Active, Passive or custom? Choosing the right target date strategy for plan participants With their emphasis on one-stop diversification and active asset allocation, target date funds (TDFs) are taking center stage in DC offerings. The DC landscape, however, faces a fundamental dilemma. While everyone from plan sponsors and recordkeepers to investment managers and advisors is trying to increase the certainty of participants retirement income, the participants themselves still determine how much to save, where to invest and when to withdraw from the plan. Building a successful target date approach requires an understanding of the interactions among participants inputs into the DC dilemma. 16 JOURNEY Fall 11
Target date funds are poised to dominate the DC market TDFs are set to become the primary investment vehicle in DC plans. Currently, TDFs make up about 11% of the $4.9 trillion DC market and are forecast to grow to % to % of the market by 15, according to a September 1 McKinsey & Co. report, Winning in the Defined Contribution Market of 15. Meanwhile, nearly 7% of plan sponsors have chosen a TDF for their Qualified Default Investment Alternative (QDIA), according to Callan Investments Institute s 11 Defined Contribution Trends Survey. Plan sponsors are implementing TDFs in a number of ways. Some are opting for an unbundled, or open architecture, approach over an off-theshelf, single manager approach. Others are adding passive blend approaches in their TDF design that combine active management in less efficient markets and asset classes with index management in more efficient areas, such as U.S. stocks. Meanwhile, as more plan sponsors consider strategies like EXHIBIT 1: Same target, different bull s eye Diversification, equity exposure among 1 TDFs can vary widely Asset class diversification 12 11 1 9 8 7 6 5 NW SW re-enrollment to drive more assets into the QDIA, some are evaluating customized TDF solutions where they can tailor a glide path for their participants or use the existing managers in their plan line-up. Making sense of the target date funds universe With over 3 different TDF approaches to choose from, selecting the appropriate solution for a specific plan can be challenging. J.P. Morgan Asset Management s Target Date Compass is a tool that can help plan sponsors and their advisors compare TDFs across providers and identify those that most closely align with their overall goals. Using publicly available information, each fund family is mapped into one of four quadrants based on its percentage of equity exposure at the projected retirement date (Xaxis) and the level of asset class diversification across the TDF suite (Y-axis). As Exhibit 1 illustrates, there is a wide variance in TDF objectives. The level of equity at retirement, for example, can NE SE 5% 15% 25% 35% % 45% 55% 65% 75% of equity at retirement Data as of December 31, 1. Powered by Lipper, a Thomson Reuters Company. Of the mutual funds available in Lipper s databases, as of 12/31/1, 47 fund suites were identified by Lipper as open end target date funds and are available for purchase by qualified retirement plans. (The ETFs ishares and TDX Independence Funds are excluded.) age of equity exposure among 1 TDFs at age 65: Strategic allocation to non-fixed income asset classes at target date, typically age 65. Asset class diversification: Determined by exposure, across each company s suite of target date funds, to 12 separate asset classes as reported to Lipper through asset allocation, capitalization, credit quality, sector, region and country data as well as underlying fund categorization. Please see the Target Date Compass Methodology booklet for additional information. range from less than 1% to as much as 65% in 1 TDFs. Many TDFs have changed their strategies in response to the financial crisis. In 7 and 8, for example, many of the TDF managers in the Southeast quadrant (higher equities, lower diversification) shifted up on the model as they added more asset classes, while more investment firms also launched new TDFs in the Northeast quadrant (higher equities, higher diversification). In 9 and 1, TDFs continued to shift upward, but there was also a slight shift to the center axis as managers reduced their equity exposure in response to market volatility and the financial crisis. This year, more TDFs are moving from the south to north quadrants even as more firms launch TDFs in the Northwest quadrant (lower equity, higher diversification). Where the TDFs are in their respective quadrants will shed light on their glide paths. As Exhibit 2 illustrates, TDFs in the Northeast quadrant continue to hold higher levels of equity at retirement, while TDF managers in the Southwest quadrant tend to have a more conservative approach and typically pare back the equity positions to about % at retirement. Choosing an appropriate target date fund The first step in selecting a TDF starts with defining the goals for the DC plan as well as the desired outcomes for participants. The next step is to identify the TDFs that seek to produce outcomes that align with those goals. Conducting due diligence on those funds that are in alignment with your goals is the final step. To determine realistic plan goals, plan sponsors will need to examine what they know and don t know about the current environment and their plan participants. What s known, for example, in the current environment is that J.P. Morgan JOURNEY 17
