Stacy Schaus Discusses Defined Contribution Trends and Concerns with Target Date Investment Defaults. Stacy Schaus, CFP Senior Vice President

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1 Stacy Schaus Discusses Defined Contribution Trends and Concerns with Target Date Investment Defaults Stacy Schaus, CFP Senior Vice President Ms. Schaus is lead Strategist within PIMCO s Defined Contribution Practice. Before joining PIMCO in 2006, she was a principal at Hewitt Associates in Lincolnshire, Illinois. During her 17-year career at Hewitt, Ms. Schaus lead significant strategic initiatives including launching the Hewitt Defined Contribution Alliance, Hewitt Financial Services Investment Consulting and Brokerage, as well as creating the Hewitt 401(k) Index and the Hewitt Personal Finance Center. She began her career in 1981 with Merrill Lynch Capital Markets in San Francisco, then concluding as a Global Strategist for Merrill Lynch Capital Markets in New York City. Ms. Schaus holds a B.A. from the University of California at Santa Barbara, and an MBA in Finance/International Business from New York University. She is also a Certified Financial Planner and on the board of the Financial Planning Association. PIMCO Senior Vice President Stacy Schaus is the lead strategist within the firm s Defined Contribution Practice. In the interview below, Ms. Schaus discusses the key trends in defined contribution plans, the risks that plan participants face in saving for their retirement and ways plan sponsors can better help participants meet their retirement goals. Q: Would you give us an overview of some of the key issues that defined contribution (DC) plan sponsors are facing today? Schaus: Since the inception of defined contribution plans in 1981, plan sponsors have primarily focused on three priorities: getting people to participate in their plans, helping plan participants increase their contribution levels and helping them allocate their assets. With the passage of the Pension Protection Act (PPA) in 2006, the government provides support for plan sponsors to automatically take action for their participants in all three of these important areas. First, plan sponsors now have safe harbor protection available if they decide to automatically enroll workers in their defined contribution plan. This will help many sponsors who were frustrated by simply trying to persuade people to participate. Similarly, PPA also addresses contribution levels, providing support to plan sponsors who automatically increase employee plan contributions. And finally, this Act provides a safe harbor for qualified default investment alternatives (QDIAs), which are expected to include target date retirement and other asset allocation vehicles that may dynamically adjust the plan participant s asset allocation over time. Given the PPA, we anticipate the majority of plans will offer auto enrollment, auto contribution increases, as well as a qualified investment default. We re all waiting for the Department of Labor (DOL) to release the final regulations that define what type of default meets the safe harbor requirements. The DOL has released proposed regulations that suggest three different types of default asset allocation plans that would be qualified under the Pension Protection Act. The first is a target retirement date or life-cycle strategy such as the 2010, 2020, and so on that, as mentioned, 1

2 modifies asset allocation over time according to the participant s age. The second type is a classic balanced fund or series of target risk funds that may target a specific level of risk such as conservative, moderate or aggressive. And the third type is a managed account, where the plan provider or an outside party manages the asset allocation on an individual participant basis. So you can see that these elements of PPA address the traditional concerns plan sponsors have had with DC plans by supporting these automatic programs. Q. What is the most likely default for DC plans going forward? Schaus: Among the proposed QDIAs, target retirement date strategies are growing most rapidly in prevalence. A recent study from Hewitt Associates shows 57% of companies have this type of fund already and another 39% are considering adding them. What s more, our recent DC Consultant survey showed that 67% of firms expect target retirement date strategies to become the most prevalent DC default in the future. Notably, this default will shift money away from stable value and money market investments, which have been the most prevalent default to date. Based on the final regulations from the DOL, we may see faster and more significant movement toward target retirement date and other automatic asset allocation programs than we have seen thus far. Q: How do target date funds work? Schaus: Target date funds adjust the mix of assets over time based on the age of the plan participants. These funds are often labeled by the targeted retirement year. For example, the default for an employee in their 20s might be the 2040 or 2050 target date strategy, which would start with a higher risk profile initially and then adjust the asset allocation over time to lower the portfolio s risk profile as the targeted retirement date approaches. Many refer to the changing asset allocation over time as the glide path which tends to show a decline of equity and other higher volatility assets as the retirement date approaches. Q: Based on PIMCO s research, what are some of the factors plan sponsors should consider when thinking about adopting a target date fund or strategy as the plan s default option? Schaus: We encourage plan sponsors to look not only at the packaged target date products that are available in the market, but also to look very closely at whether they can create their own solution by using the best-in-class managers and a mix of both active and passive strategies which often already appear in their plan as core investment options. Creating your own solution can offer some potentially significant benefits, including the ability to control the underlying investment manager mix as well as reduce plan costs. We have spoken to plan sponsors who were able to reduce the cost of implementing a target date solution by as much as 50 to 90% relative to packaged products such as mutual funds by creating their own solution which leverages the manager selection and lower costs of their core investment line up. We also encourage plans that are considering adding target date strategies whether packaged by an investment company or created on their own to take a very close 2

