Focus on DC: Target date investing trends and opportunities

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1 J.P. Morgan Asset Management Research Summit 2011 Passport to opportunity Focus on DC: Target date investing trends and opportunities Daniel Oldroyd, CFA, CAIA Client Portfolio Manager, Global Multi-Asset Group With their emphasis on one-stop diversification and active asset allocation, target date funds (TDFs) are taking center stage in Defined Contribution* offerings. The DC world, however, faces a fundamental dilemma. While everyone from plan sponsors and recordkeepers to investment managers and advisers is trying to increase the certainty of participants retirement income, the participants themselves still determine how much to save, where to invest and when to withdraw from the plan. Building a successful target date approach requires an understanding of the interactions among participants inputs into the DC dilemma. * A defined contribution plan is a retirement savings plan in which an employee s benefits during retirement depend on the employee and/or employer contributions made to the account and the investment performance of the assets in his or her account. FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY NOT FOR PUBLIC DISTRIBUTION

2 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 02 Key presentation takeaways Target date funds are poised to dominate the defined contribution market as plan sponsors consider adding more open architecture and customized approaches. In order to select an appropriate TDF, plan sponsors need to identify and evaluate TDFs that align most closely with their overall goals and participants needs. Saving for retirement is a distant second compared with other financial priorities, according to a J.P. Morgan 2010 Participant Survey. While plan participants generally become more engaged in their plans as they get closer to retirement, they are still largely accidental investors. What is a target date fund? 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 retirement date. The principal value of the fund(s) is not guaranteed at any time, including at the target date. Target date funds are set to become the primary investment vehicle in DC Plans TDFs currently make up roughly 11% of the USD 4.9 trillion DC market and are forecast to grow to 40% to 60% of the market by 2015, according to Winning in the Defined Contribution Market of 2015, McKinsey & Co., Sept Meanwhile, nearly 70% of plan sponsors have chosen a TDF for their Qualified Default Investment Alternative (QDIA), according to Callan Investments Institute s 2011 Defined Contribution Trends Survey. At the same time, over 50% of plans use the TDF managed by their recordkeeper, according to industry estimates. (See Exhibit 1.) EXHIBIT 1 Target Date Funds poised to dominate DC market 13% Other 12% Stable value 10% Balanced 13% Mid/small cap 6% Large cap value 16% Fixed income 11% Target date 6% Large cap growth 13% Large cap core TOTAL DC ASSETS = USD 4.9 tril. TARGET DATE FUNDS: USD 539 bil. industry assets Forecast to grow to 40-60% of DC assets by 2015 Estimated 70% of plans use a TDF as their qualified investment alternative. Over 50% of plans use the TDF managed by their recordkeeper. Source: Cerulli Associates, RG Wuelfing and Associates., Callan Associates 2011 Defined Contribution Trends Survey. The information shown above is for illustrative purposes only.

3 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 03 EXHIBIT 2 Same target, different bullseye Diversification, equity exposure among 2010 TDFs can vary widely Asset class diversification % 15% 25% 35% 40% 45% 55% 65% 75% Percent of equity at retirement Data as of December 31, Powered by Lipper, a Thomson Reuters Company. Of the mutual funds available in Lipper s databases, as of 12/31/10, 47 fund suites were identified by Lipper as open end target date funds and are available for purchase by qualified retirement plans. (The ETFs ishares and TDX Independence Funds are excluded.) Percentage of equity exposure among 2010 TDFs at age 65: Strategic allocation to non-fixed income asset classes at target date, typically age 65. Asset class diversification: Determined by exposure, across each company s suite of target date funds, to 12 separate asset classes as reported to Lipper through asset allocation, capitalization, credit quality, sector, region and country data as well as underlying fund categorization. Please see the Target Date Compass Methodology booklet for additional information. As TDFs continue to grow, more plan sponsors are opting for an unbundled, or open architecture approach, over an off-theshelf, single manager approach. More plan sponsors are also taking a look at passive blend approaches in their TDF design that combine active management in less efficient markets and asset classes with index management in more efficient areas, such as U.S. stocks. Meanwhile, as more plan sponsors consider strategies like re-enrollment to drive more assets into the QDIA, some are investigating customized TDFs where they can tailor a glide path for their participants or use the existing managers in their plan lineup. Making sense of the target date funds universe With over 30 different TDF approaches to choose from, selecting the appropriate solution for a specific plan can be challenging. J.P. Morgan Asset Management s Target Date Compass is a tool that can help plan sponsors compare TDFs across providers and identify those that most closely align with their overall goals. Based on publicly available information, each fund family is mapped into one of four quadrants based on its percentage of equity exposure at the projected retirement date (X-axis) and the level of asset class diversification across the TDF suite (Y-axis). As Exhibit 2 illustrates, there is a wide variance in TDF objectives.

