speaking investments THE IMPORTANCE OF DIVERSIFICATION IN DC PLAN FIXED INCOME

speaking investments THE IMPORTANCE OF DIVERSIFICATION IN DC PLAN FIXED INCOME

INTEREST RATES ARE POISED TO RISE FROM NEAR-HISTORIC LOWS, POSING CHALLENGES FOR EVEN THE MOST SOPHISTICATED INVESTORS. As rates rise, investors face the possibility of declining asset values, and defined contribution (DC) plan sponsors and participants need to be prepared for this potential challenge. Yet, an examination of the industry landscape finds a lack of diversification in the fixed income investment strategies offered by DC plans. While plans, on average, have more than 10 equity options in their investment lineups, they have fewer than three fixed income options 1, which is often too narrow to provide a sufficiently varied roster of investments. For their part, participants may have a broad range of sophistication levels and may not fully understand the strategies and solutions in their plan lineups, including how target date funds (TDFs) use fixed income within a plan s glide path. Self-directed participants who make their own allocation choices may place too much, or too little, in fixed income, exposing their retirement portfolios to added risk. A prime example of a suboptimal fixed income allocation can be seen when younger workers are too conservatively invested, holding too much in fixed income and potentially forgoing the opportunity to optimize returns. On the other hand, older workers who hold insufficient fixed income investments may also be putting their retirement security at risk due to the potential for volatility and underperformance in a declining market. 1 PSCA 56 th Annual Survey.

Ultimately, participants face many risks when investing for retirement, not the least of which is that they might misuse investment options. The power of prudent diversification Prudent diversification can help mitigate many market-related risks, including rising interest rates. Through incorporating more and different types of investments, managers who diversify their fixed income exposure may be able to increase income and improve risk-adjusted performance in their portfolios. This is partly because individual fixed income sectors will respond differently to changes in interest rates, says Priscilla Hancock, fixed income strategist, J.P. Morgan Asset Management. The potential impact of a 1% move in rates on different fixed income sectors is illustrated in Exhibit 1. In past rising-rate environments, long duration bonds have been especially vulnerable, and high yield bonds have tended to benefit from the cushion of their relatively high yields. But no two rate cycles are exactly the same. The coming rate cycle will have its own distinct characteristics because it will follow an unprecedented, global central-bank stimulus (which drove interest rates to all-time lows). Diversification of fixed income solutions in a DC plan should not mean simply adding new investment options to a plan lineup. Indeed, it is always important to eliminate redundancy. Streamlining the core menu to include a diversified fixed income solution with more traditional sectors such as Treasuries and high-grade corporates and mortgages, as well as extended sectors such as high yield and emerging market debt, can simplify choices for participants and provide them with adequate diversity, says Daniel Oldroyd, Client Portfolio Manager, Global Investment Management Solutions Global Multi-Asset Group (GIM Solutions GMAG), J.P. Morgan Asset Management. Another way to do this is to invest in a TDF that has broad diversification within its fixed income exposure. Plan sponsors, however, should still be aware of what s under the hood. As retirement nears, the allocation to fixed income within the TDF glide path is likely to increase, says Oldroyd. It is also important to note that the levels of concentration and the composition of the fixed income portfolios will vary considerably among TDFs. At the point of retirement, for example, different TDF glide paths may allocate anywhere from 35% to 92% in fixed income. The sample glide paths in Exhibit 2 illustrate different levels of fixed income exposure that may be found in TDFs. Differences in fixed income exposure Fixed income investments may be found in a number of strategies within DC plans, including traditional core fixed income as well as core plus strategies that allocate to extended sectors of the market. Core bond funds invest primarily in investment-grade securities and search for high-quality investments for risk-adjusted returns with lower volatility. Core plus strategies include both traditional and non-traditional investments in order to provide additional potential for growth and income. These funds may invest in a range of strategies and extended sectors, such as high yield, bank loans and emerging market debt, to both manage risk and take advantage of opportunities created by changing market and economic conditions. Plan sponsors might also consider including professionally managed, diversified fixed income strategies, which can be used as a single solution or deployed together with diversified portfolios comprising other asset classes. Strategic and tactical flexibility However fixed income exposure is allocated, having the flexibility to strategically allocate across different sectors and then tactically adjust them, combined with robust risk control, can help managers craft an effective fixed income strategy. Strategic flexibility enables them to construct a portfolio with different sectors and sector weightings than the benchmark, while tactical flexibility allows them to employ hedges to mitigate downside risk and, opportunistically, position their portfolios and shift allocations in response to changing investment conditions. In addition to rising rates, changing conditions might include: shifts in inflation EXHIBIT 1: A 1% RISE OR DECLINE IN INTEREST RATES IMPACTS DIFFERENT TYPES OF BONDS IN DIFFERENT WAYS 2y UST 5y UST TIPS 10y UST 30y UST Floating Rate Convertibles ABS US HY U.S. Aggregate MBS Munis IG Corps -30 U.S. Treasury, Barclays Capital, FactSet, J.P. Morgan Asset Management. Fixed income sectors shown above are provided by Barclays Capital and are represented by - Broad Market: Barclays U.S. Aggregate; MBS: U.S. Aggregate Securitized MBS Index; Corporate: U.S. Corporates; Municipals: Muni Bond 10-year Index; High Yield: Corporate High Yield Index; TIPS: Treasury Inflation Protection Securities (TIPS). Floating Rate: Barclays FRN (BBB); Convertibles: Barclays U.S. Convertibles Composite; ABS: Barclays ABS + CMBS. Treasury securities data for # of issues based on U.S. Treasury benchmarks from Barclays Capital. Yield and return information based on Bellwethers for Treasury securities. Sector yields reflect yield to worst, while Treasury yields are yield to maturity. Correlations are based on 10-years of monthly returns for all sectors. Change in bond price is calculated using both duration and convexity according to the following formula: New Price = (Price + (Price * -Duration * Change in Interest Rates))+(0.5 * Price * Convexity * (Change in Interest Rates)^2). *Calculation assumes 2-year Treasury interest rate falls 0.50% to 0.00%,as interest rates can only fall to 0.00%. Chart is for illustrative purposes only. Past performance is no guarantee of future results. Data as of 10/31/14. -10-5.8-8.4-17.3 +1% -4.7-3.9-4.3-5.6-5.7-5.7-6.7-2.0 0.1-0.1-3.2 1.0 3.6 0 Percent 5.0 3.8 4.2 5.6 3.8 6.8 5.5-1% 9.3 7.7 22.6 10 30

