Considerations for Evaluating Target Date Glide Paths Stefan Hubrich, CFA, Ph.D., Director of Asset Allocation Research, T. Rowe Price Judith Ward, CFP, Senior Financial Planner, T. Rowe Price
Things to Keep in Mind We are introducing a framework for target date evaluation. We are focusing on the equity exposure the main driver. (And recognize there are many other important factors). We will consider highly stylized cases, and in reality, plan sponsors face variety in their process. We will focus on how goals and behavior interact with target date evaluation and outcomes. 2
Target Date Evaluation Is Getting Complicated LOTS OF RESEARCH WIDE RANGE OF CHOICES MEDIA BUZZ TARGET DATE EVALUATION GOVERNMENT INVOLVEMENT Should Retirees Rely on Target- Date Funds? DC plans move to custom target-date portfolios Participant needs are key to move toward custom target-date funds Department of Labor 3
Misleading Single Drivers of Target Date Evaluation Longevity risk Fees Market risk Rollover behavior at retirement Undersaving Inflation risk Time diversification Component selection TARGET DATE EVALUATION 4
What s Important in Driving Retirement Outcomes? Behavior Equity Exposure Goals & Preferences Active/Passive Fees Glide Path Shape 5 RETIREMENT OUTCOMES
Need to Consider Everything Simultaneously GOAL RISK FOCUS SAVINGS BEHAVIOR ENVIRONMENT EQUITY EXPOSURE 6
GOAL Plan Sponsor Determines Goal What s the purpose of my plan? Why do our employees value having a 401(k)? How do we measure success the balance or income stream? Do we want our employees to stay in the plan when they leave? GOAL RETIREMENT INCOME Focus on ability to obtain a reliable income stream in retirement BALANCE ACCUMULATION Focus on balance at the time of leaving employer (retirement or job change) 7
RISK FOCUS Both Retirement Income and Balance Risk Are Impacted by Market Risk Real World Risk Drivers Uncertainties that need to be included in the analysis Risks Experienced by Participants What ultimately matters from participants perspective RETIREMENT INCOME RISK BALANCE RISK 8
SAVINGS BEHAVIOR What Is Good Behavior? Contribution HIGH Rate PARTICIPANT & EMPLOYER Leads to stronger asset growth potential Social Security is phased out at higher levels The results: Replace lower income percentage for high earners Higher earners demand more from 401(k) to maintain standard of living in retirement Salary LOW Defined Benefit Plan Reduces income demand from 401(k) assets in retirement Sponsors impact savings behavior the cash flows in and out of the plan. 9
ENVIRONMENT Capturing the Environment Appropriately Capital Markets Longevity Laws and Regulations WHY THIS MATTERS Represent how the world works Must capture correctly Empirical exercise Modeling work for the Target Date provider Model the uncertainties ( risks ) to capture the distribution of these factors Better way to be conservative than a fixed pessimistic assumption 10
Goal? Risk Focus? RETIREMENT INCOME RETIREMENT INCOME RISK EQUITY EXPOSURE MORE EQUITY BALANCE ACCUMULATION BALANCE RISK Equity exposure actually hedges retirement income risk. 11
Goal? Risk Focus? Savings Behavior? EQUITY EXPOSURE RETIREMENT INCOME RETIREMENT INCOME RISK BETTER LESS EQUITY WORSE BALANCE ACCUMULATION BALANCE RISK Good behavior makes it easier to address balance risk. 12
Goal? Risk Focus? Savings Behavior? EQUITY EXPOSURE RETIREMENT INCOME RETIREMENT INCOME RISK BETTER BALANCE ACCUMULATION BALANCE RISK WORSE Challenging behavior forces a tough choice between goal and risk. 13
Goal? Risk Focus? RETIREMENT INCOME RETIREMENT INCOME RISK EQUITY EXPOSURE MORE EQUITY BALANCE ACCUMULATION BALANCE RISK Equities can potentially help balance accumulation if sponsor is not concerned about risk. 14
Goal? Risk Focus? RETIREMENT INCOME RETIREMENT INCOME RISK EQUITY EXPOSURE LESS EQUITY BALANCE ACCUMULATION BALANCE RISK Risk tolerance drives equity exposure with accumulation goal. 15
Read the full research paper: Evaluation of Target-Date Glide Paths Within Defined Contribution Plans 16
