Ready! Fire! Aim? 2009 for Defaulted Participants

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1 Ready! Fire! Aim? 2009 for Defaulted Participants Analyzing defaulted participant behavior and QDIA target date design for institutional use only

2 About the Ready! Fire! Aim? Series This paper is the latest in a series of ongoing research that examines how plan sponsors can help strengthen potential retirement outcomes by analyzing real-world participant usage of target date strategies. It has been developed by J.P. Morgan Asset Management s Global Multi-Asset Group (GMAG), which has been managing portfolios on behalf of institutional investors, including defined contribution and defined benefit pension plans, endowments and foundations, for more than 30 years. GMAG, which consists of 43 investment professionals with an average of 15 years of industry experience, combines its capital markets, strategic and tactical asset allocation, portfolio construction and active risk budgeting capabilities with one of the broadest product offerings in the industry. J.P. Morgan s variety of return sources extends across asset classes, geographies and proven investment methodologies. This global product palette provides GMAG s experienced investment specialists with access to the ideal, low-correlation building blocks necessary for structuring efficiently diversified portfolios. Data as of December 31, 2009.

3 Overview Are target date funds serving the needs of defaulted participants? Prompted by the extreme markets in 2008, this question has dominated industry discussion about the suitability of different target date strategies as qualified default investment alternatives (QDIAs). We recently published Ready! Fire! Aim? 2009, which reexamined the target date design most likely to withstand the stresses of real-life investing. As we analyzed this research, we wanted to examine if there were notable differences between our observations for the general participant population and participants who were defaulted into a target date strategy through a plan s QDIA. Defaulted participants represented a sizable portion almost 50% of all participants in our proprietary database who were invested in a target date strategy (see Exhibit 1). Based on the investment behaviors of this group, we identified several patterns that may prove useful when evaluating different QDIA target date designs. We discuss these findings in the sections that follow. (For a more detailed description about our research methodology, please see Ready! Fire! Aim? 2009.) Exhibit 1: Participants in J.P. Morgan Retirement Plan Services proprietary database, Ages % of participant population Source: J.P. Morgan Asset Management. % of those participants invested in target date strategies % of those participants invested in target date strategies who were defaulted into them All Under age Over age J.P. Morgan Asset Management 1

4 Defaulted Participant Behavior Patterns QDIAs were introduced through the Pension Protection Act (PPA) of 2006, which established several legislative features designed to help increase the odds that more Americans invested in their financial futures. One of the most important changes provided plan sponsors with the ability to automatically enroll employees into a retirement plan, using a QDIA as a default investment if participants failed to select another option. This represented a significant advancement in retirement savings for employees who had not previously participated in their firms 401(k) programs, but it also required plan sponsors to evaluate which type of QDIA was best designed to meet their specific plans goals. The most appropriate QDIA for a particular plan depends largely on the investment needs of the participants most likely to be defaulted into the strategy, and plan sponsors must carefully analyze quantifiable characteristics, such as age, income, average tenure and saving patterns, to make prudent assumptions about what is most suitable for this group. To begin our analysis, we examined data from 2006 through 2008, evaluating behavior patterns for defaulted participants in four critical areas: salary, contributions, loans and withdrawals. We then compared these findings to common target date industry assumptions about participant behavior, Defaulted participant behavior findings Defaulted participants generally have lower salaries. Contribution rates for defaulted participants start too low and remain well below industry expectations across their entire careers. A sizable number of defaulted participants take loans, and we expect these numbers to rise if account balances grow larger. A number of defaulted participants take pre-retirement distributions, and most withdraw their entire account balances shortly after they stop working. as well as to the behavior patterns identified in earlier research of the larger participant population (see Exhibit 2). Salary Key finding #1: Defaulted participants generally have lower salaries The average starting salary for defaulted participants was $35,000 per year compared to the average $38,000 starting annual salary for all participants in our analysis. It is often assumed that participants receive annual raises. However, we Exhibit 2: Participant behavior patterns Common target date industry assumptions J.P. Morgan research findings Broad participant population Salary raises Participants get a raise every year. On average, participants get raises every other year. Contributions Rates start at 6%, increase year by year, reaching 10% of salary by age 35. On average, contribution rates start at 5.8% and increase slowly, reaching 8% by age 42, and 10% not until age 55. Loans Participants don t borrow. 17% of participants borrow, on average, 23% of account balance. Defaulted participants On average, defaulted participants get raises every other year. On average, contribution rates start at 5% and increase even more slowly, reaching 8% by age 50, and 10% not until age % of defaulted participants borrow, on average, 23% of account balance. Pre-retirement distributions Premature distributions don t happen. 15% of participants over age 59 ½ withdraw, on average, 26% of assets. Remain in plan three years 100% 19% 22% after retirement 1 Source: J.P. Morgan Retirement Plan Services participant database, As measured by participants over age 65 who have stopped working. 6% of defaulted participants over age 59 ½ withdraw, on average, 30% of assets. 2 Ready! Fire! Aim? 2009 For Defaulted Participants