or inflation expectations; unexpected volatility caused by geopolitical instability; and movements in spreads among the various fixed income sectors. In contrast, managers of passively managed funds that reflect a benchmark s sector, duration and credit quality weightings may find it difficult to mitigate the negative impact of an underperforming sector or a sharp rise in rates. Style purity and transparency As plan sponsors and participants evaluate their fixed income strategies, they should bear in mind that a strategy s style purity can be critically important to avoid duplication of investments and overexposure to particular sectors. While some managers drift from their strategy s stated investment goals and process, as defined in their fund s prospectus, a style-pure manager will stay very close to those defined goalposts. Whatever the strategy, transparency is key. As fiduciaries, plan sponsors should have a clear understanding of the role of fixed income in their plan s core investment lineup and be knowledgeable about how specific menu options are allocated across sectors, duration and credit quality, as well as how and why derivatives are being used in a portfolio. For TDFs, plan sponsors should also understand how fixed income is used in the glide path across the plan s chosen TDF series. Finally, plan sponsors need to educate participants on the important role fixed income can play in a retirement portfolio. This asset class can reduce overall portfolio volatility and help a participant diversify, potentially mitigating risk in different market environments. Given these potential benefits, and those gleaned from having a well-diversified fixed income portfolio that may fare better in a rising-interest-rate environment, plan sponsors should take a close look at their plans investment menus to ensure that their participants have access to an appropriate mix of fixed income options. RETHINKING YOUR DC PLAN S FIXED INCOME OPTION Depending on the plan s goals and objectives, a plan sponsor may position the fixed income option in a number of different ways. Here are some key considerations that should be explored: What is the role of fixed income in your plan? How do the plan s fixed income selection(s) line up with the needs of plan participants? Should it be available as a stand-alone option in the core menu or is it best deployed through an asset allocation fund? Have there been any material changes to the investment lineup that require additional due diligence? EXHIBIT 2: DIFFERENT GLIDE PATH FIXED INCOME EXPOSURES Glide path focused on longevity risk 61.4% Fixed income and cash alternatives & cash 38.0% Equity Should the managers who service the company s defined benefit plan be leveraged? If the plan has an Investment Policy Statement (IPS), how do any manager changes impact those guidelines? CLIENT NEEDS AND INVESTMENT SOLUTIONS SHOULD BE ALIGNED 25 30 35 40 45 Glide path focused on market risk 25 30 35 40 45 50 55 AGE 50 55 AGE 60 60 65 65 70 70 75 75 80 80 88.3% Fixed income and cash alternatives & cash 11.7% Equity CLIENT NEED Preservation of capital, income and diversification to stocks Total return generation which can provide additional income and the potential for returns FIXED INCOME STYLE Core Core Plus Source: J.P. Morgan Asset Management. For illustrative purposes only. Some totals may not equal 100 due to rounding.

TARGET DATE FUNDS. Target date funds are funds with the target date being the approximate date when investors plan to start withdrawing their money. Generally, the asset allocation of each fund will change on an annual basis with the asset allocation becoming more conservative as the fund nears the target retirement date. The principal value of the fund(s) is not guaranteed at any time, including at the target date. Certain underlying Funds of the Target Date Funds may have unique risks associated with investments in foreign/emerging market securities, and/or fixed income instruments. International investing involves increased risk and volatility due to currency exchange rate changes, political, social or economic instability, and accounting or other financial standards differences. Fixed income securities generally decline in price when interest rates rise. Real estate funds may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector, including but not limited to, declines in the value of real estate, risk related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by the borrower. The fund may invest in futures contracts and other derivatives. This may make the Fund more volatile. The gross expense ratio of the fund includes the estimated fees and expenses of the underlying funds. This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice. J.P. Morgan Asset Management is the marketing name for the investment management businesses of JPMorgan Chase & Co. and its affiliates worldwide. Those businesses include, but are not limited to JP Morgan Chase Bank, N.A., J.P. Morgan Investment Management Inc., Security Capital Research and Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.