Rethinking. the defined contribution core investment line-up. Better choices can lead to better outcomes

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1 Rethinking the defined contribution core investment line-up Better choices can lead to better outcomes Despite the changes in the defined contribution (DC) industry over the past 30 years, the typical core investment menu continues to fall short in meeting the needs of the vast majority of plan participants. Faced with complex or too many choices, participants end up making poor choices such as chasing performance that may leave them inadequately or overexposed to risky asset classes. J.P. Morgan Asset Management s Core Menu Innovation (CMI) is a new approach that aims to consolidate the entire core investment line-up into three broadly portfolios: stocks, bonds and cash alternatives. Underlying allocations are professionally managed to optimize asset class specific portfolio efficiency and are systematically rebalanced to maintain proper risk and reward characteristics. JOURNEY Spring 2012

2 While target date funds remain an effective investment solution for most DC participants, there are still some participants who opt out of their target date funds or who want to take a more active role in managing their investments. Replacing complex and often redundant core fund line-ups with a simplified menu of three investment portfolios can potentially increase participant engagement while narrowing the range of extreme investment outcomes. More options aren t necessarily better Until recently, the trend over the past decade has been to expand investment options in DC plans to provide participants with greater choice. Unfortunately, this approach has not delivered better investment results and may unknowingly have been detrimental to participant success. Behavioral research shows that while people say they prefer the idea of having more choice, having too many options can often lead to inaction or poor decision making. While the average DC plan includes 18 different investment options and often many more 1, the average participant invests in 3.6 funds 2. Often, having made their selections, only 7% of participants rebalance their investments over time and they rarely move into new line-up additions, according to J.P. Morgan Retirement Plan Services. Meanwhile, there is a fundamental disconnect between how participants view themselves as investors and how 1 PSCA s 53rd Annual Survey of Profit Sharing and 401(k) Plans, J.P. Morgan Retirement Plan Services. they actually invest their assets. Nearly 69% of participants consider themselves delegators those who prefer to invest in professionally managed asset-allocation funds, such as target date funds. But 80% of DC assets sit in do-it-yourself core menu options, potentially exposing participants to considerable investment risks, according to J.P. Morgan Retirement Plan Services. Developing a smarter DC core menu line-up Core Menu Innovation helps ensure that participant portfolios are structured to achieve more consistent and efficient investment results. This Consolidating the core menu into three straightforward options allows investors to focus on their asset allocations instead of individual fund selection. distinct approach goes beyond the current partial menu consolidation some plans are implementing. The Core Menu Innovation initiative aims to replace sub-optimal and often redundant fund line-ups with three institutional-quality, openarchitecture portfolios. Each investment option can incorporate existing investments from the plan sponsor s line-up or use other options outside the plan. Offering a simplified but more sophisticated core menu can potentially increase participant engagement and lead to better investment outcomes. Since most DC industry innovation has revolved around defaulting participants into target date strategies, Core Menu Innovation applies this same level of institutional thinking to participants who have opted out of target date funds or who have a view on how they want to allocate their investment portfolios typically do-ityourself investors. Consolidating the core menu into three straightforward options allows investors to focus on their asset allocations instead of individual fund selection. Individuals and plan sponsors also can get access to extended asset classes that they might not otherwise have access to with standalone options. Ultimately, the hope is that if people are more engaged with their plan and feel less confused they are more likely to make better investment decisions and set aside more for their retirement. Providing participants with better choices can lead to better outcomes over the long run. J.P. Morgan believes target date funds are effective investment solutions that meet the vast majority of DC participants investment needs, yet there are still a large number of participants who prefer to make investment decisions themselves. Core Menu Innovation is most appropriate for these participants. Benefits for Plan Sponsors For plan sponsors, there are multiple benefits to implementing a Core Menu Innovation approach. At a time when the investment and regulatory landscape has become more complex, plan sponsors are under more scrutiny to ensure they fulfill their fiduciary

3 a BUILDING THE RIGHT PLAN LINE-UP If participants prefer... A ready-made solution Feel uncertain about investing terms and concepts Lack the time or interest to study investment details Take comfort from having access to professional expertise 2020 they may want to consider... Choosing the target date fund closest to their expected retirement year b To choose their own mix Take the time to check their investments every few months Feel comfortable with stock market terms, but don t study the day-to-day changes c More investment options Prefer to balance choice with ease Thoroughly understand the different types of investments Enjoy taking the time to regularly study the stock market Consider investments outside the retirement plan when forming an investing strategy Selecting a mix from the plan s three core investment options. stocks Exploring the range of choices available in a self-directed brokerage account. Mutual funds bonds Individual stocks cash alternatives Target date funds are funds with the target date being the approximate date when investors plan to start withdrawing their money. Generally, the asset allocation of each fund will change on an annual basis with the asset allocation becoming more conservative as the fund nears the target retirement date. The principal value of the fund(s) is not guaranteed at any time, including at the target date.