17 ACTUALLY What s Happening?
What is your priority in target date design between asset growth to support lifetime income generation vs. capital preservation? (A) (B) (C) (D) (E) 1 2 3 4 5 Exclusive emphasis on capital preservation Both objectives equally important Exclusive emphasis on lifetime income generation 18
36% 27% 34% 4% 0% (A) (B) (C) (D) (E) 1 2 3 4 5 Exclusive emphasis on capital preservation Both objectives equally important Exclusive emphasis on lifetime income generation 19
Participants Have a Retirement Income Focus Too 84% 65-year-old Terminated Participants are out of plan in 3 years Assets remain invested in the retirement system 20
Participants Don t React to Market Events 86% 97% Non-Target Date investors did nothing Target Date investors did nothing 21
How Do Participants Behave? As of December 31, 2012 100% Industry Average of Participants Contributing (left axis) S&P 500 Index Year-End Close (right axis) 1,500 80% 60% 40% 20% 1,400 1,300 1,200 1,100 1,000 900 Percentage of participants contributing to their plan stays in the mid-80%s regardless of market performance 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 800 22 Source: PSCA s 56th Annual Survey of Profit Sharing and 401(k) Plans (2013), reflecting plan year 2012
How Do Participants React? As of December 31, 2012 20% S&P 500 Index Year-End Close (right axis) Industry Average of Contribution Amount (left axis) Contribution Target Amount (left axis) 1,600 15% 10% 5% 1,400 1,200 1,000 800 600 Participant contribution amount stays around 5% regardless of market performance 0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 400 23 Source: PSCA s 56th Annual Survey of Profit Sharing and 401(k) Plans (2013), reflecting plan year 2012. Non-HCEs.
We Need to Close the Gap As of December 31, 2012 S&P 500 Index Year-End Close (right axis) Contribution Target Amount (left axis) Industry Average of Contribution Amount (left axis) 20% 1,600 15% 15% Contribution Target Amount 1,400 1,200 Participants are not saving nearly enough 10% 1,000 800 5% 600 0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 400 24 Source: PSCA s 56th Annual Survey of Profit Sharing and 401(k) Plans (2013), reflecting plan year 2012. Non-HCEs.
The Tradeoff We can t have our employees save 2% more. That would mean a 2% drop in their lifestyle; they can t handle that! Implied framing: 25
No Treatment (Do Nothing) David ($40,000 salary): Age 25 $0 balance 0% contribution rate 0% employer contribution When David starts withdrawals at age 65, what percent of his salary will he replace? 26
David, Age 25 100% 75% 50% 25% 0% 72% DROP IN LIFESTYLE 28% Income Replaced Drop in Lifestyle 51% Income Replaced 49% No Treatment Auto-enrollment: 3% Auto-increase: 0% Income Replaced 100% Auto-enrollment:6% Auto-increase: 2% Total: 15% 27 Employer match of 50%, up to 6%; 7% rate of return; 3% inflation. Current lifestyle is 90% of current salary (remainder lost to payroll taxes, rounded off to 10%) minus final savings rate; 25% of current salary is replaced by Social Security and Other sources (e.g., DB plan or wages). Number shown is percent of lifestyle covered by savings at age 65 with a 4% initial withdrawal amount. This chart is for illustrative purposes only and not meant to represent the performance of any specific investment option.
Reframe the Trade-off It s not 2% vs. 0% The choice is 2% vs. 72%! 28
David, Age 25 100% 75% 50% 72% DROP IN LIFESTYLE 51% DROP IN LIFESTYLE 100% INCOME REPLACED 25% 0% 28% Income Replaced 49% Income Replaced No Treatment Auto-enrollment: 3% Auto-increase: 0% Auto-enrollment:6% Auto-increase: 2% Total: 15% 29 Employer match of 50%, up to 6%; 7% rate of return; 3% inflation. Current lifestyle is 90% of current salary (remainder lost to payroll taxes, rounded off to 10%) minus final savings rate; 25% of current salary is replaced by Social Security and Other sources (e.g., DB plan or wages). Number shown is percent of lifestyle covered by savings at age 65 with a 4% initial withdrawal amount. This chart is for illustrative purposes only and not meant to represent the performance of any specific investment option.
Who Is Being Helped by Auto Solutions? Current New Improve savings behavior by including all employees in auto solutions. 30
Here s What You Need to Remember You should consider plan goals and risk focus when evaluating target date glide paths. Most plan sponsors and participants still display a retirement income focus implying a healthy equity exposure is appropriate for them. Behavior is a key input for target date evaluation, and it drives retirement outcomes. Plan sponsors can overcome challenging savings behavior with intelligent plan design. 31
Call 1-877-804-2315 to request a prospectus, which includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. The principal value of target-date investments is not guaranteed at any time, including at or after the target date, which is the approximate date when investors plan to retire. These investments typically invest in a broad range of stocks, bonds, and short-term investments and are subject to the risks of different areas of the market. In addition, the objectives of target-date investments typically change over time to become more conservative. 32 T. Rowe Price Investment Services, Inc., distributor, T. Rowe Price mutual funds.