Roundtable. Retirement. issues to consider in deciding if a custom target date strategy is right for your defined contribution plan

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1 Brought to you by: Retirement Moderator: Peter Gallagher National Sales Manager, Institutional Business Development, Invesco Celine Dufetel Principal McKinsey & Company Greg Jenkins, CFA Senior Director, Consultant Relations, Invesco Kathryn Capage Director of Retirement Research, Invesco Jason King Senior Product Strategy Manager, Product Strategy and Investment Services, Invesco Roundtable Key issues to consider in deciding if a custom target date strategy is right for your defined contribution plan we spoke with several experienced Recently, retirement industry professionals including Celine Dufetel, Greg Jenkins, Kathryn Capage and Jason King to discuss their views on the growth of the target date market and the trend toward designing custom strategies to better meet the needs of today s plan sponsors and participants. Peter: Target date funds have exploded in growth over the past 10 years, largely since their debut as a qualified default investment alternative (QDIA) in In the wake of the 2008 financial crisis, the decline in participants assets increased scrutiny that the one size fits all design in most off-the-shelf target date funds may be flawed. Target date funds now hold a prominent position on plan sponsor, participant and government agendas. Recently we ve begun to see these products evolve to seek better outcomes for participants, with such innovations as multi firm management, introduction of alternative asset classes, multiple vehicle and packaging options, as well as the ability to design custom target date strategies.

2 Peter: Celine, as we see changes occurring in not only the defined contribution market, but also in target date funds specifically, I m sure many plan sponsors want to know how their peers are adapting. What are you seeing in terms of usage and growth of target date funds in defined contribution (DC) plans? Celine: We are continuing to see growing adoption of target date funds. Recently we ve seen a rise in plan sponsors re-defaulting participants. The plan sponsor is not only using auto-enrollment on a goforward basis, but also going back and defaulting current employees who are not in the plan. This will have a significant impact on target date fund growth, given their role as the default option in many plans. By 2015, target driven solutions will account for 60% of defined contribution plan assets. McKinsey & Company Study 1 A target date fund identifies a specific time at which investors are expected to begin making withdrawals, e.g., Now, 2020, The principal value of the fund is not guaranteed at any time, including at the target date. Peter: I mentioned earlier that we ve begun to see some innovation in the way target date products are designed. In the smaller end of the market, we still see a number of plan sponsors using proprietary offerings that may introduce new asset classes or vehicles like ETFs. In the larger end of the market, and even to some degree in the mid-plan market, we ve seen a trend toward more customized target date strategies. Can you provide some insight into what you re seeing as the key drivers for plans that are considering a custom approach? Celine: Like many innovations in the DC world, we see things start with the mega plans and then make their way down market to the large and mid-sized plans. First and foremost, I think plan sponsors are starting to consider what percentage their plans target date funds, which are likely the default option, represent of total plan assets. As target date funds become an increasing share of the plan assets, it forces the question, Do we want to have the majority of our assets with one fund manager? We all know target date funds represent a large percentage of the flows into DC plans, and as time goes by the flows become assets. Those assets can be a significant share of the total plan to be concentrated with one manager. It can lead to the question of, Is this what we want to do from a fiduciary standpoint and do we want more control over manager choices for different asset classes? I also believe that the events of 2008 have shed some light on target date funds, not only in performance losses, but in construction as well. This has likely encouraged plan sponsors to evaluate their target date strategy more than they have in the past. Plan Sponsors believe in the idea of target date funds, but now seek to improve the execution. Casey Quirk Study 2

