Many developed nations have ‘defined contribution’ retirement savings instruments known as the target date funds. India still doesn’t have these, but globally, such schemes manage nearly $2.3 trillion in assets.
With the growing focus on retirement planning, many AMCs (asset management companies) will see the need for target date funds in India. These are also known as target-date retirement funds, lifecycle funds, etc.
How does it work?
A target-date fund uses an age-based formula to maintain the asset allocation of the investor’s retirement savings. It assumes that the investor will retire in a given year and depending on the time left, it adjusts the asset allocation model every year. The idea is to rebalance the portfolio periodically. And, as it approaches the target retirement date (year), the portfolio needs to become less growth-focused (i.e., lower equity allocation) and more oriented towards capital preservation (i.e., higher debt allocation).
If this sounds a bit familiar, then you are right. The NPS in India takes a similar approach. The NPS ‘Auto’ Choice is an option provided for those subscribers who do not have the required knowledge or time to manage their investments or do not want to manage them on their own. Under this choice, investments are made in a life-cycle fund. These are of three types:
-Aggressive Life Cycle Fund (LC75) – Equity component starts with 75 percent and goes down to 15 percent by age 55.
-Moderate Life Cycle Fund (LC50) – Equity component starts with 50 percent and goes down to 10 percent by age 55.
-Conservative Life Cycle Fund (LC25) – Equity component starts with 25 percent and goes down to 5 percent by age 55.
Coming back to the target date funds. These funds are themselves made up of other schemes. The underlying funds offer diversified exposure to a mix of asset classes such as domestic equities (large, mid and small-caps), foreign equities, domestic bonds, foreign bonds, gold and cash-equivalent instruments.
Generally, the year mentioned in the target date fund’s name corresponds approximately to the investor’s retirement date/year.
Here is a small example of how these funds work in practice.
Suppose you are an investor born in 2000-2001. In 2021 you finish your higher education at the age of 21 years. Now, you have close to 40 years left for retirement at 60. That is, 40 years from today is around 2060-61.
So you will pick a Target Date Retirement Fund 2060. Tt will have a higher equity component, given the number of years ahead. Maybe it would have 85 percent equity, 10 percent debt and 5 percent gold.
Compare this with an investor getting ready to retire during 2038-2042. They would be investing in a Target Date Retirement Fund 2040. It will have a comparatively lower equity component of, say, 75 percent.
Similarly, a Target Date Retirement Fund 2030 may just have 50 percent equity and Target Date Retirement Fund 2025 may have just 25 percent equity.
Changing allocations over the years
This is decided by the glide path – the rate at which a target-date fund adjusts its allocations to equities and debt over time. Also, different fund managers may have different frameworks to manage the glide paths of their funds. So, the funds with similar target dates can still transition/rebalance in different ways and at different times.
But in general, the broad approach is to systematically de-risk the retirement portfolio as one approaches retirement. And that is a wise thing to do in general to tackle the sequence-of-returns risk. But a reduction in the equity component as one gets closer to the target date doesn’t mean that the portfolio is completely de-risked with zero percent equity. Some equity still remains in the portfolio even after crossing the target retirement line.
Though target-date funds are still not available in India today, I am sure that whenever they are introduced, these will be great options for retirement savers. NPS is already here, but given its liquidity restrictions, it’s not a favorite of many retirement savers.
Till then, what’s the best approach to save for retirement in India?
Keep it very simple. Don’t look for exotic products. Just limit yourself to a combination of EPF (and VPF), PPF, debt funds and SIP in equity funds. These are more than sufficient for saving towards your retirement. You may even add NPS to the mix if you want to bring in the annuity angle.