Insights into participant behaviors and their implications for DC investments EXHIBIT 2: Target date fund designs are based on different goals and assumptions Representative allocations of target date fund approaches for comparison One of the key insights learned from J.P. Morgan Retirement Plan Services participant survey is that participants remain accidental investors and saving for retirement is a distant second compared with other financial priorities. Consider participants responses to the 8 financial crisis. According to the firm s survey, less than 1% of people actually made any changes in their plans in the fourth Daily expenses are most important Top financial priority 1% Other 2% Saving for children s education 5% Paying off/ down car loan 12% Paying off/down mortgage 1% Paying off/down credit cards 17% Saving for retirement 49% Paying monthly bills 5% Saving for emergency fund Source: J.P. Morgan Retirement Plan Services, 1 Participant Survey. quarter of 8. Meanwhile, only 17% of plan participants say that saving for retirement is a top financial priority, a distant second to paying monthly bills, according to a J.P. Morgan 1 Participant Survey. In another sign that plan participants are largely accidental investors, about 37% of new participants in J.P. Morgan s recordkeeping complex in 1 joined their DC plan through sponsor direction. In many cases, investors aren t maximizing the company match or making the full contributions for the year. Indeed, participant engagement using online advice tools, contacting call centers to ask questions and checking balances only starts to pick up closer to retirement. And within a few years after retiring, most participants particularly those with larger balances tend to quickly pull their assets out of the plan. For plan sponsors, participant behavior can have implications for investment selection. Participants lower engagement levels, for example, increases the importance of single, one-stop solutions for participants to make easy decisions. Meanwhile, plan sponsors may want to provide a range of solutions within the core line-up for participants who are accumulating assets and also for those who are in the decumulation phase. Northwest Quadrant 25 3 35 45 5 55 65 7 75 Northeast Quadrant 25 3 35 45 5 55 65 7 75 Southwest Quadrant plan sponsors are the plan fiduciaries and that 1(k)s and DC plans are fast becoming the primary source of retirement income outside of Social Security. The unknown variables in this case include future legislative changes. When it comes to participant characteristics, plan sponsors know basic demographic data, such as participants age, income levels, average tenure and contribution levels. Among the safe assumptions they can make: participants aren t saving enough for retirement, many will start making withdrawals from the plan between the ages of 59 ½ and 65, and most aren t familiar with the best ways to use lump sums to extend retirement income. There are also many unknowns, such as what the market environment will be like when participants start making withdrawals. Choosing the appropriate strategy requires an understanding of how retirement outcomes are shaped by the TDF design and performance. In our view, outcomes are largely shaped by how a TDF manager approaches three key considerations: the riskadjusted return potential, volatility management and the level of equity exposure at retirement. continued on p. 19 25 3 35 45 5 55 65 7 75 Southeast Quadrant 25 3 35 45 5 55 65 7 75 REITs Emerging Equity U.S. Fixed Income Real Estate Source: Industry prospectuses EAFE High Yield TIPS Cash U.S. Large Cap Emerging Debt Commodities U.S. Small Cap 18 JOURNEY Fall 11
Legislative Corner continued from p. 5 Plan Sponsor Playbook continued from p. 15 Designing a custom target date solution Larger plan sponsors generally those with more than $5 million in DC assets are moving today to a custom TDF approach where they have the ability to build a glide path designed for their participants or can use the existing plan s managincome, as well as enabling older workers to continue working on a reduced basis even while they are in retirement pay status. Bob: There s great discussion in Washington and across the country about deficit reduction. Can you share some perspectives around employee benefits and deficit reduction? jim: This, of course, is extremely timely with the Joint Committee on Deficit Reduction developing its proposals by Thanksgiving, and Congress directed to pass