UPDATE Russell ARA: Aiming for the bull s-eye. Innovative enhancements are the next evolution in target date investing. Improving on target date funds

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1 UPDATE Russell ARA: Aiming for the bull s-eye Innovative enhancements are the next evolution in target date investing Josh Cohen, CFA, Managing Director, Head of Institutional Defined Contribution Jeff Eng, CFA, Director, Retirement Income Solutions What happens when you take the ease of using target date investing and add some of the individualization available in managed accounts? You have a recipe for transforming the way plan participants invest for retirement while providing a clearer picture of how well they are tracking toward meeting their retirement goals. Improving on target date funds In early 2012, Russell Investments introduced an innovative new managed account, based on asset class level assumptions designed to be used as a qualified default investment alternative (QDIA) Russell Adaptive Investing (RAI). Defined contribution (DC) plan sponsors can use the RAI approach to help participants construct a personalized asset allocation called a Russell Adaptive Retirement Account (ARA), thereby improving retirement outcomes over age-based glide paths associated with traditional target date funds. When target date funds were first introduced, their ability to provide an appropriate asset allocation based on the projected retirement date of a typical plan participant was a feature embraced by plan sponsors and participants alike. Each target date fund has a set glide path designed to meet a participant s retirement income goals without the need for lengthy personal interviews and individual data gathering. More importantly, because target date funds automatically adjust their asset allocation based on participant age, they offer a costeffective, age-appropriate default solution for participants and a level of fiduciary protection for plan sponsors as well. Participants end up with a diversified portfolio using age as the key factor in setting the asset allocation. These features have made target date funds a popular default investment option, particularly as compared to prior solutions such as stable value funds, static balanced funds or self-directed participant portfolios. Using these attractive features of target date investing as a starting point, Russell Adaptive Retirement Accounts evolve the default investing solution by keeping the best of target date investing while addressing some of its shortfalls. Russell Investments // UPDATE Russell ARA: Aiming for the bull s-eye MAY 2014

2 We know that demographic data beyond age can matter when it comes to retirement outcomes. For example, we know that building customized target date funds for a specific plan based on that plan s average demographics, such as median salary, contribution rate and retirement age results in asset allocation glide paths that differ from those of the typical plan. Exhibit 1 shows the results of various customized target date glide paths relative to those of Russell s standard glide path. As the graph illustrates, while they all possess the same basic shape, there can be differences of as much as 15% in growth assets in certain parts of the glide paths. The glide path allocates between Growth and Capital Preservation assets. Exhibit 1: Custom glide paths based on different average participant demographics Source: For illustrative purposes only. Not meant to represent any actual investments. In this example, Client A s participant planned to retire at a younger age than Client B s or Client C s participant. Therefore, the glide path allocation to growth assets started to decline sooner for Client A s participant. Client A s participant s ending glide path allocation to growth assets remained slightly higher than those for Client B s and C s participants to compensate for a longer time horizon in retirement. Since we know that plans with different average demographics can have an impact on the resulting glide path, then certainly individual participants within each plan would benefit from having glide paths tied more closely to their specific demographic information. A tale of two brothers Another important factor that influences retirement investment outcomes is the market experience during the specific time period in which a participant lives and saves. For example, let s imagine two brothers, born five years apart. They have similar jobs with the same salary; save in the same way: The older brother started working in 1977, during a period of tough financial times, which included rising inflation, an oil embargo, and more. Based on the assumptions shown in Exhibit 2, he invested in a standard 60/40 portfolio; he could have $637,000 by age 55. His younger brother started working in 1982, during the Reagan administration. He also invested in a standard 60/40 portfolio, but by age 55 he has only $384,000. Why the difference? Two brothers, similar in every way, had different outcomes due to market factors. In order to meet their respective retirement income goals, these brothers probably should have used different investment strategies, but with traditional target date funds, that s not an option. Russell Investments // UPDATE Russell ARA: Aiming for the bull s-eye 2

