TARGET DATE FUND RESEARCH INSIGHTS. Ready! Fire! Aim? Reloaded

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1 TARGET DATE FUND RESEARCH INSIGHTS Ready! Fire! Aim? Reloaded How some target date strategies miss the mark on meeting the needs of real-world participants This report is a condensed version of our white paper Ready! Fire! Aim? The original paper contains a more detailed discussion of portfolio analytics, capital market return assumptions and participant simulations employed in our analysis. Readers interested in the full report can download it from our website at jpmorgan.com/definedcontribution.

2 About JPMorgan Asset Management Global Multi-Asset Group The Global Multi-Asset Group (GMAG) has been managing portfolios on behalf of institutional investors, including defined contribution and defined benefit pension plans, endowments and foundations, for more than 25 years. The group, which consists of more than 40 investment professionals with an average of 10 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. JPMorgan s variety of return sources extends across asset classes, geographies and proven investment methodologies. This global product palette provides GMAG s experienced multi-asset class investment specialists with access to the ideal, low correlation building blocks necessary for structuring efficiently diversified portfolios. SmartRetirement, the group s target date strategy, provides defined contribution plan sponsors and participants with an institutional-quality investment solution. Our fund design combines the skills and asset classes to which our most sophisticated DB plan clients have access, with more than 20 years of insights on participant behavior from JPMorgan Retirement Plan Services, recognized as one of the most innovative and participant-focused recordkeepers in the industry. SmartRetirement Portfolio Management Team Anne Lester Managing Director Senior Portfolio Manager Global Multi-Asset Group Patrik Jakobson Managing Director Senior Portfolio Manager Global Multi-Asset Group Michael Schoenhaut Vice President Head of Portfolio Implementation and Strategy Global Multi-Asset Group Katherine Santiago Quantitative Research Analyst Global Multi-Asset Group Daniel Oldroyd Vice President Portfolio Manager Global Multi-Asset Group

3 Foreword Over the past several years, many of our clients have taken steps to strengthen their 401(k) plans, making participants better able to generate sufficient savings for a safe retirement. Recently, sponsors have further focused these efforts in response to numerous studies reporting how poorly prepared many participants are for retirement. The passage of the Pension Protection Act of 2006 has given sponsors significant new powers to help participants meet their retirement goals. We view sponsors new ability to automatically enroll participants, increase their contributions and adopt new default investment options as critical tools in the battle to engender more consistent saving and investing behavior by participants. We also think these tools create a new implicit social contract between sponsors and employees one that requires plan sponsors to clearly articulate goals for their default investment options and to clearly communicate to participants their own responsibilities. We began the research behind this paper because we believe target date strategies are a sponsors best choice in the new environment. Although prior studies of target date strategies have identified important issues, our intuitive understanding of how participants use their 401(k) accounts made us feel the research was incomplete. As a result, we undertook a rigorous, quantitative examination of saving and spending patterns based on our proprietary database covering the 1.3 million participants whose 401(k) accounts are administered by JPMorgan Retirement Plan Services. We were not surprised to find that many participants both raise and lower their contribution rates during their careers, and that they take frequent loans and distributions from their accounts, particularly once they reach the age of 59½. We were surprised, however, to see what a large impact this volatility in participant cash flow could have on projected 401(k) balances at retirement. We then reviewed several different target date retirement approaches to determine how well they managed the combined volatility of cash flows and market returns. For most strategy designs, we found that their asset allocation choices holding high and undiversified levels of equity made returns too volatile and subjected many participants to the risk of not being able to replace their working income at retirement. We propose a different target date structure, one that accommodates both uneven contributions and volatile markets. Our approach is an institutional-quality portfolio that is broadly diversified and seeks to earn the necessary expected return at lower levels of risk, and thus should be more effective at achieving retirement income security. We believe this goal is especially important for the many employees who don t have the time, talent or interest to manage their own retirement and are likely to be the best candidates for target date strategies as a default option. We hope this research will assist plan sponsors in evaluating this new type of investment and will help as many participants as possible to retire with the income they need. Sincerely, Anne Lester Katherine Santiago Managing Director Quantitative Research Analyst anne.lester@jpmorgan.com katherine.s.santiago@jpmorgan.com