5 found both groups actually received salary increases, on average, every other year, with a slightly lower frequency for defaulted participants. The disparity between salary levels continued across participants careers. The average annual salary for defaulted participants at retirement was $58,000, almost 10% lower than the average $64,000 for all participants. As a result, defaulted participants needed less replacement income in order to maintain their standard of living in retirement, but we were concerned about whether or not they would achieve this level of retirement security. Our past research consistently showed that lower salaries usually were directly linked to lower contributions, and this proved to be the case with this group as well. 2 Contributions Key finding #2: Contribution rates for defaulted participants start too low and remain well below industry expectations across their entire careers Contribution levels are often assumed to begin at 6% and reach 10% by age 35. Our research, however, consistently found average contribution rates to be much lower. Based on the salary patterns noted above, we were not surprised to find that the average 5% starting contribution for defaulted participants was below the average 5.8% for all participants. Unfortunately, this trend proved to be consistent across age groups, and the average defaulted participant only reached an 8% contribution rate by age 50 and a 10% rate by age 65. This significantly lagged the broader group, where the average participant s contribution rate increased to 8% by age 42 and 10% by age 55. More important, these levels were well below the 10% 12% annual rate often recommended by financial advisors as necessary to achieve adequate retirement savings. Making QDIA decisions as a fiduciary It is important to remember that QDIA selection is a fiduciary act that requires plan sponsors to act prudently and solely in participants best interests. To help accomplish this, plan sponsors must carefully evaluate known and unknown characteristics about the plan, its participants and the current investment environment. A critical component of this responsibility is developing and following a prudent selection process that examines: The plan s desired purpose for the QDIA. The retirement and participant assumptions used in the selection and monitoring process. The types of investments, allocations, risks and costs appropriate for the plan. Assessing these issues can help plan sponsors determine the type of target date strategy most appropriate for their plans needs. In addition, court decisions involving fiduciary liability have held that ERISA fiduciary standards are largely met by following a prudent investment-selection process, even if the process may lead to a particular decision that results in unfavorable investment performance. Loans Key finding #3: A sizable number of defaulted participants take loans, and we expect these numbers to rise if account balances grow larger Another common industry assumption is that participants do not borrow against their 401(k) portfolios. Our research, however, showed that, on average, 13% of defaulted participants had loans outstanding in any given year. While this was below the 17% figure for all participants, the average loan amount was consistent across both groups, at 23% of account assets. We were encouraged to see fewer participants taking loans, but this lower rate may be a reflection of how little was in the average defaulted participant s account. In related studies, we observed a clear pattern linking increased account balances with an increase in loan activity, and we would expect this population to act no differently if their account balances began to rise. 2 J.P. Morgan. Sharpening Your Aim, February J.P. Morgan Asset Management 3