3 Exhibit 2: Adjust your investment strategy to stay on track Comparing 30 year periods For both cases, assumes $30,000 starting salary, 2% inflation, 10% annual contributions and allocation to 60% MSCI World Index and 40% Barclays US Aggregate Bond Index static portfolio. Hypothetical example provided for illustrative purposes only. Analysis is based on the assumptions noted. Indexes are unmanaged and cannot be invested indirectly. Past performance is not indicative of future results. More data, better allocation Russell s glide path methodology is designed to provide an asset allocation through time that can give plan participants the highest probability of meeting income replacement goals while minimizing the risk of falling significantly short. Russell ARA is designed to further increase the probability of reaching targeted retirement income goals by taking into account multiple data points beyond age for each participant such as savings rate, current salary, gender, account balance when assigning asset allocation. In other words, Russell ARA gives participants a higher level of customization over the one-size-fits-all approach of traditional target date funds by factoring in more than just age. Russell ARA uses data points that are already available from the record keeper and plan sponsor. Through a technology platform, collecting the data is as simple as pulling information already in the record keeper s or company s HR system and does not require additional information from, or interaction with, the participant. With this information and using an asset allocation model, Russell ARA customizes a retirement income goal for each individual participant, based on present salary; expected pay increases; the existence of a defined benefit plan, or any other retirement savings; any projected income from Social Security; and Russell s capital market assumptions (See Exhibit 3). Exhibit 3: The six pieces of information needed to implement a Russell Adaptive Retirement Account Participant age Age is used to determine length of time to retirement Contribution rate Current account balance Salary Gender Does participant also have a defined benefit plan? How much savings will continue to go into the account? How much has the participant accumulated to date? Used to determine the required income replacement goal Statistics show women will need their retirement income to last longer If so, reduces the amount of income needed from the defined contribution plan Russell Investments // UPDATE Russell ARA: Aiming for the bull s-eye 3

4 When all of these data points are taken into account, Russell ARA uses the formula in Exhibit 4 to give participants a measurement of how well they are tracking toward meeting their retirement goals, a measurement we call the Funded ratio. The Funded ratio is then used as the basis using a financial model to begin building an individual asset allocation for each participant. Exhibit 4: Begin by finding the Funded ratio for each participant Exhibit 5: Putting the data to work at five years to retirement Source: Russell Investments. This is a hypothetical example shown for illustrative purposes only and is based on the following assumptions: 6% contribution rate, 40% target replacement income, $49K starting salary, 1.5% annual salary growth and retirement age of 65. Once the Funded ratio is determined, we know how well a participant is tracking toward meeting the retirement goal, and an asset allocation can be determined. The participant s customized asset allocation is then implemented based on the funds available on the plan menu. Every quarter, we examine how well a participant is tracking for an adequately funded retirement and make changes to the asset allocation as necessary. In Exhibit 5, the blue zone represents participants who are on target of their retirement income goals. For these participants, exposure to risky assets is minimized. This relatively more conservative risk strategy supports their continued funding at the same pace and to help avoid the chance of their savings falling below target. The gray zone represents participants who are well above target. They have saved aggressively, and/or the market has been kind to them. They are well situated to reach their retirement income goals. Interestingly, unlike participants in defined benefit plans, where there is not much upside in taking on more risk, participants who are overfunded in defined contribution plans may benefit by taking on some risk. The opportunity to create additional Russell Investments // UPDATE Russell ARA: Aiming for the bull s-eye 4

5 income in retirement can potentially result in an increase in lifestyle spending or a larger bequest to heirs. The orange zone represents participants whose funding is below target. They are in a position similar to that of participants in an underfunded defined benefit plan, and some of them may consider taking on additional risk as they seek to meet their retirement income goals. However, it is important to note that risk should never be taken to the point of further jeopardizing retirement savings, and that participants who are greatly underfunded will not be able to invest their way out of a savings problem. We recommend communicating to these participants that they should increase their savings instead. Consider the differences when compared to the standard Russell target date fund allocation: Exhibit 6: Asset allocation based on individual characteristics Sample allocations are provided for illustrative purposes only and are based on assumptions provided. The above examples show the asset allocations for three different participants. They are all 15 years away from retirement at age 65, but they have different funded ratios and different probabilities of meeting their targeted retirement income goals. With a target date fund, they would all have the same asset allocation based on an age of 50, but that would not necessarily improve the probability that each participant will achieve their retirement goal. Russell ARA is designed to help improve retirement outcomes by adjusting each participant s asset allocation strategy relative to funded ratio and time horizon to retirement. Participant A is underfunded relative to income goal, so ARA would recommend a higher allocation to growth assets as a way to potentially increase her retirement savings. Participant C, on the other hand, is overfunded relative to income goal and it is highly likely that he will achieve his income goal. Therefore, ARA would advise Participant C to invest in more growth assets to potentially provide for a higher retirement income level. Lastly, Participant B has a funded ratio that is on track to meeting his retirement income goal, so ARA would seek to maximize the probability of that outcome by reducing allocation to growth assets and increasing allocation to capital preservation assets. Russell Investments // UPDATE Russell ARA: Aiming for the bull s-eye 5