4 Ready! Fire! Aim? Reloaded Table of Contents Introduction...1 A new retirement architecture....2 Setting an objective....4 Understanding participants...5 Choosing an investment program...8 The payoff of target date strategies A comprehensive communications program...13 Conclusion: A new generation of 401(k) plans Editor Barbara Heubel Vice President Institutional Investment Marketing barbara.m.heubel@jpmorgan.com

5 Introduction This paper presents JPMorgan s original research into target date strategies as default options for 401(k) plans. We define our view of a prudent goal for both sponsors and participants one that allows as many employees as possible to replace the roughly 40% of working income that, when added to anticipated Social Security benefits, will allow participants to maintain the lifestyle of their working years. We illustrate how some target date managers appear to make unrealistic assumptions about participants saving behavior and why sponsors must take into account employees actual behavior in evaluating which target date strategy best suits the characteristics of their participant populations. We compare the investment approaches of four different types of target date designs, including JPMorgan s SmartRetirement design. We examine how they demonstrate very different attitudes on risk and diversification over participants lifetimes and how they are likely to vary in their success in building retirement income security. 1

6 A new retirement architecture From the 1950s through the 1980s, the U.S. retirement system was a structure built on three pillars: employer-provided defined benefit plans, Social Security, and thrift, savings or profit-sharing plans. The traditional goal has been income replacement of 80% what many retirees need to keep up their working-life standard of living of which Social Security provided about 40%, and the traditional pension plan another 40%. 1 Any income from profitsharing and similar supplemental plans added an extra measure of income security. Since the arrival of the 401(k) plan 25 years ago, however, the architecture of retirement has taken on a different look. Social Security still provides its share, but traditional corporate defined benefit plans started to disappear in 1983 dropping from 175,000 to fewer than 48,000, according to the most recent reports from the Department of Labor leaving the difference to be made up by 401(k) plans. 2 A new social contract The bursting of the global stock market bubble in the early 2000s forced investors, sponsors and legislators to face difficult issues about America s retirement security. One realization was that despite access to 401(k) plans, millions of working Americans were not on track to meet their retirement income requirements. Congress recently passed the Pension Protection Act of 2006 (PPA); its DC-related provisions address the shortcomings of 401(k) plans and employee saving behavior by implementing major changes to regulations governing participation and investing. We view the 401(k) provisions of the PPA as part of a new social contract, recasting the retirement responsibilities among sponsors and participants. The PPA allows sponsors to act more forcefully to increase plan participation and improve contribution rates (through automatic enrollment and automatic escalation of contributions, respectively). It also endorses a number of qualified default investment alternatives, or QDIAs, to direct participants contributions into investments suitable for retirement saving. One QDIA option is the target date approach. When combined with automatic enrollment and contribution escalation, target date strategies offer what we believe are the best opportunities to replace working income for the largest number of participants. Target date strategies are especially well-suited for the 40% to 70% of a typical plan s participants who are investment delegators those without the time, talent or interest to closely manage their own retirement. These strategies are professionally managed and provide automatic asset and risk allocation suitable to a participant s age. They invest more aggressively in the early years to build capital, but reduce exposure to market risk as participants approach retirement, when the account value is at its largest, and is therefore most vulnerable to market swings. New obligations Participants To fulfill their part of the updated social contract of workplace retirement, participants will need to exercise greater financial discipline by: Saving more Starting to save earlier Leaving their savings intact until retirement With target date strategies, participants are not directly involved in choosing investments, but they still have the primary responsibility for contributing enough to their accounts. 1 The Aon Consulting/Georgia State University 2004 Retirement Income Replacement Ratio Study, Aon Consulting. 2 Private Pension Plan Bulletin: Abstract of 2004 Form 5500 Annual Reports, U. S. Department of Labor/Employee Benefits Security Administration, October

