DEFAULT STRUCTURES IN DEFINED CONTRIBUTION PLANS

White Paper Series June 2017 Authors Kristen E. Colvin, CAIA Director, Investment Solutions Group Peter A. Delaney, CFA Director, Investment Solutions Group Shawn A. Cohen, CFA, LL.B Director, Relationship Management Ross Cartwright Director, Consultant Relations James Lindsay Director, UK & Ireland DEFAULT STRUCTURES IN DEFINED CONTRIBUTION PLANS Lessons from around the globe IN BRIEF With defined contribution schemes fast becoming the primary retirement savings vehicle around the globe, there has been an increase in the adoption of default structures to ease the investment decision making burden of individual members and participants. Regulatory initiatives around the globe, such as the Qualified Default Investment Alternative (QDIA) regulations in the US in 2007 and the Australian Stronger Super Reforms in 2011, have directly impacted flows into default strategies. Most default strategies adopted around the world are diversified asset allocation portfolios, but their structure varies from region to region, with lifestyle strategies the most popular in the United Kingdom, target date funds the most popular in the United States and increasingly in Canada and balanced strategies the most popular in Australia. Over the past decade, global defined contribution (DC) assets have grown at twice the rate of defined benefit (DB) assets. 1 With DC pensions fast becoming the primary retirement savings vehicle around the world, this is not surprising; however, it does highlight the reality that individuals are now largely responsible for making saving and investing decisions. Fortunately, features such as automatic enrollment and compulsory savings in some countries are helping to get more individuals enrolled in schemes and contributing at a meaningful level. From an investment perspective, many countries have adopted default investment solutions designed to simplify investment decision making for retirement savers. While the utilization of default solutions is a global trend, there are significant differences in the types of defaults used around the world. This paper provides a landscape overview of default solutions, seen through the lens of four markets at varying points along the journey from DB to DC: the United States, the United FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY

Kingdom, Canada and Australia (Exhibit 1). Specifically, we address the role of legislation in the widespread adoption of default solutions, the evolution of default strategies and differences in asset class exposure from country to country. Exhibit 1 Growth of DC assets Size of DC Market ($) 2010 2015 CA DC market $1.0 trillion DB/DC Split 68% DB/32% DC UK DC market $136 billion (CAP Assets) DB/DC Split 95% DB/5% DC DC market $6.7 trillion DB/DC Split 40% DB/60% DC 10% 20% 30% 40% 50% 60% 70% 80% 90% % of Retirement Assets Invested in DC Schemes US DC market $1.3 trillion DB/DC Split 13% DB/87% DC Sources: Investment Company Institute (4Q 2015), Towers Watson Global Pension Assets Study 2011 & 2016, Sun Life Designed for Savings 2014, Pensions Policy Institute Occupational Pension Schemes Survey 2014, OECD Pensions at a Glance 2015, Great-West Life CAP Benchmark Report 2014, Melbourne Mercer Global Pension Index 2015, LIMRA Secure Retirement Institute. Canadian DC assets as of 6.30.2016, Benefits Canada December 2016 magazine. Exhibit 2: Savings rates around the globe will be a key driver of default growth Australia Beginning in 1992 with the implementation of the Superannuation Guarantee Program, employers have been required to contribute to a Superannuation account (a tax-advantaged retirement program) on behalf of employees. The required initial contribution was 3% when the program was introduced, is currently 9.5% and will be increased to 12% by 2025. United Kingdom A law introduced in 2012 requires all employers to offer a workplace DC scheme and automatically enroll eligible workers in it. Contribution requirements will be phased in, with the initial minimum contribution set at 2% of earnings, growing to 5% of earnings in 2018 and ultimately to 8% of earnings in 2019. United States Here we find a truly voluntary DC system, although the Pension Protection Act (PPA) of 2006, while allowing the use of auto-enrollment, did not require a minimum contribution amount. Ten years post-ppa, 65% of plans in the US automatically enroll employees at an average deferral rate of 4.2%. Canada The governance of retirement plans varies from province to province, and Quebec is currently the only one to make workplace plans mandatory. In Quebec, voluntary registered savings plans (VRSPs) must be offered by all companies that do not offer a group-sponsored