6 Implementation The next logical question for a plan sponsor is What is the best way to add Russell Adaptive Retirement Accounts to my plan? Since ARA is designed as a default option, the most effective way to use it in a plan is to have it replace the plan s Qualified Default Investment Alternative (QDIA). For example: if the plan offers a series of target date funds as the default option, those target date funds would be replaced by Russell Adaptive Retirement Accounts and each participant would be mapped into ARA. After that all new participants that do not choose an investment election would also be placed in ARA. Additionally, if the plan sponsor believes that the majority of their participants could benefit from ARA, it may make sense for them to do a full plan re-enrollment and get all their participants invested in asset allocations designed to help them achieve better retirement outcomes. Ready, set, go By building a retirement income target for each individual, you point participants away from traditional lump-sum goals and toward goals that are defined not by simple wealth accumulation, but by how well they could potentially replace their salary in retirement. Another benefit to Russell ARA is that results are reported as expected annual income in retirement. For example, instead of reporting that the participant is projected to accumulate $500,000 by age 65, the statements report that starting at age 65; the participant may be able to receive a yearly income of $30,000. Exhibit 7: Sample ARA report Example provided for illustrative purposes only and is not meant to represent any actual portfolio. The use of a retirement income goal in communications with plan participants and setting asset allocation strategies can do two things. First, it provides a more relevant context for the performance and measurement of their retirement plan. Second, it provides information about participants potential need to adjust asset allocation, increase contribution rates, and/or adjust their expectations about when they may be able to retire. For those participants who want greater engagement with their plan, we can provide tools for modeling changes to their retirement investing. Russell ARA web tools allow participants to access customized investment reports and advice. A focus on retirement income also gives the sponsor a different view of their plan. With ARA reporting, the sponsor can focus on participant outcomes as a measure of the plan s success; evaluate participants likelihood of achieving their retirement goals and track improvements in contribution rates and replacement ratios. Russell Investments // UPDATE Russell ARA: Aiming for the bull s-eye 6

7 Exhibit 8: Sample report Example provided for illustrative purposes only and is not meant to represent any actual portfolio. Conclusion Russell ARA not only offers the well-known benefits of target date funds, but also creates a customized managed account for each plan participant based on progress toward meeting retirement income goals. To help support participants progress, the account is monitored and adjusted on a quarterly basis. We believe Russell ARA s enhancements in individualization represent a significant step forward in the evolution of target date Exhibit 9 * Participants pay a fee for a Russell Adaptive Retirement Account. Russell Investments // UPDATE Russell ARA: Aiming for the bull s-eye 7

8 ABOUT RUSSELL INVESTMENTS Russell Investments provides strategic advice, world-class implementation, state-of-the-art performance benchmarks and a range of institutional-quality investment products, serving clients in more than 35 countries. Russell provides access to some of the world s best money managers. It helps investors put this access to work in defined benefit, defined contribution, public retirement plans, endowments and foundations and in the life savings of individual investors. FOR MORE INFORMATION: Call Russell at or visit Important information Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Russell Adaptive Retirement Accounts is a product of Russell Investment Management Company (RIMCo). The implementation of Russell Adaptive Retirement Accounts in investors portfolios and related investment advice are provided through investment advisers and other financial intermediaries that are independent of RIMCo and its affiliates. The advice provided by RIMCo in Russell Adaptive Retirement Planner is based on asset-class level assumptions only. Your employer has designated the funds included as representative of specific asset classes (such as U.S. equity, U.S. fixed income, etc.) included in Russell Adaptive Retirement planner for your company and may change their designations at any time. Russell Adaptive Retirement Planner utilizes a quantitative model. The asset allocation generated by the model is dependent upon the factors used in the quantitative analysis, the weight placed on each factor, and changes from the factors historical trends. These factors include Russell Investments capital markets assumptions, which may differ from actual results, and the models asset allocation may be more aggressive or more conservative than necessary. There can be no assurance that the model will enable Russell Adaptive Retirement Planner to achieve its objective. Models may be flawed or not work as anticipated. The projections produced by Russell Adaptive Retirement planner are estimated by using Russell s capital markets assumptions and are subject to change based on market conditions. There is no guarantee that the stated projections will be achieved. Investing in a Russell Adaptive Retirement Account involves risk; principal loss is possible. The principal value of the account is not guaranteed at any time. Strategic and Adaptive Asset Allocation and diversification do not assure profit or protect against loss in declining markets. The Russell Adaptive Retirement Account ("ARA") does not assure a profit or protect against loss in declining markets. There is no guarantee that ARA will result in a better outcome than traditional Target Date fund investing. THIS MATERIAL IS FOR INSTITUTIONAL INVESTORS AND PLAN SPONSOR USE ONLY. IT IS NOT FOR DISTRIBUTION TO CURRENT OR POTENTIAL INVESTORS. Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. The Russell logo is a trademark and service mark of Russell Investments. Copyright Russell Investments 2013, All rights reserved. This material is proprietary and may not be reproduced, transferred or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: February 2013 (Revised May 2014) USI Russell Investments // UPDATE Russell ARA: Aiming for the bull s-eye 8