7 New obligations Sponsors Sponsors have several new obligations in the new DC world pertaining to the implementation of target date portfolios as a default investment option: Define the objective in terms of the desired outcome for participants Understand the savings habits of plan participants Select the strategy that offers the best chance of building employees contributions into the capital they need at retirement JPMorgan brings a unique set of skills to meet the 401(k) challenge. From an investment perspective, our Global Multi-Asset Group, which manages the SmartRetirement target date strategies, has more than 25 years experience in managing complex portfolios for large institutions. To this investment knowledge base, we add nearly 20 years of insight into participant behavior through JPMorgan Retirement Plan Services, a recognized innovator in participant communication and education. 3

8 Setting an objective Financial planning studies show that most people need an income equal to about 80% of their ending salaries to maintain their lifestyle in retirement. (Many people can keep the same lifestyle with less income, once retired, because they have paid off their mortgages, and are also paying lower tax rates.) Social Security typically replaces about 40% of income. Participants therefore need to set their sights on building a retirement account that can generate the remaining 40%. 3 We believe replacing working income is also a meaningful planwide goal for sponsors. From the sponsor s viewpoint, a successful 401(k) program is one that gives the greatest number of employees a solid chance of maintaining their standards of living. Even though many companies have converted their retirement benefits from DB to DC, the objective remains the same: to provide income replacement security. Why income replacement? Much of the industry research on target date designs has framed a goal for sponsors of establishing lifelong investing programs (i.e., from graduation to grave ). We believe this approach may not be appropriate for many plans as it extends the investment horizon into an unknowable future, where individual financial situations, family needs and resources are unique and hard to predict. In our view, measuring the success of a 401(k) plan is best achieved by evaluating its ability to provide income replacement at retirement. The notion of income replacement at the date of retirement represents a milestone for both employee and sponsor. It s also a measure that can be estimated for every participant from a few data points available in human resources files. The proportion of working income to be replaced can also be measured as a lump sum required at retirement the amount a participant would need, hypothetically, to purchase an annuity providing that level of income for life. Exhibit 1 illustrates the necessary income replacement ratios, as well as the equivalent annuity amounts, for two ending salaries, as of late Exhibit 1: Examples of required income replacement ratios and equivalent annuity costs Required income Purchase price of Ending salary replacement ratio equivalent annuity $65,000 35% $400,000 $85,000 42% $600,000 Source: The Aon Consulting/Georgia State University 2004 Retirement Income Replacement Ratio Study, Aon Consulting. Annuity prices can vary. Replacement ratios for lower-salaried employees are generally lower, since Social Security replaces a larger proportion of final income. To replace 35% of a $65,000 final salary, market prices of annuities were about $400,000 in late 2006, while buying an annuity to replace 42% of a final salary of $85,000 required roughly $600,000. Crossing the finish line JPMorgan s SmartRetirement target date strategies are designed to meet the goals of both participants and sponsors, and give the largest number of participants in a plan the highest probability of reaching their income targets. SmartRetirement portfolios are broadly diversified, investing in an asset mix that is more efficient than comparable target date designs meaning the strategy can earn a comparable return at a lower level of risk. This design is intended to control volatility and cushion the portfolio during stressful markets, to help keep participants from pulling out of their investments at just the wrong time and to improve their chances of reaching retirement with the portfolio balances they need. 3 Replacement ratios vary around the 40% level depending on final salary levels: lower-salaried employees receive a greater proportion of final income from Social Security, leaving a smaller share to be replaced by retirement accounts. 4 Annuity prices can vary significantly; our analysis assumes the annuity earns a 5% return with inflation at 2.5% annually. The annuity amounts are inflation-adjusted to represent today s dollars. For a more detailed discussion, please refer to the original version of this paper, Ready! Fire! Aim?, at jpmorgan.com/definedcontribution. 4