3 look at the types of risk that are entailed in the asset mix or glide path that is being provided to their participants. Careful consideration of this asset mix is critical because the probability of various outcomes whether a majority of plan participants achieve their post-retirement income goals, or not will depend heavily on the glide path methodology. Q: What are some of the risks plan sponsors might want to consider when constructing a target date solution? Schaus: We suggest plan sponsors start by focusing on the purpose of the plan. The U.S. Bureau of Labor Statistics recently reported that only 21% of private-sector workers now have a defined benefit pension plan. That means defined contribution plans are the primary company-sponsored retirement plan for most private-sector workers today, and the plan sponsor should be thinking about how to minimize the risk of participants falling short of their retirement income goal. When you think of the plan in that way, the goal should be to ensure that the greatest percent of employees will be able to retire successfully on the money that is accumulated. With this goal in mind, plan sponsors need to look very critically at the glide path to determine the probability of failure relative to the probability of success. They may find that the glide path provides a small number of plan participants with the opportunity to greatly exceed their goals, but the tradeoff is the risk that an unacceptably high number of participants may fail to meet their goals. In other words, evaluating the risk of a glide path is not simply a matter of measuring volatility or standard deviation. You also have to look at the probability of failure, with failure being defined as not accumulating sufficient income to meet the plan participants retirement income needs. Again, we believe reducing this shortfall risk is key to plans that provide the primary source of retirement income. Another risk sponsors have historically considered is volatility or the fluctuation in returns. This is very important in a DC plan as participants are more likely to sell out of an investment if it s too volatile and we know the volatility they respond to is declines in value. Target date strategies help reduce volatility by combining multiple asset classes. We suggest that plan sponsors seek assets that will reduce volatility even further. For instance, they should consider including real estate, Treasury inflation protection securities (TIPS), and even a small percent of commodities as a powerful way to add diversification which may both reduce expected volatility and enhance expected returns. There are also other asset classes they may want to consider, including global fixed income, high yield bonds and emerging market exposure. Another risk to mention is inflation. Unlike most defined benefit plans that are paid out in nominal terms, individuals must pay their expenses in real or inflation adjusted terms. This is particularly important as more retirees decide to retain their assets in their former employer s plan at retirement. Adding asset classes that typically perform well in inflationary times should be a focus for plans especially when they have a high retiree population in their plan. We ve found that securities including real estate, TIPS 3

