Redefining the safety option Target date funds and risk management

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1 PERSPECTIVES Redefining the safety option Target date funds and risk management September 2013 IN BRIEF Defined contribution (DC) plan participants face a broad range of risks when investing for retirement but historically the financial services industry has defined risk in terms of market and asset class. A broader definition of risk is needed that redefines the safety option in DC investment menus and focuses on possible outcomes looking at factors, such as length of time until retirement and the potential for participants to invest 100% of assets in a single menu option. A traditional view of risk Investment risk has historically been defined in terms of, which might be measured by traditional Modern Portfolio Theory measures, such as standard deviation. In building investment menus for DC plans, plan sponsors have primarily focused on asset class or investment product risk-return profiles when determining how safe or risky the various investment options are for participants. A typical DC investment line-up might span the risk spectrum beginning with a conservative safety option, such as stable value or money market funds, and move out towards fixed income, balanced and equity funds as well as a brokerage option. EXHIBIT 1: DC PLAN PARTICIPANTS ARE EXPOSED TO A BROAD RANGE OF S Failure to save enough due to lack of growth, low savings rate or unexpected market event AUTHOR Risk that value of principal will be eroded by inflation INFLATION ACCUMULATION Risk is dynamic and multi-faceted LONGEVITY Risk of outliving savings John Galateria Head of Defined Contribution Investment Solutions J.P. Morgan Asset Management john.galateria@jpmorgan.com Risk that fixed income securities will lose value if rates rise INTEREST RATE MARKET Risk of capital or investment losses due to market or asset class PARTICIPANT USER Source: J.P. Morgan Asset Management. Shown for illustrative purposes only. Possibility participant will misuse investment options (too conservative or aggressive, under-diversified) NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 Redefining the safety option Risk is dynamic and multi-faceted This traditional view of risk focuses almost exclusively on market-related risks. In reality, however, DC plan participants are exposed to a broad range of risks when investing for retirement and, as shown in Exhibit 2, not all participants face the same risks at the same time. Among them, participants risk outliving their savings (longevity risk), erosion of principal value due to inflation (inflation risk), rising rates (interest rate risk) or misusing the investment options (participant user risk). By investing too conservatively or too aggressively, or being under-diversified, participants may not optimize their investing potential. There is also the risk that participants might not make and sequence asset allocation decisions that are beneficial over the long term. Why age matters If you take a broader view of risk, then you should evaluate risk differently. Focusing on asset class risk/return profiles alone presents an interesting conundrum when looking at different age cohorts on the retirement continuum. Conservative investments like stable value and money market funds have long been considered the safety options in a plan. However, if younger workers (25-35 age cohort shown in Exhibit 3) were to invest 100 percent of their money in the safety option, growth of their retirement savings would likely be much lower than a portfolio with a more diversified asset class mix potentially creating a significant account balance shortfall. EXHIBIT 2: DC PARTICIPANTS ALSO FACE DIFFERENT MAGNITUDES OF OVER TIME 100 Longest time horizon (Up to age 40) The middle years (Ages 40 65) At and in retirement (Age 65 and after) Percentage of portfolio allocation ACCUMULATION PARTICIPANT USER MARKET PARTICIPANT USER INTEREST RATE INFLATION MARKET ACCUMULATION MARKET INFLATION INTEREST RATE LONGEVITY Age Source: J.P. Morgan Asset Management. For illustrative purposes only. 2 Redefining the safety option: Target date funds and risk management