9 Understanding participants In the new environment created by the Pension Protection Act, sponsors are encouraged to look out for their participants DC retirement savings more actively than in the past. One way sponsors can do this is by better understanding the saving and investing traits of their participants, and incorporating that knowledge explicitly into the choice of available investments. Most target date analysis assumes incorrectly that contributions, salary levels and pay increases are higher than they are in real life, that contributions increase smoothly and steadily and that participants leave their balances intact and fully invested during their entire careers. To understand the gap between assumptions and reality, we studied the behavior of 1.3 million participants in JPMorgan s Retirement Plan Services database, and identified several crucial differences. First, many target date managers base their retirement projections on contributions of 10% of salary by age 35. We found, however, that most participants actually increase their saving far more slowly. As seen in Exhibit 2, our studies show that contribution rates average about 6% early in many participants careers, but increase to 8% by age 40. (This contribution rate excludes employers matching contributions, which average just 3% across our plan population.) Exhibit 2: Participant average contribution rates versus age Average rate (%) 14% 12% 10% 8% 6% 4% Age Source: JPMorgan Retirement Plan Services, RPS participants, In addition, most people don t receive pay increases annually, but see them only in two out of every three years, so that their salaries don t reach the levels they otherwise might. Not only do many people contribute too little, they also don t leave their money invested long enough. Many people borrow from their plans during their careers, and a surprisingly large number start withdrawing before retirement, when they reach the taxadvantaged age of 59½. (Exhibit 3 compares our findings to the assumptions made by many target date managers.) Exhibit 3: Participant behavior Simplified industry assumptions versus Reality: JPMorgan research findings Contributions Rates start at 6%, increase year by On average, contribution rates start at 6% and year, reaching 10% of salary by increase slowly, reaching 8% of salary by age 40, age 35. and 10% not until age 55. Salary raises Participants get a raise every year. On average, participants get raises every 2 out of 3 years. Loans Participants don t borrow. 20% of participants borrow, on average, 15% of account balance. Pre-retirement Premature distributions 15% of participants over the age of 59½ withdraw, distributions don t happen. on average, 25% of assets. In-retirement Participants withdraw a The average participant withdraws over 20% distributions consistent 4% 5% annually. per year at or soon after retirement. Sources: AllianceBernstein Target-date Retirement Funds A Blueprint for Effective Portfolio Construction, October 2005; JPMorgan Retirement Plan Services participant database,

10 Obviously, when participants don t contribute enough during their working years, and withdraw funds before retirement, they can t fully benefit from the tax-deferred investing power of 401(k) accounts, and are far less likely to have what they need on the day they retire. Subtle? Not at all The shortfalls in contributions and withdrawals may seem like subtle points, but over 30 or 40 years the cumulative effect can be quite large. To show the impact of uneven contributions and early withdrawals over a career, we present Exhibit 4, showing two alternative scenarios for a hypothetical participant who joins his DC plan at age 25 and retires at 61. The first case uses the simplified (and overly optimistic) assumptions subscribed to by many fund managers. The participant receives annual raises, causing his salary to rise from $45,000 to $84,000 at retirement (measured in today s dollars). He makes annual contributions of 6% of salary at age 25 and increases to 10% by age 35. In addition, he receives an employer match of 3% annually. The second case assumes the participant earns the same salary and contributes at the same rate, but Exhibit 4: How participant contributions and withdrawal patterns can affect retirement outcomes (illustrative example) $1,500 Simple Portfolio $1,200 Real Life Contribution Portfolio Real Life Contribution Path 401(k) portfolio level $900 $ (k) portfolio level $300 He ends almost $400,000 behind $0 30% Loan repayment Loan repayment % of salary contributed 0% $10k out -30% $15k out A loan to buy a home College loan Pre-retirement withdrawal Participant s age Source: JPMorgan Asset Management estimates. For illustrative purposes only. Hypothetical accounts are assumed to be invested 100% in the S&P 500 stock index. 6