3 Peter: As we talk about the adaptation of target date funds in the wake of the financial crisis, managing all aspects of risk has been a key area of focus. In talking with consultants who design custom target date strategies, can you give us any insight into what you are hearing in terms of plan sponsors having greater oversight on these products? Greg: Having greater oversight of a plan s target date strategy is a hot topic right now for plan sponsors and their consultants. With many offthe-shelf target date products, the plan sponsor has limited or no control over the fund. As Celine mentioned, for the larger end of the market these strategies can make up a large share of the total plan assets, and implementing a custom strategy can put plan sponsors back in command. First, it provides control of underlying managers. According to PSCA s Target Date Fund Study, 2 nearly one-third of plan sponsors surveyed who implemented a custom strategy, say they did so to have greater control over underlying managers. Naturally, plan sponsors want to offer the best options possible. After seeing target date funds gain traction in concept with participants and acceptance from a regulatory standpoint, it makes sense that they are now turning their attention to the construction. It reminds me of how the proprietary recordkeeping platforms were forced by the marketplace to embrace open architecture. Once plan sponsors conquered some of the other challenges associated with offering DC plans, they wanted better access to investments. Plan sponsors now have the ability to offer best-in-class managers inside of target date funds, and can perform their own due diligence or get help from their consultants. If it would be prudent to replace an underperforming manager in the target date strategy or increase diversification by adding a manager, they can do it themselves- potentially lessening risk to the overall plan, the fund and the participants. With an off-the-shelf product, they can t make those decisions. In addition, many plan sponsors already perform this due diligence on their core investment options or on their pension plans. The resources may already be in place; it s just a matter of leveraging that research for the target date funds. Respondents by Reasons for Building a Custom Target Date Strategy 9% 9% 17% 34% 31% Control of underlying managers 34% Wanted a more diverse asset allocation 31% Fee transparency/cost 17% Fiduciary concerns over buying off-the-shelf 9% Wanted a custom glidepath 9% Source: Casey Quirk/Profit Sharing Council of America Target-Date Fund Survey,

4 Second, as Celine mentioned, it removes manager concentration risk. Few plan sponsors would offer only one manger to handle all the investments in their DC plan so why do it in a target date strategy? This also allows separation of the asset allocation function from investment management function. Lastly, cost containment is a big consideration. Many times, fees can be much higher in an off-theshelf product. Plan sponsors in the larger end of the market can utilize their scale to secure lower fees through more cost-effective vehicles such as collective trusts or institutional shares. Peter: Celine, the glidepath which is the rate at which the asset mix changes over time, has been referred to as the backbone of a target date fund. Do you have any thoughts on considerations for plan sponsors or consultants looking to design a custom glidepath? Celine: Plan sponsors should consider what other forms of retirement vehicles the employee population may have access to. If the DC plan is the primary retirement vehicle or if it s in complement to a DB plan, they may have a different perspective on what kind of glidepath is appropriate for their employees. Also, based on the demographics of the plan and who the employees are, an employer may form a different perspective on just how aggressive they want the funds to be or how they want the glidepath to look. After seeing target date funds gain traction in concept with participants and acceptance from a regulatory standpoint, it makes sense that plan sponsors are now turning their attention to the construction. Greg Jenkins, CFA, Invesco Peter: As mentioned earlier, there has been a lot of chatter on Capitol Hill on this topic. One area of discussion has been the need for more detailed disclosure at the participant level on the structure of the glidepath. Do you foresee any coming legislative action on this? Kathryn: Legislation is still pending in this area; however, regulation I am seeing already. Whether a plan sponsor utilizes an off-the-shelf product or have designed a custom strategy, I expect that communicators will be required to clearly articulate the details of the glidepath provided. Plan sponsors will need to ensure they are offering enough information so that their participants clearly understand how the target date glidepath works for them. As part of that communication process, plan sponsors should encourage participants to consider their outside investments, whatever their spouse is investing in, and personal needs as well when evaluating if the target date strategy is right for them. In addition, do expect the literature and disclosure requirements to change in the near future.