legislation by Christmas. The tax preferences for employee benefit programs are squarely part of this discussion. This year, the Federal government estimates that the tax expenditure the lost tax revenue for employerprovided health coverage is $177 billion. The exclusion for employersponsored defined benefit pension and defined contribution plans totals $112 billion. A critical question is whether policymakers view the tax expenditures for the employer-sponsored benefits system as sources of revenue to reduce the deficit or a great bargain because the private employer-sponsored system relieves financial pressure on Social Security and Medicare. We are very engaged in the dialogue on behalf of our members and the millions of Americans they represent. These are important issues that can affect the retirement landscape for generations to come. re-enrollment has resulted in a 96% participation rate a % increase from 8. Additionally, the decision to map participants into target date funds has resulted in a more appropriate distribution among the target date funds, equities and the less aggressive options available Active, Passive or Custom? continued from p. 18 Plan sponsors also need to consider how the TDF strategy aligns with the plan s objectives. TDFs with higher levels of equity across the glide path will typically result in higher account balances at retirement but with potentially more ups and downs along the way. Conservative TDFs, meanwhile, may sacrifice potential upside but benefit from lower levels of volatility. in the plan. In fact, across younger age groups, the average allocation to stable value is now below 1% -half of what it was in 8. Even more encouraging, however, is the anticipated impact of these design changes on participants level of retirement readiness. Not only have income replacement levels increased from 32% to 74%, but also half of all participants are now on track to achieve greater financial security by receiving at least 7% of their current income replacement in retirement. ers. Custom TDFs may also allow plan sponsors to include alternative investment structures, such as insurance contracts, hedge funds or direct real estate investments. Building a custom TDF portfolio can also allow plan sponsors to get more precise about setting their glide path objectives whether, for instance, they want their glide path to be managed to or through retirement. Looking forward A successful retirement program provides the most employees with the highest probability of maintaining their standard of living in retirement. Plan sponsors must establish realistic goals at the onset and consider a range of criteria, such as the current investment environment and participants demographic data. Furthermore, as more plan sponsors take into account participants engagement levels throughout their working years, there are opportunities to build better plan line-ups through customized approaches or by adding strategies to address longevity, volatility and purchasing power risks. J.P. Morgan JOURNEY 19
Each issue, we answer questions we receive from readers. Please send your questions to: journey_ magazine@ jpmorgan.com How can you improve target date fund adoption among your participants? Despite plan sponsors efforts to introduce target date funds into plans, the level of adoption among participants is still strikingly low. What can fiduciaries do to improve plan adoption rates? In Fiduciary implications: Using re-enrollment to improve target date fund adoption, Fred Reish, partner, Drinker Biddle & Reath, LLC, offers insight on the strategies plan sponsors can consider when seeking an increase in the level of target date fund adoption in their plans. The white paper provides analysis of target date implementation options and discusses the fiduciary implications of plan sponsor decisions. You can download a copy of the paper at www.jpmorganfunds.com/jpmfdocs/wp-re-enroll.pdf J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. and its affiliates worldwide. Publications referenced in this material are presented for general educational purposes only. JPMorgan and its affiliates did not receive any compensation or consideration for referencing these titles. The opinions and information presented in these titles do not necessarily reflect the opinions of JPMorgan Chase & Co. and its affiliates. This document is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein may employ proprietary projections of expected returns as well as estimates of their future volatility. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Discussions presented should not be construed as legal opinions or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity that you represent or advise. Past performance is no guarantee of future results. J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates world wide. IRS Circular 23 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties. 11 JPMorgan Chase & Co. All rights reserved.