11 also factors in several life events that cause him to take loans and withdrawals from his account and stop his contributions for a time: At age 32 he takes a loan of $15,000 to buy a house. He repays it over the next four years, but during that time stops his contributions At age 50, he takes a second loan of $10,000 to help pay for his kids college (again stopping contributions for four years) At age 60, he withdraws $10,000 to buy his dream boat for retirement Both hypothetical accounts are assumed to be invested 100% in the S&P 500, earning the historical returns of the index over the 35 years from 1972 to Even though the two loans in the second case were paid back within four years, and the withdrawal to buy the boat came just one year before retirement, the difference in value of the two scenarios is dramatic. When the participant turns 61 in 2006, his balance in the first scenario with contributions year in and year out, and no withdrawals stands at about $1.3 million. The second case, assuming a few typical interruptions, shows a balance of $900,000, about one-third less. The difference in outcomes is striking. The shortfall in the second case is partly due to the participant having less capital at work during an unusually strong stock market for several years late in his career, during the time of the second loan. But the example is realistic nonetheless: participants can t predict or change when they may need to take a loan, so a retirement investment program needs to consider the worst, as well as the best, possible scenarios. Loans, withdrawals and contribution holidays are common, and can cause large shortfalls at retirement. A sponsor first needs to understand actual participant behavior, and how cash flow in and out of participant accounts interacts with the returns and volatility of the market. With those insights, the sponsor can then choose a target date strategy that brings the greatest number of participants to their income replacement goal. 7

12 Choosing an investment program Portfolio risk and glide paths By definition, all target date portfolios deliver professional management through adjustment of the portfolio s risk profile over time. Most allocate 80% or more of assets to equities in the early years for capital growth, and gradually add bonds and cash to generate income and preserve principal. There are, however, several important differences among target date strategies: Portfolio risk profiles during the early working years Speed of transition from riskier assets to bonds and cash Portfolio risk profiles during the years closest to retirement Amount of diversification used to manage risk In Exhibit 5, we illustrate the transition from higherrisk investments to lower-risk ones often referred to as the glide path of three typical target date designs, plus JPMorgan s SmartRetirement strategy. Equity assets are shown in several shades of blue, while cash and bonds appear in brown. The Aggressive strategy holds a high proportion of equities during the entire investment horizon, starting at 94% at age 25 and dropping to 59% by age 65. The Concentrated strategy holds 90% of assets in U.S. and international stocks at age 25, rolling down to 50% at age 65. (We deem this approach Concentrated because it holds a high proportion of equity assets in large cap U.S. stocks, with smaller allocations to small cap and international markets than the other three strategies.) The Conservative strategy starts at age 25 with an equity holding a mix of U.S. and international stocks of 89%. It quickly decreases its equity exposure, however, substituting bonds and cash until the equity allocation is just 17% of assets at age 65. Given their asset allocation strategies, these three target date designs differ in their expected risk and return characteristics. They are very much alike, however, in that their portfolios are chosen primarily from a limited set of assets traditional equities and bonds. JPMorgan s SmartRetirement design takes an altogether different approach to portfolio construction: SmartRetirement portfolios hold a wider spectrum of assets, creating a strategy that is more diversified and less influenced by the volatility of traditional equity returns than the Aggressive, Concentrated or Conservative designs. Diversifying assets include real estate (both direct and REITs), emerging market equity, and emerging market and high yield debt making up an average of over 25% of the portfolio during the participants entire career. While the Aggressive and Concentrated strategies include some of these diversifying assets, they are held in only small amounts. (In Exhibit 5, these additional asset classes are shown in shades of green.) SmartRetirement portfolios are designed to be more efficient. This means their diversifying assets have fairly high expected returns close to those of equities but are not highly correlated with the equity markets. Investing a large fraction in these extended and alternative assets can lower expected portfolio risk for a comparable level of return. 8

13 Exhibit 5: Asset allocation over time Cash and bonds Extended and alternative assets Equity Cash High yield Emerging market equity TIPS Emerging market debt EAFE U.S. fixed income Direct real estate U.S. small cap REIT U.S. large cap Comparing target date fund designs Aggressive glide path 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Age Cash and bonds Extended and alternative assets Equity Asset mix at ages: 25 years 45 years 65 years 3% 9% 35% 3% 6% 7% 94% 86% 59% Concentrated glide path 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Age Cash and bonds Equity Asset mix at ages: 25 years 45 years 65 years 10% 18% 50% 90% 82% 50% Conservative glide path 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Age Cash and bonds Equity Asset mix at ages: 25 years 45 years 65 years 11% 34% 84% 89% 66% 17% SmartRetirement glide path 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Age Sources: JPMorgan Asset Management and industry prospectuses. Note: Numbers don t always sum to 100% because of rounding. Cash and bonds Extended and alternative assets Equity 9 Asset mix at ages: 25 years 45 years 65 years 6% 13% 53% 22% 22% 20% 72% 65% 27%