4 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 04 The level of equity at retirement, for example, can range from less than 10% to as much as 65% equities within 2010 TDFs. What is interesting to note is that TDFs have changed their strategies in response to the financial crisis. In 2007 and 2008, for example, many of the TDF managers in the Southeast quadrant (higher equities, lower diversification) shifted up on the model as they added more asset classes, while more investment firms also launched new TDFs in the Northeast quadrant (higher equities, higher diversification). In 2009 and 2010, TDFs continued to shift upward, but there was also a slight shift to the center axis as managers reduced their equity exposure in response to market volatility and the financial crisis. This year, more TDFs are moving from the south to north quadrants even as more firms launch TDFs in the Northwest quadrant (lower equity, higher diversification). Where the TDFs are in their respective quadrants will shed light on their glide paths. As Exhibit 3 illustrates, TDFs in the Northeast quadrant, for example, have a glide path with a gradually declining equity allocation but continue to hold higher levels of equity at retirement, while TDF managers in the Southwest quadrant tend to have a more conservative approach and typically pare back the equity positions to about 20% at retirement. Choosing an appropriate target date fund The first step in selecting a TDF starts with defining the goals for the DC plan as well as the desired outcomes for participants. The next step is to identify the TDFs that seek to produce outcomes that align with those goals. Conducting due diligence on those funds that are in alignment with your goals is the final step. To determine realistic plan goals, plan sponsors will need to examine what they know and don t know about the current environment and their plan participants. What s known, for example, in the current environment is that plan sponsors are the plan fiduciaries and that 401(k)s and DC plans are fast becoming the primary source of retirement income outside of Social Security. The unknown variables in this case include the market performance and future legislative changes. EXHIBIT 3 Target date fund designs are based on different goals and assumptions Representative allocations of different target date fund approaches for comparisons of tradeoffs Source: Industry prospectuses

5 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 05 When it comes to participant characteristics, plan sponsors know basic demographic data, such as participants age, income levels, average tenure and contribution levels. Among the safe assumptions they can make: participants aren t saving enough for retirement; many will start making withdrawals from the plan between the ages of 59 ½ and 65; and most aren t familiar with the best ways to use lump sums to extend retirement income. There are also plenty of unknowns, such as what the market environment will be like when participants start making withdrawals, their overall retirement portfolio strategy and whether they have any supplemental income sources. Choosing the appropriate strategy requires an understanding of how retirement outcomes are shaped by the TDF design and performance, and how different types of strategies can affect participant outcomes at retirement. In our view, outcomes are largely shaped by how a TDF manager approaches three key considerations: the risk-adjusted return potential, volatility management and the level of equity exposure at retirement. Plan sponsors also need to think about how aggressive or conservative the TDF strategy is and whether that strategy aligns with the objectives and goals of the plan. TDFs with higher levels of equity across the glide path will typically result in higher account balances at retirement but with potentially more ups and downs along the way. Conservative TDFs, meanwhile, may sacrifice potential upside but benefit from lower levels of volatility. Latest insights into participant behavior One of the key insights learned from J.P. Morgan Retirement Plan Services participant database is that participants remain accidental investors and saving for retirement is a distant second compared with other financial priorities. Consider participants responses to the 2008 financial crisis. According to the firm s database, less than 10% of people actually made any changes in their plans in the fourth quarter of 2008 an indication that for the most part, people aren t that engaged month to month or quarter to quarter. Meanwhile, only 17% of plan participants say that saving for retirement is a top financial priority, a distant second to paying monthly bills, according to a J.P. Morgan 2010 Participant Survey. (See Exhibit 4.) EXHIBIT 4 Daily expenses are most important Top financial priority 2% Saving for children s education 1% Other 5% Paying off/down car loan 5% Saving for emergency fund 12% Paying off/down mortgage 10% Paying off/down credit cards 17% Saving for retirement 49% Paying monthly bills Source: J.P. Morgan Retirement Plan Services, 2010 Participant Survey. In another sign that plan participants are largely accidental investors, about 37% of new participants in J.P. Morgan s recordkeeping complex in 2010 joined their DC plan through sponsor direction. In many cases, investors aren t maximizing the company match or making the full contributions for the year. Indeed, participant engagement using online advice tools, contacting call centers to ask questions and checking balances only starts to ramp up closer to retirement. And within a few years after retiring, most participants particularly those with larger balances tend to quickly pull their assets out of the plan. Designing a custom target date solution Larger plan sponsors generally those with over USD 500 million in DC assets are moving today to a custom TDF approach where, for example, they have the ability to build a glide path designed for their participants or can use the existing plan s managers. Custom TDFs also provide more room for plan sponsors to include alternative investment structures, such as insurance contracts, hedge funds or direct real estate investments.

6 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 06 Building a custom TD portfolio is, in many ways, similar to setting the plan s goals and objectives. The difference, however, is that plan sponsors can get more granular. Plan sponsors, for example, can get much more precise about setting their glide path objectives whether, for instance, they want their glide path to be managed to or through retirement. Plan sponsors also have more room to incorporate the participants behaviors into the design of the glide path. Looking forward A successful retirement program provides the most employees with the highest probability of maintaining their standard of living in retirement. Plan sponsors must establish realistic goals at the onset and consider a range of criteria, such as what they know and don t know about the current investment environment and the age, income and behavior of the plan s participants. Further, as more plan sponsors seek to unbundle existing TDFs in favor of more customized approaches, we believe plan sponsors have more opportunities to influence participants inputs into more predictable outcomes. 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 specific securities, 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 employs proprietary projections of expected returns as well as estimates of their future volatility. The relative relationships and forecasts contained herein are based upon proprietary research and are developed through analysis of historical data and capital markets theory. These estimates have certain inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees or other costs. References to future net returns are not promises or even estimates of actual returns a client portfolio may achieve. The forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Target date funds are funds with the target date being the approximate date when investors plan to start withdrawing their money. 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