It s Getting Personal: The Shift to Customized Portfolios. Chris Weirath Head of Production Management, Managed Solutions Morningstar

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1 It s Getting Personal: The Shift to Customized Portfolios Chris Weirath Head of Production Management, Managed Solutions Morningstar

2 What is your current QDIA/default investment option for your DC plan? 1. Balanced fund 2. Off-the-shelf target-date fund 3. Custom target date-fund 4. Managed accounts 5. None 6. Don t have a QDIA

3 Did you seriously consider or conduct extensive due diligence on managed accounts when selecting your QDIA? 1. Yes 2. No

4 The Evolution Toward Custom Solutions Default investing has evolved over the last 20 years. The trend: more customized solutions applying the best in what we have learned in behavioral finance and the individual participant data available.

5 The Evolution Toward Custom Solutions Default investing has evolved over the last 20 years. The trend: more customized solutions applying the best in what we have learned in behavioral finance and the individual participant data available.

6 Equity Exposure (%) Pick One Target-Date Funds To Choose From For illustration only Age

7 Is Everyone the Same? Can you imagine walking into the doctor s office and getting a shot/pill/operation based on the average 30/40/50/60 year-old? How can a solution that invests everyone in the same portfolio regardless of risk tolerance or retirement readiness be optimal?

8 Why Do You Hold More than One Target-Date Fund? I m not sure what year I m going to retire 70% It s a bad idea to put all of my eggs in one basket 61% I selected a fund based on the year in which I expect to leave my current employer, even if I m not retiring. I want a higher mix of stocks than my real retirement date will give me. I m saving for retirement and other goals as well, such as a child s education or vacation home. I want a higher mix of bonds than my real retirement date will give me. 36% 31% 24% 22%

9 Personalization for Portfolio Construction Comparison of a typical target-date fund allocation with typical allocation for a managed account user, leveraging only basic data available via the recordkeeper.

10 Leveraging Available Data - Advantages of Managed Accounts Intelligent Use of Readily Available Individual Data Managed Accounts Target-Date Funds Age Salary Account Balance Age Gender Where You Live Sponsor Match Design Social Security Impact Savings Rate Pension & Other Plans

11 Disadvantages of Managed Accounts Incorrect Perceptions Not appropriate for a QDIA Only viable for older participants or those who have outside accounts Cost prohibitive

12 The Impact of Managed Accounts: More Wealth in Retirement Participants increased their savings rates by nearly 28% after using the program, an average of 2% of their salary. 1 87% of participants increased their savings rates after receiving recommendations. 2 Before using the program, almost half (48%) of participants in this study held 3 or fewer funds suggesting participants who choose to manage their accounts themselves may not have a diversified portfolio. 3 After using the program, the majority held 6 or more funds. Participants enrolled in the program maintained their equity allocations throughout this economic cycle. Those not enrolled reduced their allocations and did not raise them back entirely, potentially missing out on market gains. 4 A 25-year-old participant could have almost 40% more retirement income from an advice and managed accounts service with an annual fee of 0.40%. Also, there is an 89% chance that a 25-year-old using the program will have greater retirement wealth. 5

13 Example #1: Odds of Advice Paying Off How Do We Spend Our Alpha/Expense Budget?

14 Example #1: Odds of Advice Paying Off Quantifying the Value of Financial Planning Gamma Factors Holistic View Dynamic Withdrawal Annuity Recommendation Tax-Efficient Investing Liability Driven Investing More than risk tolerance Human Capital Risk Capacity Go beyond the 4% rule Based on returns and life expectancy Account for all income sources Not a one-size-fitsall approach Wealth Time horizon Income sources How to place assets How to withdraw assets Account for inflation Potentially 23% more income Source: Through a series of simulations, researchers estimate a hypothetical retiree may generate 23% more income on a utility-adjusted basis utilizing a Gamma-efficient retirement income strategy that incorporates the concepts total wealth, dynamic withdrawal, annuity allocation, asset location and withdrawal sourcing, and liability-relative optimization, when compared to a base scenario which assumes a 4% withdrawal rate and a 20% equity allocation portfolio. The results from these simulations are hypothetical in nature, not actual investment results, and not guarantees of future results. For more information and to receive a copy of the 2013 study, Alpha, Beta, and Now Gamma, please contact Nadine Pizarro at nadine.pizarro@morningstar.com

15 Example #2: Where Do You Live? State Taxes Matter Case Study Technology Corporation XYZ Headquartered in San Francisco California state income tax of 10+ percent Bulk of employee growth is in Las Vegas, NV Zero percent state income tax Two identical employees - UX Designer, same age, job code, and pay band William eats sushi twice a week in the Bay Take home pay is 60 percent of his gross income each week 10 percent state income tax John eats the Caesar s buffet twice a week Take home pay is 70 percent of his gross income each week No state income tax