14 Exhibit 6: Comparative risk and return characteristics* A: Expected returns B: Expected volatility 10% 8% Aggressive Concentrated Conservative SmartRetirement 16% 12% Aggressive Concentrated Conservative SmartRetirement 8% 6% 4% 4% Age % Age * Results are based on analysis derived from JPMorgan Asset Management long-term capital market assumptions 2006 (using arithmetic returns), JPMorgan Asset Management and industry prospectuses. SmartRetirement s portfolio efficiency is illustrated in the two panels of Exhibit 6. Panel A shows that SmartRetirement generates expected returns comparable to the Aggressive and Concentrated strategies, both of which make higher allocations to equities up to age 65. As Panel B illustrates, however, the SmartRetirement strategy shows an expected volatility of returns consistently below both the Aggressive and Concentrated designs because of its portfolio allocation to a broad range of diversifying assets and lower allocation to equities. (The volatility of the Conservative strategy ranks the lowest among the four approaches, but since it is derived from a lower allocation to equities, the strategy also shows the lowest expected return.) SmartRetirement s asset allocation approach meets the needs of the real-world participant in two ways. First, it is designed to generate an expected return comparable to the Aggressive strategy that may help participants accounts grow over time and meet their retirement needs. Second, diversification into a broader range of assets means the SmartRetirement strategy should have much less volatile returns than those strategies concentrated in traditional equities. The portfolio mix should provide downside protection superior to less diversified strategies. As a result, we expect smaller fluctuations in participant accounts during volatile markets, leading to more rapid growth in account balances. Moreover, lower volatility and less market shock should help participants to stay invested in the markets and lead to fewer pulling out altogether. Strong communications programs will further strengthen participants resolve for saving and investing through their target date strategy. 10

15 The payoff of target date strategies Differences among the investment strategies of target date designs can have a substantial impact on assets at retirement. For example, in Exhibit 7 we show the projected account balances at retirement for a statistical simulation of 10,000 participants for Aggressive, Concentrated and Conservative designs as well as the SmartRetirement design. In the graph, each bar represents the range of projected balances for each strategy. The top and bottom of the bars represent the 75th and 25th percentiles, respectively. The lines above and below the bars show the distribution of the highest and lowest values. Note that the range of projected outcomes is very wide, even though each employee started his or her career with the same salary. Using the Aggressive strategy as an example, the lowest and highest projections of account value at retirement are $228,000 and nearly $1.4 million, respectively a difference of more than $1 million. The sample includes participants of all types: from those who contributed consistently and left their accounts untouched, to others who saved more erratically, to others who borrowed or withdrew from their 401(k)s. Another reason for the wide range of outcomes is the variety of market conditions in the simulations, ranging from strong rallies to market crashes. (For a more detailed discussion of the simulation of retirement outcomes, please see our original white paper Ready! Fire! Aim? ) How do the projected results of the different portfolio strategies compare under these real-world conditions? First, consider the projections for the Aggressive strategy, on the left. It invests heavily in equities throughout the participant s career, and even into retirement. Since equities have the highest expected returns among the traditional asset classes, the Aggressive strategy might be expected to consistently produce the highest account values, both at the maximum and minimum. Due to their higher volatility, however, equities don t always produce the best results. True, the Aggressive strategy, with the highest equity, has the highest upside, at over $1.4 million. However, the upper range of the Concentrated approach and SmartRetirement both approach $1.2 million. (The Conservative design shows the lowest top value, at nearly $900,000.) But the Aggressive and Concentrated strategies also generate the lowest downside projections, at $228,000 and $224,000, respectively, which are lower than even the lower boundary of the Conservative approach. Clearly, overweighting with equities is not a winning approach for all participants and conditions. At the median, the projected outcome is the same for both the SmartRetirement and the Aggressive Exhibit 7: Range of expected account balances at retirement with JPMorgan participant research findings (000)s $1,500 $1,400 $1,300 $1,200 $900 $600 $400 $300 $ Aggressive Concentrated Equity glide path approach 357 Percentile 5% 25% 50% 75% 95% Broad asset Conservative SmartRetirement Results are based on analysis derived from JPMorgan Asset Management long-term capital market assumptions 2006, JPMorgan Asset Management and industry prospectuses. See Exhibit 3 for assumptions on participants average contribution rates. All dollar values are inflation-adjusted. 11