4 and commodities, in addition to being excellent diversifiers, also may provide the inflation responsiveness that plans need. One final risk that I would like to mention is point in time or time period risk that is, the extent to which success depends on when you start investing, when you retire, and the market cycles that occur over that time span. We all know there have been extended periods in history when equities or other assets provided poor performance, so if you are unfortunate enough to retire during one of those periods, your retirement income could fail to meet your goals. Again, one way you hedge this time-period risk is through asset diversification. Q: How can plan sponsors evaluate the probability of success or failure in meeting the plan s goals? Schaus: They need to look at the range of possible outcomes for a given set of assets. For example, if you invest 100% of your assets in the S&P 500, the range of potential outcomes can be very broad, whereas if you invest 100% of your assets in TIPS there is minimal variation in potential outcomes, even when you factor in inflation. In other words, you have a better idea of what you are going to get with TIPS. And then, there are various combinations of assets that will give you a range of potential outcomes that is somewhere in between the relative certainty offered by TIPS and the wide range of outcomes that can arise from investing solely in equities. So the question is how broad that range of outcomes can be before an unacceptably large number of plan participants face the risk of not being able to meet their retirement income goals. There are ways to estimate the probability of different outcomes from a given mix of assets. For example, Monte Carlo analysis can be used to estimate not only the average expected return but also the likelihood of other outcomes based on a distribution of values around the average. Rather than simply looking at the average expected outcome, or even one standard deviation from the average, which only covers about two-thirds of the probable outcomes, we would encourage plan sponsors to look at all of the probable outcomes out to four standard deviations. They need to consider this tail risk, which in this case is the risk participants will fall short of their retirement income goal. We have run this type of analysis on existing glide path methodologies and have found that some are quite aggressive in terms of the wide range of potential outcomes. And we find that very alarming considering that many of these plans are likely to be the participants primary source of retirement income. Q: Based on PIMCO s analysis, what would an optimal glide path look like? Schaus: The optimal glide path really depends on the purpose of the plan and needs of the plan participants. But generally speaking, to minimize the percentage of plan participants that fail to meet their retirement income goals, we think glide paths should take a more conservative approach, should be more diversified and should provide a hedge against inflation. 4

5 One way to look at glide path construction is to consider what is happening in defined benefit plans. Many corporations with defined benefit plans have taken bold steps in changing their investment approach to significantly reduce the risk of needing to fund their plans at an unplanned level. In the past, defined benefit plans focused primarily on maximizing potential returns, as many defined contribution glide paths do today. But increasingly, defined benefit plans are focusing on how to minimize their risks. Defined contribution plan glide paths should have the same focus as defined benefit plans on how to minimize risk. Again, this is particularly important if the DC plan serves as the primary retirement program. As the primary plan, defined contribution plan participants should be given a default mix of assets that is most likely to meet their retirement income goals, in other words, a mix that is well matched to their ultimate liabilities. An individual s ultimate liability is the need for an income stream that is sustainable throughout retirement even after accounting for the effects of inflation. And glide paths can and should help participants minimize the risk of falling short of this real liability. Q: Does PIMCO expect a significant increase in inflation or an extended period of poor performance in the equity market? Schaus: We are certainly not looking for a surge in inflation. I think what is important though is that even a very small increase in inflation for example, an increase from 2% to 3% inflation could make a very big difference in a participant s ability to reach retirement or to actually remain in retirement. Even at a modest inflation level of 2.5%, spending power would be reduced by nearly 25% in just over a decade. That s a risk retirees need to take into account. In terms of a bear market in equities, we are not projecting one way or another. We are looking at this from the perspective of an individual s ability to take on certain risks. Most people when they retire are not going to have the ability to go back to work to make up shortfalls in their retirement income, so we believe they need to take a conservative approach to make sure that they are reaching their retirement income goals first. Our suggested approach includes equities, yet not at the extreme level we see in many of the glide paths in the market. We suggest that once a participant s basic retirement income needs are met, then they may want to take on a higher level of equities or other more volatile assets. Our focus is on helping plan sponsors both understand and minimize retirement income shortfall risk for their participants. Q: Thank you, Stacy. Schaus: My pleasure, thank you. This article contains the current opinions of the author but not necessarily those of Pacific Investment Management Company LLC. Such opinions are subject to change without notice. This article has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 5

6 Past performance is no guarantee of future results. Each sector of the bond market entails risk. Inflationindexed bonds issued by the U.S. Government, also known as TIPS, are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. Repayment upon maturity of the original principal as adjusted for inflation is guaranteed by the U.S. Government. Neither the current market value of inflation-indexed bonds nor the value a portfolio that invests in inflation-indexed bonds is guaranteed, and either or both may fluctuate. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Commodities are assets that have tangible properties, such as oil, metals, and agricultural products. An investment in commodities may not be suitable for all investors. Commodities and commodity-linked securities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes, and international economic and political developments, as well as the trading activity of speculators and arbitrageurs in the underlying commodities. Investing in non- U.S. securities may entail higher risk due to non-u.s. currency fluctuations and political or economic uncertainty which may be enhanced when investing in emerging markets. An investment on high-yield securities generally involves greater risk to principal than an investment in higher rated bonds. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA , PIMCO. 6