6 Withdrawals Key finding #4: A number of defaulted participants take pre-retirement distributions, and most withdraw their entire account balances shortly after they stop working Many industry models assume that participants do not take pre-retirement distributions and withdraw a consistent 4% 5% annually once they reach retirement age. According to our data, 4.5% of defaulted participants under age 59½ took withdrawals from their accounts in any given year, lower than the 6.5% for the broader group. Once they reached age 59½, an average 6% of defaulted participants withdrew 30% of their assets in any given year compared to 15% of all participants, who withdrew an average 26% of their assets. This figure increased significantly once participants reached age 65 and stopped working, when an average 22% of defaulted participants started to withdraw 85% of their account balances each year. While this is lower than the withdrawal patterns of the larger participant population, the large withdrawal sizes of both groups post-retirement translated into rather rapid depletion of 401(k) assets once participants stopped working. In fact, the vast majority of defaulted participants almost 80% withdrew their entire account balances within just three years of entering retirement (see Exhibit 3). Exhibit 3: Percentage of participants over age 65 who stopped working in 2006 and remained invested in their plan Percent Source: J.P. Morgan Retirement Plan Services participants database. 76 Percent of participants over age 65 who terminated in 2006 and remain in plan Percent of defaulted participants over age 65 who terminated in 2006 and remain in plan Dec 2005 Dec 2006 Dec 2007 Dec Comparing Target Date Fund Designs Most would agree that a successful 401(k) program provides the most employees with the highest probability of maintaining their standard of living in retirement. We believe a prudent measure for this goal is to maximize the number of individual participants who reach the minimum level of income replacement at the point of retirement. This offers a number of quantifiable objectives: It sets a fixed time horizon. It helps forecast potential retirement assets, which can be projected with some degree of certainty from estimated contributions and investment earning ranges. It helps establish a realistic retirement target, a finish line that when modeled with an annuity purchase can provide income replacement comparable with a traditional defined benefit plan. Similar to our earlier Ready! Fire! Aim? research, we examined different types of target date asset allocation models, using J.P. Morgan Asset Management s Target Date Compass SM. This evaluation program maps actual funds in the marketplace into one of four categories: NE-Aggressive, SE-Concentrated, SW-Conservative and NW-Broadly Diversified (the category J.P. Morgan SmartRetirement falls into). We then analyzed which type of target date design was most likely to help defaulted participants successfully cross the retirement finish line, based on the saving behaviors discussed earlier. (Please see Ready! Fire! Aim? 2009 for a more detailed description of the Monte Carlo analysis methodology and different target date portfolios used in this evaluation.) Summary of outcomes Projected balances at age 65 were significantly lower for defaulted participants. Fortunately, these participants also generally have a lower retirement savings finish line to cross. Investing at controlled levels of risk through broader diversification and relatively rapid reduction in equity exposure in the years leading up to retirement increases the number of defaulted participants likely to reach their retirement income goals. 4 Ready! Fire! Aim? 2009 For Defaulted Participants