16 strategies, at $551,000, due to the strong expected return of SmartRetirement. Even though it contains less equity, SmartRetirement s portfolio construction results in a more efficient use of risk than the Aggressive strategy. Crossing the finish line As a final comparison, note the red line crossing all four bars in Exhibit 7. It represents an account balance at retirement of $400,000 the asset threshold needed to purchase an annuity to replace 35% of a working income of $65,000. From the participant s viewpoint, the entire range of projections including the downside, and what might be earned on the upside is important. But the attention of the fiduciary should be on those cases that are below the median, and especially those which don t cross the $400,000 threshold. With respect to retirement income, there s an asymmetry around the $400,000 level: the pain of having less retirement income, say, $5,000 per year below an equivalent working income, is far greater than the benefit of a $5,000 per year surplus. To illustrate the point, place yourself at the cafeteria at lunchtime. The cheeseburger costs $4: if you have $5, you can get lunch, and a cookie, too. But let s say you only have $3: now you can t afford any lunch at all. The penalty of having $1 too little (no lunch) hurts more than the benefit of having an extra $1 (the cookie). Fiduciaries are obliged to choose strategies that will ensure retirees have adequate income in terms of this example, $4 at lunchtime and expose as few as possible to the downside of a difficult retirement. The simulations of retirement outcomes in Exhibit 7 demonstrate that SmartRetirement s portfolio construction is indeed stronger on the downside than other strategies: SmartRetirement has a median projected value of $551,000, equal to the median of the equityheavy Aggressive approach, even though SmartRetirement takes far less risk across the participant s career. SmartRetirement is the only investment strategy that provides enough to replace 35% of working income for 75% of participants. SmartRetirement s broadly diversified portfolio also generates the highest minimum projection, even higher than the bond-intensive Conservative approach. The percentile calculations of Exhibit 7 can also be expressed in terms of people the numbers of retirees who, in real-world conditions, could wind up below their income replacement level. Exhibit 8 illustrates the projected results for a hypothetical plan of 10,000 people. Our projections suggest that within the Aggressive strategy, about 72% of participants will reach their replacement income, along with 69% of those in a Concentrated design and 65% invested in a Conservative strategy, while 76% of employees with SmartRetirement cross the finish line with the income they need. In a 10,000-life plan, SmartRetirement would produce 400 more income replacement successes than an Aggressive strategy, 700 more than a Concentrated design and 1,100 more than a Conservative design. Exhibit 8: Additional participants expected to cross the income replacement goal with the SmartRetirement design (Plan with 10,000 lives; account balance goal of $400,000)* Other target date designs SmartRetirement Strategy Expected success rate Expected success rate Expected participant impact Aggressive 72% 76% 4% or 400 more successes Concentrated 69% 76% 7% or 700 more successes Conservative 65% 76% 11% or 1,100 more successes * Results are based on analysis derived from JPMorgan Asset Management long-term capital market assumptions 2006, JPMorgan Asset Management and industry prospectuses. See Exhibit 3 for assumptions on participants average contribution rates. 12

