U.K. corporate plans waking up to benefits of target-date funds

Target-date funds are enjoying a moment in the sun as U.K. corporate retirement plans begin to use them as a result of pension freedoms adopted in 2015.

These vehicles are a familiar feature of defined contribution plans in the U.S., where they grabbed some 18.4% of the $3.28 trillion total defined contribution assets among the largest plans in 2016, according to Pensions & Investments' annual survey of the largest U.S. retirement plans.

But they've lagged in the U.K., largely because plan members were obliged to purchase annuities upon retirement, rather than keeping their retirement assets invested. The U.K.'s pension freedoms legislation gave members more flexibility in their retirement options, including a drawdown option that allowed participants to take a portion of their money in a tax-free lump sum and keep the remainder invested.

Early target-date fund adopters in the U.K. were multiemployer DC plans known as master trusts, such as the £1.8 billion ($2.3 billion) National Employment Savings Trust, London. But the vehicles now are attracting the attention of U.K. corporate plans.

Money managers say they are beginning to find target-date fund business with multinational companies in the U.K., which are keen on centralizing retirement plan practices.

Alistair Byrne, head of European DC investment strategy at State Street Global Advisors in London, said a few of the firm's clients — retirement plan executives at U.S.-based companies — have started to adopt target-date funds for global operations, particularly their U.K. subsidiaries. "There are more clients in the pipeline that are about to pull the trigger," Mr. Byrne added. He would not name the clients.

Pension plan executives and consultants in the U.K. said a new role is emerging for target-date funds, where they could add value by helping participants manage their assets through retirement.

Sonia Kataora, associate at actuarial consulting firm Barnett Waddingham in London, said: "In light of pension flexibilities introduced by the pension freedoms legislation ... target-date funds can also manage members past a target date. They are useful for income drawdown when derisking is still to a target date but the investment strategy needs to continue beyond that."

Thomson Reuters' U.K. defined contribution plan, with £500 million in assets, is considering moving to a default investment strategy aligned to different career stages, said Matthew Webb, head of retirement benefits in London.

"In the early career stages, growth and volatility is more ​ acceptable, and as members move through their careers, volatility control and asset protection become important. Target-date funds could play a part in the decumulation phase," he said.

Spence Johnson, owned by Broadridge Financial Services, a data and intelligence consultancy, sized the total U.K. target-date funds market at £3.2 billion in 2016, up from £1.9 billion at the end of 2014, and estimated the market would further grow to £102 billion by 2025.

But some sources think​ a number of challenges need to be overcome before the funds can grow to that level.

Currently, lifestyle funds are a prevalent default investment option in the U.K. Like a target-date fund, lifestyle funds gradually switched participants into bonds as they age. But unlike a number of target-date funds in the U.S., lifestyle funds did not continue through retirement. At the time of retirement, participants bought an annuity.

But the increasing popularity of taking a drawdown — and keeping funds invested throughout retirement — requires different investment management strategies.

Because of that, Ms. Kataora said, lifestyle strategies "began to look less effective."

"The introduction of the pension freedoms​ has made the drawdown option more attractive in the U.K. People now have an option to do a flexible drawdown instead of being forced to buy an annuity," Mr. Webb said. That creates a much better potential for growth in target-date funds' use in the U.K.

Still, some sources noted factors that could limit growth in the target-date fund market.

The legacy of lifestyle strategies doesn't just pose challenges around the flexibility of products, but also to systems and relationships among providers.

Brian Henderson, partner, DC and wellness leader at Mercer in Edinburgh, said one of the barriers to target-date funds taking off in the U.K. could be the platforms' inability to add funds with a target retirement date for each year.

Many providers of target-date funds in the U.K. generally group members into three-year bands. But NEST already has implemented the change, offering a target-date fund for every year a member could retire. Large corporate plans are looking at similar solutions, where members could flexibly choose a band of one year, rather than three or five years, as they move closer to retirement. That option offers more flexibility and a more targeted approach should needs or retirement plans change.

However, Richard Parkin, head of pensions policy at Fidelity International in London, said investment platforms would actually welcome target-date fund solutions but there are legacy issues that might be holding plan sponsors back.

"Target-date ranges can be costly to run and only the very largest will be able to justify a bespoke solution," Mr. Parkin added.

Fidelity International offers target-date funds in Germany, and Mr. Parkin said the introduction of a DC system in Germany next year could reshape that market. Mr. Parkin said the change might lead to more interest in flexible retirement options in the next few years.