plan. Eligible employees must be enrolled in a VRSP but can opt out. There are no contribution requirements for employers. If they do not opt out, employees are required to contribute a minimum of 2%, increasing to a minimum of 4% by 2018. Legislative impact The future success of DC-based retirement systems relies on adequate savings rates and appropriate investment allocations. While this paper examines default solutions and their role in improving investment allocations, we cannot ignore the reality that savings rates are a big driver of the growth of both DC pensions and assets invested in defaults. Australia and the UK have taken relatively direct approaches to encouraging DC savings when compared with the US and Canada (Exhibit 2). Australia is the only country in which saving for retirement is truly compulsory. Australia s mandatory Superannuation Guarantee program was created in 1992, and currently requires employers to contribute 9.5% of earnings to a DC retirement plan for eligible employees. In the UK, autoenrollment began in 2012 and will be fully implemented by 2018. Under the UK s auto-enrollment provision, all employers must automatically enroll eligible employees in a DC retirement scheme while also allowing them to opt out of it. In the US there are no mandatory requirements when it comes to saving in a DC pension. In Canada, while there is no national mandatory scheme, one province Quebec has a mandatory scheme with a participant opt-out provision. Default investment strategies play a critical role in DC pensions, offering an investment strategy for participants or members who either lack the necessary expertise to make investment decisions or fail to make an investment election on their own. Since most participants or members fit into this category, it s not surprising to see a significant portion of DC assets invested in default investment strategies. For example, in the UK, 78% of member contributions are invested in default strategies, and that number could grow to more than 90% by the mid-2020s. 2 In Australia, 80% of workers have their compulsory superannuation contribution allocated to a default superannuation fund, and it is estimated that in the US default strategies will attract more than 60% of DC plan contributions by 2018. 3,4 Many factors can impact the adoption of one type of default over another, but quite often legislation is a driver. Exhibit 3 is a timeline of key regulatory initiatives in each region that have significantly impacted flows into default strategies. 2 FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY

Exhibit 3: Regulatory timeline CAD Quebec Voluntary Savings Plan Introduced Superannuation Guarantee Implemented US Pension Protection Act Enacted Stronger Super Reforms CAD Alberta DC Legislation Introduced 1992 2004 2006 2007 2011 2012 2014 2015 Choice of Superannuation Funds Act Published CAD Capital Accumulation Guidelines Introduced US QDIA Regulation Finalized UK Auto Enrollment Legislation Introduced UK Pensions Freedom Reform The 2007 implementation of Qualified Default Investment Alternative (QDIA) regulations in the US is perhaps the best example of a country identifying specific strategies eligible for default contributions. Prior to the QDIA regulations, DC assets were typically defaulted into capital preservation strategies such as money market or stable value funds. The QDIA regulations identified three types of investment strategies that could be used as long-term defaults target date funds (TDFs), managed accounts or a balanced fund that takes into account the characteristics of employees as a whole population (rather than as individuals). By choosing one of the three eligible defaults, plan sponsors are afforded a safe harbor (legal protection) from fiduciary liability for investment outcomes. A more recent example of legislation focused on default investments is the Australian Stronger Super Reforms. Announced in 2011 and effective in January 2014, the Stronger Super Reforms required employers to allocate default contributions to an authorized MySuper product. MySuper products must comply with a number of provisions, including some related to the type of investment strategy to which contributions are allocated. Investment strategies can include a single diversified option (i.e., a balanced fund) or a life stage investment option (i.e., a target date/lifecycle strategy). As default strategies continue to gather assets and increase in popularity, so too will their role in driving retirement outcomes for workers around the world. Exhibit 4: Types and utilization of default strategies Balanced Cash/Capital Preservation Lifestyle Managed Account Risk Based Target Date/ Lifecycle Australia Canada United Kingdom United States Primary default strategy utilized or significant growth in flows Decreasing utilization or decline in flows Initial consideration or steady flows Sources: Australia Based on AustralianSuper (largest superannuation fund with >$100bn as of July 2016); Canada Sun Life Designed for Savings 2014 & 2016; UK Pensions Insight/JP Morgan DC Pension Plans in the UK (Sep 2016); US 2017 Callan DC Trends FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY 3