16 Example #2 Where Do You Live? Impact of State of Residence on Advice William in San Francisco Lower income goal in retirement Smaller amount of human capital More difficulty implementing the suggested savings rate Larger portion of total wealth in real estate

17 Example #3 Gender Matters in Financial Planning: Who is the Average User? Average User Men Female

18 Example #3 Gender Matters in Financial Planning: Investment and Risk Differences in Gender Risk Capacity Women have lower earnings than men (on average) Women exhibit discontinuous income, they drop out of the workforce for child rearing and drop back in at lower levels of comp than if they d been continuously working Women live longer Women are often head of single family households Risk Preference Research suggests that women are more risk averse than men Source: Morningstar Inc. For illustration only.

19 Example #3 Gender Matters in Financial Planning Behavior Differences in Gender for Female Users of Managed Accounts More Engaged More repeat sessions More likely to provide information about outside accounts More likely to provide spousal information Inertia is a Larger Risk Are less likely to increase savings rates Those that increase savings, tend to increase lower rates However, they have larger recommended changes Source: Morningstar Inc. For illustration only.

20 Example #3 Gender Matters in Financial Planning: Gender Impact on Optimal Advice More volatile human capital Longer retirement period More risk averse More engaged Less likely to implement changes Source: Morningstar Inc. For illustration only.

21 Social Security Replacement Rate Example #4: Social Security Replacement is Highly Variable: Case Study Diversified Financial Services Firm Variability of Social Security Income Replacement Rates 100% 90% 80% 70% 60% 50% Customer Service 40% 30% Investment Professional 20% 10% 0% $10,000 $50,000 $90,000 $130,000 $170,000 Income Source: Morningstar calculations and the Social Security Administration

22 Example #4 Social Security Replacement is Highly Variable: Social Security Replacement Rate Impact on Advice The Customer Service Rep Higher total income replacement goal Lower income replacement goal for their DC plan Lower savings rate recommendation More aggressive investment recommendation The Investment Professional Lower total income replacement goal Higher income replacement goal for their DC plan Higher savings rate recommendation More conservative investment recommendation Source: Morningstar Inc. For illustration only.

23 A Shifting Balancing Act

24 Important Disclosures A total of 58,444 participants were included in the study based on available participant information and various filters and include those that used Morningstar Associates Morningstar Retirement Manager SM Managed Accounts or Advice service between the dates of January 2006 and February The average increase in saving deferral rates is determined by analyzing each participant s savings deferral rate prior to using and after using the Morningstar Retirement Manager service. The result is the average across all participants included in the study. 2 The percentage of participants that increased their savings deferral rates is determined by comparing each participants savings deferral rate prior to and after using the Morningstar Retirement Manager service. Participants who increased their savings deferral rate after utilizing Morningstar Retirement Manager are included in this data point. 3 For purposes of this study, do-it-yourself participants (those mentioned as not previously using our advice and managed accounts service) are defined as those who have an allocation of 20% or less to an investment classified as an allocation (such as a target-date) fund by Morningstar, Inc. prior to using Morningstar Retirement Manager. The portfolio asset allocations held by participants prior to using Morningstar Retirement Manager were classified by investment type and those meeting the definition of a do-it-yourself investor s portfolio were analyzed to determine number of funds held in the portfolio. 4 Average equity allocations of participants prior to using Morningstar Retirement Manager are analyzed from May 2007 to February 2014 and compared to the value of the S&P 500 Index. 5 This figure represents the likelihood that a participant could potentially have more wealth at retirement by using Morningstar Retirement Manager. This analysis is based on a 58,444 participants that used the Morningstar Retirement Manager service between the dates of January 2006 and February For each participant in this universe, the hypothetical future one-year performance using the participant s portfolio prior to and after using Morningstar Retirement Manager is calculated. The difference between these results was then projected forward to the participant s assumed retirement at age 65, including an annual fee of 0.4%. Participants were categorized based on their age upon first using Morningstar Retirement Manager, and the ratio of participants in each age category who had better results after using Morningstar Retirement Manager to the total number of participants in that category was calculated to arrive at the aggregate likelihood value. For example, the analysis shows that an average 25- year-old using Morningstar Retirement Manager has an 89% likelihood of having more wealth at retirement compared to an average 25-year-old who did not use the service. The likelihood amount varies by age, and tends to decrease with the age the participant first uses the Morningstar Retirement Manager service, i.e., a 45-year-old has an 80% likelihood and a 60-year-old has a 56% likelihood of having more wealth at retirement. Additionally, the likelihood of more wealth at retirement increases as the management fee decreases; conversely, decreases as the management fee increases.

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