7 Range of Potential Outcomes Key finding #5: Investing at controlled levels of risk through broader diversification and relatively rapid reduction in equity exposure in the years leading up to retirement increases the number of defaulted participants likely to reach their retirement income goals Our simulation was designed to replicate a lifetime of investment patterns across different market environments. This provided an effective comparison of potential long-term retirement outcomes (in current dollars). Although overall account balances for defaulted participants were lower than for the larger participant population (as would be expected based on their lower contribution rates), the broader comparative trends across both groups were remarkably consistent (see Exhibit 4). The NE-Aggressive portfolio, with its higher risk/reward profile and larger equity allocation, performed better than the other portfolios during strong markets and with ideal participant behaviors. It led the outcome ranges on the upside, providing the top 25% of projected account balances with more than $627,000 and the top 5% with just over $1 million. This strategy, however, posted the widest range in potential outcomes, demonstrating its less efficient use of risk. Higher equity allocations also provided the SE-Concentrated portfolio with relatively strong performance in simulations using ideal market conditions and participant behaviors. But, unlike the NE-Aggressive portfolio, the SE-Concentrated strategy does not include extended asset classes to help supplement equity performance. Due to this over-reliance on equity returns, the strategy s downside exposure was the worst across all four portfolios. Exhibit 4: Range of expected account balances at retirement Broad participant population 1,500,000 defaulted participants 1,500,000 1,300,000 1,201 1,333 1,212 1,300,000 1,100,000 1,100, , , , , , , , NW: Broadly Diversified NE: Aggressive SE: Concentrated SW: Conservative Source: J.P. Morgan Retirement Plan Services participant database, , , , ,000 Target NW: Broadly Diversified NE: Aggressive SE: Concentrated SW: Conservative $400,000 $400,000 $400,000 $400, A guide to the box-and-whisker charts The box marks the range of the 25th, 50th (median) and 75th percentile outcomes, from top (best) to bottom (worst). The whiskers reaching out from the top and bottom of the box show the range up to the 5th and down to the 95th percentiles of the distribution of outcomes. As the dispersion of returns increases, the box-and-whiskers becomes more elongated. J.P. Morgan Asset Management 5

8 CROSSING THE RETIREMENT FINISH LINE In Exhibit 4, a red line runs across both sets of projected outcomes at a specific retirement savings target. This represents the asset threshold necessary to purchase an annuity supplementing Social Security benefits at a level that maintains participants standard of living in retirement. (For a more detailed discussion of this calculation, please see Ready! Fire! Aim? 2009.) In our analysis, this retirement savings finish line is set at $400,000 for the broader participant group and $320,000 for defaulted participants, due to differences in replacement salary needs. On average, the larger participant population earned $65,000 annually just before entering retirement compared to $58,000 for defaulted participants (in current dollars). In addition, Social Security benefits should constitute a proportionately larger component of replacement income for defaulted participants, and these two factors result in a significantly lower retirement savings target. The SW-Conservative portfolio achieved a maximum upside that was much lower than the other portfolios, as would be expected given the strategy s heavy reliance on cash and traditional fixed income. This more conservative approach also proved to be restrictive across all likely long-term outcomes, with the majority well below the other strategies. In fact, almost 40% of the portfolio s projected account balances fell short of the amount necessary to secure an appropriate level of retirement income. The NW-J.P. Morgan SmartRetirement portfolio s upside potential was comparable to both the NE-Aggressive and SE-Concentrated portfolios. Equally important, the strategy s focus on risk-adjusted performance delivered a tighter range of outcomes, and its sophisticated approach to managing volatility helped protect this range from shifting lower on the expected value scale, in contrast to the consistently lower outcomes of the SW-Conservative portfolio. By investing at controlled levels of risk, the J.P. Morgan SmartRetirement portfolio seeks to lower volatility without sacrificing long-term return potential. Based on our projected outcomes, this approach could help secure a more appropriate level of retirement funding: 75% of the J.P. Morgan SmartRetirement strategy outcomes met replacement income goals compared to 73% in the NE-Aggressive portfolio, 69% in the SE-Concentrated portfolio and 63% in the SW-Conservative portfolio. The strategy posted median and 75th percentile outcomes higher than all three other portfolios. It also outperformed the other portfolios for outcomes in the bottom quartile of returns. For a plan with 10,000 participants, these percentage differences translated to an expected 200 to 1,200 more individuals reaching their retirement goals under the J.P. Morgan SmartRetirement strategy. Assessing These Results This research illustrates that, similar to the broader participant population, the saving behaviors of defaulted participants are more varied and volatile than many common industry expectations. Defaulted participants tend to: Earn less in salary across their careers. Make fewer active contribution changes and instead rely on EXHIBIT 5: ADDITIONAL PARTICIPANTS EXPECTED TO CROSS THE INCOME REPLACEMENT GOAL WITH THE J.P. MORGAN SMARTRETIREMENT DESIGN (PLAN WITH 10,000 LIVES; ACCOUNT BALANCE GOAL OF $320,000) Other target date designs J.P. Morgan SmartRetirement Strategy Expected success rate (%) Expected success rate (%) Expected participant impact NE-Aggressive % or 200 more successes SE-Concentrated % or 600 more successes SW-Conservative % or 1,200 more successes Results are based on analysis derived from J.P. Morgan Asset Management long-term capital market assumptions 2008, J.P. Morgan Asset Management and industry prospectuses. See Exhibit 2 for participant assumptions. 6 Ready! Fire! Aim? 2009 For Defaulted Participants