Default investment types Balanced Typically a static asset allocation portfolio with assets generally invested in equities and fixed income securities; in Australia, also often includes allocations to private equity, direct property, infrastructure and other alternatives Cash/Capital preservation A low-risk investment option such as money market, stable value or guaranteed interest account Lifestyle Widely used in the UK; progressively shifts members into bonds or cash as they approach the retirement age selected when initially joining the plan Managed account Primarily a US offering; professionally managed asset allocation portfolio customized to an individual s financial situation Risk-based Asset allocation based solely on risk tolerance, with the goal of maximizing returns for risks taken Target date/lifecycle Broadly diversified investment option designed to automatically shift asset allocation from a growthorientation to a more conservative allocation as the target date (typically retirement) approaches. Types of default structures and asset class exposures by country Default strategies are generally well-diversified asset allocation portfolios, although their composition and implementation vary significantly country to country. As illustrated in Exhibit 4, there is wide variation based on asset flows into or out of each type in the types of default strategies adopted and their popularity. Australia Balanced strategies have historically been the most widely used default solution in Australia, especially for industry funds. Generally, the asset allocation is determined by a superannuation provider and is typically comprised of 60% 75% growth assets (i.e., equity and property) with the balance invested in more defensive, lower-risk assets. Relative to balanced strategies in other countries, Australian balanced funds often include more meaningful allocations to asset classes such as private equity, infrastructure and alternatives (i.e., hedge funds and absolute return strategies). Notably, superannuation investments in infrastructure have been encouraged by the Australian government and, as of January 2014, superannuation funds had about a 5% allocation committed to infrastructure (both equity and debt). 5 Exhibit 5 below demonstrates the evolution of Australian balanced funds over the past 15 years. Two additional areas of the Australian default market that are growing significantly include lifecycle (or target date) solutions and self-managed super funds. Lifecycle investment strategies have been widely adopted by the retail segment of the Australian retirement market. Like the target date strategies broadly used in the US and Canada, these strategies automatically adjust members asset allocations as their circumstances (primarily age) change. With the recently implemented MySuper regulations, the use of lifecycle strategies is expected to continue growing. Another fast growing segment of Australia s retirement system is selfmanaged super funds, which currently represent 29% of the $2.1 trillion superannuation pool. 6 With these funds, individuals are responsible for making investment decisions and complying with super and tax laws. A self-managed super fund is maintained for the sole purpose of providing retirement benefits to members or their dependents. Exhibit 5: Typical Australian fund 15 years ago Exhibit 5a: Typical Australian fund as of June 2015 Growth Assets Growth Assets Defensive Assets Cash 5% Defensive Assets Cash 0% Alternatives 5% Australian shares 35% Fixed income 7% Australian shares 30% Fixed income 25% Property 9% Infrastructure 3% Alternatives 3% Property 6% Property 10% International shares 25% Infrastructure 7% Private equity 5% International shares 25% Source: PwC, Investment Consulting, Comparing super funds: Apples vs apples or fruit salad, June 2015. 4 FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY

Canada Default structures in Canada have transitioned from capital preservation strategies (guaranteed interest accounts and money market strategies) to TDFs, for which there are approximately 14 providers and 17 fund suites. While the transition has been predicated on learnings from the US, we now see several provinces prescribing TDFs as potential defaults. Representative data from Canada show default structure use stands at 16% money market, 11% balanced, 15% target risk, 55% TDFs and 2% other structures, including guaranteed interest accounts (GIAs) and bond funds. 7 The new provincial legislation should drive even higher growth in TDF assets in Canada. Looking at the evolution of TDFs in Canada, we have seen significant decrease in the home-country equity bias and a more moderate decrease in domestic bonds in favor of global equity and bond allocations. Allocations to alternative asset classes, including listed and direct real estate and infrastructure, have also replaced some domestic assets. United Kingdom For the UK, the primary default structure is the lifestyle fund, which invests in several underlying funds that shift from growth to lower-risk investments as retirement approaches. The typical glide path includes an allocation to global equities for the growth phase, and then, perhaps 5 to 15 years out from retirement, a decrease in the equity exposure and an increase in the exposure to less risky funds such as multi-asset diversified growth funds, bonds or cash. Diversified growth funds, which often help to reduce volatility while aiming to produce equity-like returns over the medium to long term, are used as underlying funds in many lifestyle structures. These funds invest in assets with returns that have historically had a low correlation to equities or bonds, including commodities, private equity, infrastructure and hedge funds. In April 2015, the British government introduced a new reform referred to as Freedom and Choice, effectively changing the tax rules to provide DC members greater access to their pensions. Members are no longer forced to purchase an annuity. The new freedoms allow DC members to Leave the pension pot untouched Purchase an annuity Take an adjustable income (drawdown product) Take their whole pension pot as a lump sum or series of lump sums Take a combination of the above United States In the US, we have seen a significant transformation in default options since the passage of the Pension Protection Act in 2006 and QDIA regulations in 2007. Prior to 2007, the most common default options were capital preservation strategies (i.e., stable value or money market) or risk-based/balanced funds. As of June 2017, more than 85% 8 of plans use TDFs as their default strategy, with the remainder using a mix of capital preservation funds, balanced funds and managed accounts. Over the past few years, TDF asset class exposures have shifted from focusing primarily on domestic and international stocks and bonds to increases in REITS, TIPS, commodities and Exhibit 6: Underlying asset allocation exposure comparison Global Equities Domestic bonds Foreign Bonds High Yield EMD Inflation- Linked Bonds Private Equity Hedge Funds Property REITS Infrastructure Commodities Multi- Asset Australia Canada United Kingdom United States Higher Prevalence Moderate Prevalence Minimal Prevalence Prevalence of underlying asset classes in diversified growth funds (DGFs) Sources: Australia PwC Comparing super funds (June 2015); Canada Sun Life Designed for Savings 2016; UK Schroders FTSE Default DC Schemes Report (May 2016); US Morningstar 2017 Target-Date Fund Landscape (April 2017) FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY 5

niche-fixed income asset classes (i.e., high-yield and EMD). More recently, target date strategies have contemplated investments in more institutional asset classes such as private equity, hedge funds and other liquid alternatives. The demand for TDFs has pushed the growth of these products to roughly 50 prepackaged funds available in June 2017. 9 But although 70% of plans used their recordkeeper s proprietary TDF in 2011, now only 34% of plans do so. As plans revisit their TDF offering, some, especially those with total plan assets of more than $1 billion, have opted to build their own custom target date solutions (representing 17.1% of plans in 2015). To get a broader sense of what the underlying asset class exposure of default strategies looks like across countries and regions, see Exhibit 6. While exposures vary around the globe, one common theme is to incorporate more institutional asset classes in default structures. This overview of the global default structure landscape provides a context for key insights based on what we learn from the evolution of these strategies around the world. With DC plans continuing to replace DB plans as the retirement vehicle of choice, we expect to see further changes in default structures. The drivers of change will likely be those in play over the past decade, which include the following: Regulatory shifts geared toward protecting the best