17 A comprehensive communications program Although the Pension Protection Act grants employers broad new powers, communication with participants is still a crucial part of every 401(k) program. However, the combination of automatic enrollment, automatic contribution escalation and a strong default investment option, such as a target date strategy, will enable sponsors to reallocate the time they spend on teaching investment basics and details of investment choices to showing participants the value of a target date strategy, as well as their progress against their investment and retirement goals. We envision that a best-practices communication program for a plan based around a target date default option will reach out to participants in four areas: Setting goals and dreams, and how to achieve them. Sponsors need to recognize that each participant has different dreams for retirement. Where possible, these goals and dreams should be recognized in all communications. As administrators, our experience shows that participants are less likely to respond to complex analyses, and are more engaged by messages that involve their own passions and interests. Motivating consistent contributions and consistent increases. Because participants are easily overwhelmed when asked to make several financial decisions at once, we believe that the most effective communication proceeds one step at a time. We suggest an incremental approach that starts with the simple decision to participate, and later urges participants to increase contributions at other actionable times such as salary increases, birthdays or employment anniversaries. Testing investment knowledge and interest, and showing participants whether they are suited for the target date default option. Effective communication will show participants that there is nothing wrong with appointing someone else to make their investment decisions by delegating allocation decisions. The communication effort can focus on the effectiveness of the portfolio, and how it may fit their goals. Comparing progress to goals to determine whether the participant is on track. Financial tools for projecting assets at retirement are widely available, both through recordkeepers (as part of an integrated package), and several specialist providers. Our experience shows that the most effective communications are those that can make basic projections based on information already in the benefits database, and require minimal input from the participant. Although target date strategies relieve participants of investment responsibilities, they still need to be actively involved with their accounts to reap the benefits. Sponsors can emphasize the idea of meeting income needs in retirement, and focus participants attention on the best way to build a cushion of safety for a solid retirement income by increasing their savings. 13

18 A new generation of 401(k) plans The first generation of 401(k) plans were designed for a world that imagined participants were ready for the challenges of retirement saving and had the time and skill to make their own long-term investment decisions. The Pension Protection Act has corrected a number of those misconceptions by giving 401(k) plan sponsors new powers to help ensure that employees become participants, and participants become fullfledged retirement savers and investors. Among these new powers is the choice of a default investment option. Many sponsors have already moved their plans to target date retirement portfolios, and providers have responded with a range of products that vary in the risks they take, and the assets in which they invest. Although these portfolios share a common structure higher investment in riskier assets early on, and more conservative holdings later there are crucial differences in risk and return that over 30 to 40 years will make the difference between a difficult or comfortable retirement. Equally important is how the target date structure accommodates the behavior of participants. Default enrollment and escalation does not automatically equate to sufficient saving: participants encounter many life events that lead to interruptions in their saving, with big impacts on their retirement progress. Target date strategies may not require the participant to manage the investments, but they require a steady flow of contributions to hit retirement goals. As a result, communication programs and progress reports on the adequacy of saving are still as important as ever. JPMorgan Asset Management has a record of accomplishment in both retirement investing and innovative 401(k) administration. With this background, we developed a target date strategy that aims to deliver the necessary investment returns for retirement savings at controlled levels of risk. SmartRetirement is designed for the real world both in its broad diversification to manage investment volatility and its high expected return. We believe that SmartRetirement is a superior solution for the majority of participants, but especially the many reluctant savers and investment delegators in every employee population who need the most help. We look forward to discussing how SmartRetirement might enhance the retirement security of your 401(k) participants. 14

19 About JPMorgan Asset Management For more than a century, institutional investors have turned to JPMorgan Asset Management to skillfully manage their investment assets. This legacy of trusted partnership has been built on a promise to put client interests ahead of our own, to generate original insight and to translate that insight into results. Today, our advice, insight and intellectual capital drive a growing array of innovative strategies that span U.S., international and global opportunities in equity, fixed income, real estate, infrastructure, private equity, hedge funds and asset allocation. This report is a condensed version of our white paper Ready! Fire! Aim? The original paper contains a more detailed discussion of portfolio analytics, capital market return assumptions and participant simulations employed in our analysis. Readers interested in the full report can download it from our website at jpmorgan.com/definedcontribution. Opinions, estimates, assumptions and simulations offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. 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. These materials have been provided to you for information purposes only and may not be relied upon by you in evaluating the merits of investing in any securities referred to herein. Past performance is not indicative of future results. Indices do not include fees or operating expenses and are not available for actual investment. Indices presented, if any, are representative of various broad base asset classes. They are unmanaged and shown for illustrative purposes only. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal advisor regarding such matters. JPMorgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. and its affiliates worldwide which includes but is not limited to J.P. Morgan Investment Management Inc., JPMorgan Investment Advisors, Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. JPMorgan Chase & Co., January 2008 IM_SMARTR_LT

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