9 auto-enrollment and auto-escalation rates, which are often too low to secure adequate retirement funding. Take more loans and more pre-retirement withdrawals than many standard industry assumptions (although at a relatively lower level than the broader participant population). Withdraw the majority of their 401(k) assets relatively soon after they reach age 65 and stop working. Plan sponsors can use these patterns to better understand how to help defaulted participants seek a more secure retirement. While it can be difficult to change participant behavior, there are a number of options that can help defaulted participants maximize the potential benefits of 401(k) investing: 1. Proactive auto-enrollment and auto-escalation programs can improve participation rates, but these programs need to be set at high enough contribution levels to firmly place defaulted participants on a more prudent savings path. Many of these programs start with contribution rates of only 3% and increase up to only 6%, which our research indicates is an inadequate savings level for retirement. (These numbers do not include employer contributions, which we assume for modeling purposes to be 3% in our research.) 2. effective participant communication must actively engage these participants and educate them on how critical their saving patterns are to achieving retirement success. From a fiduciary standpoint, communication programs can also help defaulted participants set realistic retirement goals and determine if they are well suited for the plan s QDIA by articulating why a particular strategy has been selected and the types of outcomes it is designed to deliver. 3. Prudent QDIA selection must address all important factors that may affect defaulted participants ability to achieve sufficient retirement savings. This includes an understanding of the impact defaulted participant behavior can have on potential retirement outcomes, particularly in terms of how cash flow volatility may interact with embedded portfolio volatility to compromise the probabilities of participant success. The most successful retirement plans represent a true partnership between participants and plan sponsors. Ultimately, the most effective way of increasing the certainty of retiring with more assets is to save more, and participants must contribute enough to secure adequate funding levels. A prudently designed QDIA target date strategy can help with these efforts by making participants assets work as hard as possible to capture attractive levels of return at lower levels of volatility. Our research found that the portfolio design of many target date strategies may be missing the mark on providing defaulted participants with an adequate level of retirement security. In our analysis, target date funds that relied too heavily on equity performance increased potential overall volatility and exposed defaulted participants to steep market declines, especially in the crucial five to ten years before retirement. At the other extreme, portfolios that reduced risk purely with more conservative holdings were less volatile, but they also drastically restricted long-term performance. A more prudent investment approach was offered by target date strategies that focused on investing at controlled levels of risk through broader diversification and relatively rapid reduction in equity exposure in the years leading up to retirement. By including asset classes such as emerging market equity, emerging market debt, direct real estate, REITs and high-yield fixed income, these portfolios reduced expected volatility without sacrificing long-term return potential. This sophisticated approach to risk efficiency is a key component of J.P. Morgan SmartRetirement s portfolio strategy. By targeting long-term returns competitive to more equity-concentrated target date strategies, but with lower volatility and more limited downside risk, these portfolios seek to address real-world market volatility and defaulted participant behavior patterns. Communication conundrum J.P. Morgan Retirement Plan Services conducted a nationwide survey of 401(k) plan participants and found that 67% admitted they do not take the time to read the information they receive from their plans. While disheartening, it is probably safe to assume this figure is even higher for defaulted participants. Source: J.P. Morgan. Anything But Certain, October J.P. Morgan Asset Management 7