4 obligations and act with responsibility for the prudence and suitability of participant investment decisions. The investment thinking driving this strategy is aligned to support fiduciary responsibilities. For one, the Core Menu Innovation platform is open architecture, allowing plan sponsors to build portfolios from their existing core line-ups or choose other options outside the plan. Core Menu Innovation encourages participants to focus on broader asset-allocation decision making rather than on the brand or the granularity of selecting individual funds. From a plan sponsors perspective, that helps reduce individual manager risk and decreases brand bias at the participant level. Plan sponsors also will be able to quickly replace an underperforming manager without potential backlash from participants who may be attached to a particular fund brand. Importantly, the strategy has the potential to capture greater fee efficiency and transparency when combined with a move from a mutual fund structure to a commingled fund structure. The commingled fund structure of Core Menu Innovation portfolios proposed by J.P. Morgan could be less costly than standard mutual funds and the fund of fund structure eliminates fee subsidization at a participant level. It also provides improved fee transparency by unbundling recordkeeping and investment management fees. Visit CoreMenuInnovation.com for more information on J.P. Morgan s evolutionary approach to the DC core investment menu. Implementation and communication J.P. Morgan believes the most effective way to implement the Core Menu Innovation strategy is through a re-enrollment program, which most plan sponsors may consider when making any substantial changes to the investment menu. Plan sponsors may receive QDIA safe harbor protection through a re-enrollment program for investments defaulted into the plan s QDIA. Plan participants are given the opportunity to make a new investment election for existing balances and future contributions. For participants actively making an election, they can select from the target date funds or create an asset allocation from the newly consolidated core menu options. Those who do not make an active election will be defaulted into the plan s QDIA. In its current iteration, Core Menu Innovation is best suited to plan sponsors with the scale to implement customized solutions. However, we expect high demand for the off-theshelf-type products for small- to midsized plans. Given that some participants may view the Core Menu Innovation implementation as a reduction in choice, it is important to position Core Menu Innovation in the context of the larger investment strategy and include the number of individual investment managers and styles embedded in the portfolios. J.P. Morgan found this was viewed as a positive thing in many focus groups it conducted as it was viewed as the choices were still available to them. In other words, participant choice is still preserved just moved to a potentially different channel, typically a brokerage window. At the same time, it also will be easier for plan sponsors to help investors choose appropriate portfolios based on the way they like to invest. Socalled delegators, for example, may opt for a ready-made solution, such as target date funds; do-it-yourself investors can select a mix from the plan s three core investment options; and the truly self-directed investors can build a portfolio from the range of funds and individual stocks in the self-directed brokerage account (see illustration on the previous page). Core Menu Innovation helps ensure that participant portfolios are better structured to achieve more consistent and efficient investment results. Historically, the types of participant communications that have worked well are those that have a specific call to action. By simplifying the solution set, plan sponsors can get more directive in terms of what participants can do which can ultimately lead to better outcomes. While some plan sponsors may be concerned about participant backlash, it is worth noting that plan sponsors in an effort to be better fiduciaries have already begun to reduce the number of funds in the core menu line-up in recent years with very little participant back-

5 lash. Additionally, many plan sponsors have re-enrolled and defaulted participants into target date funds the ultimate reduction in choice again with very little participant backlash. It is likely that the industry will see similar participant behavior when a Core Menu Innovation approach is implemented. Conclusion While we are not saying that Core Menu Innovation guarantees better outcomes compared with the traditional core line-up, re-thinking the core menu can help plan fiduciaries encourage better investment behavior. J.P. Morgan believes there are obvious challenges in the core menu today such as participants low rate of engagement or their tendencies to market time or invest sub-optimally but we can solve some of those problems by trying to narrow the range of extreme investment outcomes. As plan sponsors search for ways to consolidate line-ups and increase participant engagement, Core Menu Innovation takes those efforts to the next level, simplifying participant choice while providing access to the professionally designed asset allocation and sophisticated diversification solutions found in many institutionally managed defined benefit plans. Publications referenced in this material are presented for general educational purposes only. JPMorgan and its affiliates did not receive any compensation or consideration for referencing these titles. The opinions and information presented in these titles do not necessarily reflect the opinions of JPMorgan Chase & Co. and its affiliates. This document is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein may employ proprietary projections of expected returns as well as estimates of their future volatility. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Discussions presented should not be construed as legal opinions or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity that you represent or advise. Past performance is no guarantee of future results. J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties JPMorgan Chase & Co. All rights reserved. J.P. Morgan JOURNEY V