interests of participants or members who now shoulder more of the responsibility for their retirement investment and saving decisions Asset allocation changes designed to simplify investment decision making and improve retirement outcomes across employee populations Asset class exposure variations aimed at capturing different sources of return, particularly among what are considered more institutional asset classes For each of these drivers, the dialogue is ongoing. Working with DC plans across the globe, MFS is an active participant in these conversations. As a follow-up to this default landscape discussion, MFS will share periodic insights on best practices for default structures and lessons learned from around the world. Our first set of insights, to be published shortly, will cover the measurement of a default structure s success, risk management, investing for social good, the role that default structures might play in transitioning participants or members from accumulation to decumulation and the creation of retirement income. 6 FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY

Endnotes 1 Willis Towers Watson, Global Pension Assets Study 2017. 2 Pensions Policy Institute, Briefing Note 73, Defined contribution default funds and investment governance, March 2015 3 Australian Government, The Treasury, Stronger Super, (https://strongersuper.treasury.gov.au.). 4 Cerulli Associates, U.S. Defined Contribution Distribution 2016: Engaging the Boutique DC Consultant in the Mid-Sized DC Plan Market. 5 PwC Australia, Investing in Infrastructure: International Best Legal Practice in Project and Construction Agreements, January 2017. 6 ABC News, Self-managed super funds still providing smaller returns than APRA regulated funds: ATO, 21 December 2016. 7 Sun Life Financial, Designed for Savings, 2016. 8 Callan 2017 DC Trends Survey, Q1 2017. 9 Morningstar 2017 Target Date Funds Landscape (April 2017). The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. Unless otherwise indicated, logos and product and service names are trademarks of MFS and its affiliates and may be registered in certain countries. Issued in the United States by MFS Institutional Advisors, Inc. ( MFSI ) and MFS Investment Management. Issued in Canada by MFS Investment Management Canada Limited. No securities commission or similar regulatory authority in Canada has reviewed this communication. Issued in the United Kingdom by MFS International (U.K.) Limited ( MIL UK ), a private limited company registered in England and Wales with the company number 03062718, and authorized and regulated in the conduct of investment business by the U.K. Financial Conduct Authority. MIL UK, an indirect subsidiary of MFS, has its registered offi ce at One Carter Lane, London, EC4V 5ER UK and provides products and investment services to institutional investors globally. This material shall not be circulated or distributed to any person other than to professional investors (as permitted by local regulations) and should not be relied upon or distributed to persons where such reliance or distribution would be contrary to local regulation. Issued in Hong Kong by MFS International (Hong Kong) Limited ( MIL HK ), a private limited company licensed and regulated by the Hong Kong Securities and Futures Commission (the SFC ). MIL HK is a wholly-owned, indirect subsidiary of Massachusetts Financial Services Company, a U.S.-based investment advisor and fund sponsor registered with the U.S. Securities and Exchange Commission. MIL HK is approved to engage in dealing in securities and asset management-regulated activities and may provide certain investment services to professional investors as defi ned in the Securities and Futures Ordinance ( SFO ). Issued in Singapore by MFS International Singapore Pte. Ltd., a private limited company registered in Singapore with the company number 201228809M, and further licensed and regulated by the Monetary Authority of Singapore. Issued in Latin America by MFS International Ltd. For investors in Australia: MFSI and MIL UK are exempt from the requirement to hold an Australian fi nancial services licence under the Corporations Act 2001 in respect of the fi nancial services they provide to Australian wholesale investors. MFS International Australia Pty Ltd ( MFS Australia ) holds an Australian fi nancial services licence number 485343. In Australia and New Zealand: MFSI is regulated by the SEC under US laws and MIL UK is regulated by the UK Financial Conduct Authority under UK laws, which differ from Australian and New Zealand laws. MFS Australia is regulated by the Australian Securities and Investments Commission. FOR INSTITUTIONAL AND INVESTMENT PROFESSIONAL USE ONLY MFSE-DEFAULT-WP-6/17 38153.1