5 Peter: Once a plan sponsor has made the decision to go custom, there are a lot of things to consider in terms of asset allocation and glidepath construction as Celine touched on earlier. Jason, in your role in product strategy, you ve engaged in the development of the asset allocation framework on numerous products. In your experience, what are the key considerations for plan sponsors and consultants when developing their own custom asset allocation framework for target date funds? Jason: At the end of the day, various models and due diligence efforts can help mitigate risks, but the cost of getting it wrong can be enormous for participants. I have found the best risk control is to invest the time in understanding participant needs, risks and investment objectives. It is not sufficient to jump into the fray with preconceived notions of the appropriate fixed income and equity allocations along an arbitrary glidepath. Plan sponsors need to consider the broad range of individual risk profiles associated with a diverse participant base. Building an asset allocation framework is an extremely critical and complicated function. Working with an experienced consultant could be helpful with this design. A few sample questions that plan sponsors and their consultants should consider include: How will the strategy match the appropriate asset class exposures to the needs and objectives of your participant base? How can the asset allocation and glidepath be constructed to avoid some of the market extremes that traditionally have thrown many investors off the right path? Should the strategy include tools that facilitate making tactical allocation changes, and if so, what is the best way to accomplish this? How should the portfolio s asset class assumptions be tested? What are the primary economic outcomes that investors are likely to face, and how should you allocate against that? Asset Classes to Consider The chart below illustrates various asset classes to consider when building a custom target date strategy that seeks to defend against losses in the three major economic environments. Inflationary Growth Recessionary/deflationary Low-Inflationary Growth Inflation hedges may include: Commodities Direct real estate Treasury Inflation-Protected Securities (TIPS) Deflation hedges may include: Long-term government bonds Growth assets may include: Emerging-market equities Developed-market equities Stocks may decline in response to investor sentiment, general economic and market conditions, regional or global instability, and currency and interest rate fluctuations. Fixed-income products, such as corporate bonds, are subject to the effects of changing interest rates. Obligations issued by U.S. government agencies and instrumentalities may receive varying levels of support from the government, and Treasury Bills and long-term government bonds would be affected should they default. Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds. An investment in emerging market countries carries additional risks compared to more developed economies. Investments focused in a particular sector, such as real estate, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

6 Peter: I d like to thank our distinguished contributors for their insight. With custom target date strategies gaining traction, it is important for plan sponsors to evaluate not only the benefits, but also the commitment. We hope this roundtable offers some guidance on several of those key considerations. Looking at economic periods of non-inflationary growth, inflationary growth and recession, one or more asset classes can be identified as beneficiaries of each outcome. For example, non-inflationary growth has historically benefited equities, due to generally brisk real growth and controlled inflation. Certain bonds, such as high yield, also have historically benefited in such times. Longterm government bonds historically perform best in periods of recession, as short-term interest rates, real growth and inflation fall. Inflationary growth has historically supported the returns of real assets, such as commodities and inflation-linked bonds. Plan sponsors will need to consider both which asset classes to include for such objectives and how those asset classes will be combined. Invesco s Defined Contribution Institute is dedicated to helping plan sponsors and their consultants build better plans with insights from Invesco s experts. For more information about this and other timely topics relevant to defined contribution plans, please contact your Invesco representative, us at IDCI@invesco.com or visit us at Once you have your final product, plan sponsors and consultants need to ensure that participants understand the underlying premises that were established for these issues. Confusion among participants on how a target date strategy works for them can undermine the best of efforts. 1 McKinsey & Company Study Winning in the Defined Contribution Market of 2015, September Casey Quirk Study Target-Date Retirement Funds: The New Defined Contribution Battleground, November Profit Sharing Council of America Target-Date Fund Survey, March 2009 Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should contact their advisers for a prospectus and/or summary prospectus or visit invesco.com/fundprospectus. Note: McKinsey & Company is an independent organization and is not affiliated with Invesco. For more information on any of the topics discussed, please contact your Invesco representative. This roundtable is not intended to be legal or tax advice or to offer a comprehensive resource for tax-qualified retirement plans. Always consult your own legal or tax professional for information concerning your individual situation. All material presented is the opinion of the contributors and compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment making decision. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. The Chartered Financial Analyst (CFA ) designation is globally recognized and attests to a charterholder s success in a rigorous and comprehensive study program in the field of investment management and research analysis. Asset allocation does not guarantee a profit or eliminate the risk of loss. invesco.com/us IDCIRR-BRO-2 05/11 Invesco Distributors, Inc. 5473