is not the only advantage DB plans hold in terms of investment capabilities. The scale, sophistication and pooled nature of DB pensions allows them to invest in a wider range of assets than can traditionally be implemented for DC plan members, who must invest individually. A DB-like solution should also incorporate exposure to private market assets and the additional return- and risk-enhancing properties they provide.
The largest DB pensions in Canada invest roughly 20% of their portfolio in real assets, which include real estate, infrastructure and private commercial mortgages. These assets offer a number of advantages: steady income via rents or mortgage payments, capital appreciation, a hedge against inflation, a liquidity premium, and, perhaps most important, a valuable diversifier to public market assets.
These benefits of alternative assets could potentially improve outcomes during the accumulation phase of the plan member's journey as well as during the retirement phase, when cash outflows in the form of retirement income make the portfolio more vulnerable to market volatility.
For more detail, read the full article.
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