10 Conclusion A well-structured target date program can offer significant benefits for 401(k) retirement savings, especially when used as a QDIA option. Through appropriate auto-enrollment and autoescalation levels, effective communication programs and prudent target date selection, plan sponsors can provide defaulted participants with a meaningful opportunity to help achieve retirement security. Although target date portfolios generally share a common structure higher allocations to riskier assets in early accumulation years and steadily increasing conservative holdings as retirement approaches there are widely different approaches to managing risk and return that, over extended periods, can make the difference between a difficult or comfortable retirement. Choosing the most appropriate strategy requires an understanding of how retirement outcomes are shaped by the interaction of portfolio design, market performance and participant behavior. Based on our research, defaulted participant saving patterns can offer insights into three critical selection criteria: Risk-adjusted return potential: Defaulted participants, on average, are not saving enough for retirement, as evidenced by their consistently lower contribution rates and account balances. As a result, the most effective target date design must seek to make assets work harder to capture attractive levels of return at lower levels of risk. Volatility management: In our research, high levels of embedded portfolio volatility have consistently proven to be counterproductive, particularly for participants at risk of falling into the bottom ranges of potential retirement outcomes. Reducing portfolio volatility can help mitigate this risk in an effort to provide a steadier path to retirement. Equity exposure, particularly at and near retirement: Once defaulted participants stop working, they exhibit varied and unpredictable withdrawal patterns, but the vast majority do not stay invested with their plan, withdrawing their entire account balances within three years. Given these patterns, a prudent target date strategy must significantly reduce equity exposure in the years leading up to retirement to help participants protect their accumulated assets. In our analysis, target date strategies that invested at controlled levels of risk increased the number of defaulted participants able to cross the retirement finish line. These findings are consistent with our research for the broader participant population and illustrate that the sophisticated portfolio design of J.P. Morgan SmartRetirement may help increase the potential for participants to reach an appropriate level of retirement funding, regardless of whether they actively select the strategy or are defaulted into it. 8 Ready! Fire! Aim? 2009 For Defaulted Participants

11 for InstItutIonAl use only Ready! Fire! Aim? materials Ready! Fire! Aim? 2009 for Defaulted Participants Analyzing defaulted participant behavior and QDIA target date design Ready! Fire! Aim? 2009 This study is an update to our industry-defining research published in 2007 (Ready! Fire! Aim? How some TDF designs are missing the mark on providing retirement security for those who need it most), using real participant behavior and target date outcomes observed since the original paper (2001 to 2006). Aiming At a Moving Target This paper explores the challenge of translating the need for inflation protection into a pooled fund vehicle. An extension of our Ready! Fire! Aim? white paper series, the paper offers a view on the forms of inflation risk and proposes various solutions for portfolio construction. Ready! Fire! Aim? This white paper provides an in-depth discussion on how some target date fund designs are missing the mark on providing retirement security to those who need it most. Sharpening Your Aim This white paper presents detailed analyses of the industryspecific behavior patterns of plan participants and shows the results of testing target date designs across industries and companies. Also available are individual fact sheets that isolate findings based on each specific industry. J.P. Morgan Asset Management 9

12 Authors Anne Lester Managing Director Senior Portfolio Manager Katherine Santiago, CFA Vice President Quantitative Research Analyst RISKS ASSOCIATED WITH INVESTING IN THE FUNDS. Certain underlying J.P. Morgan Funds may invest in foreign/emerging market securities, small capitalization securities and/or high-yield fixed income instruments. There may be unique risks associated with investing in these types of securities. International investing involves increased risk and volatility due to possibilities of currency exchange rate volatility, political, social or economic instability, foreign taxation and differences in auditing and other financial standards. The fund may invest a portion of its securities in small-cap stocks. Small-capitalization funds typically carry more risk than stock funds investing in well-established blue-chip companies since smaller companies generally have a higher risk of failure. 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