3 EXHIBIT 3: PARTICIPANT SCENARIO 1: AGE COHORT Return Safety Options Fixed Income Target Date Funds ** Equities Brokerage Stable Value Core Bond/Barc Agg Income Fund Large-Cap Growth Self-directed Money Market Short-term Bond 2015 Fund Large-Cap Core 2020 Fund Large-Cap Value 2015 Fund Mid-Cap Growth 2025 Fund Mid-Cap Value 2030 Fund Mid-Cap Core 2035 Fund Small-Cap Growth 2040 Fund Small-Cap Value 2045 Fund Small-Cap Core 2050 Fund Int l Equity 2055 Fund 2060 Fund Risk Low / safest Moderate Higher Highest Less likely Less likely Most likely More likely Least likely OUTCOME PROBABILITY* * Outcome probability is defined as the probability of participants in the specified age cohort achieving a desired retirement outcome. Assumes participants invest 100% of their assets in the specified investment option. ** Volatility level and outcome are contingent upon how much risk a particular target date fund manager is taking. The above chart is shown for illustrative purposes only. In the most conservative investment option, it s likely that their savings will not grow at an appropriate level an opportunity cost that could put them in danger of not saving enough to meet their retirement goals. Looking at the traditional core menu, with fixed income, equity and brokerage options there s a broad range of risk represented, from moderate to high risk. Depending on the participant s level of skill and engagement, he or she might do relatively well or have substandard results with these options. When you consider potential outcomes of investing 100 percent of a participant s retirement money in one investment option, professionally-managed, diversified options like target date funds look relatively safe for younger investors with 40 or 50 year investment time horizons. Of course, the safety level depends on how much risk the target date manager is taking, which can differ significantly among target date funds. 1 DC plan participants may be exposed to a broad range of risks, including market risk, user risk, inflation risk, interest rate risk, sequencing risk, shortfall risk, longevity risk and drawdown risk. For older workers (55-65 age cohort in Exhibit 4) the risk of having 100 percent of funds invested conservatively is not as large, however, they may be more susceptible to market conditions given shorter time horizons to retirement. An aggressive weighting in equities, whether in a traditional core menu or brokerage option, could have an extremely negative impact on retirement savings and income if the markets or asset class decline sharply. Like younger plan participants, they also may benefit the most from professionally-managed, diversified options like target date funds. Redefining the safety option Considering the many different risks participants are exposed to and the inability of many participants to manage these risks effectively, we believe that options in a DC plan s investment menu should be evaluated not based only on their riskreturn profiles but on the potential outcomes that might result should a participant invest 100% of his or her assets in J.P. Morgan Asset Management 3

4 Redefining the safety option EXHIBIT 4: PARTICIPANT SCENARIO 2: AGE COHORT Return Safety Options Fixed Income Target Date Funds ** Equities Brokerage Stable Value Core Bond/Barc Agg Income Fund Large-Cap Growth Self-directed Money Market Short-term Bond 2015 Fund Large-Cap Core 2020 Fund Large-Cap Value 2015 Fund Mid-Cap Growth 2025 Fund Mid-Cap Value 2030 Fund Mid-Cap Core 2035 Fund Small-Cap Growth 2040 Fund Small-Cap Value 2045 Fund Small-Cap Core 2050 Fund Int l Equity 2055 Fund 2060 Fund Risk Low / safest Moderate Higher Highest More likely Less likely Most likely Less likely Least likely OUTCOME PROBABILITY* * Outcome probability is defined as the probability of participants in the specified age cohort achieving a desired retirement outcome. Assumes participants invest 100% of their assets in the specified investment option. ** Volatility level and outcome are contingent upon how much risk a particular target date fund manager is taking. The above chart is shown for illustrative purposes only. any one option. 1 This new way of thinking about risk has major implications for the way DC investment menus should be designed and evaluated. If investment menu options are evaluated based on potential outcomes, then we believe target date funds should be considered one of the safest options in the plan, because of the portfolio manager s ability to manage the many different types of risk DC participants must contend with as they strive to reach their long-term retirement goals. Target date funds have a built-in ability to manage asset allocation along their glide paths based on how their portfolio managers prioritize different market-related risks, such as inflation, rising interest rates, changing market conditions and asset class, as well as the glide path s time horizon. As diversified, professionally-managed solutions, they also reduce the potential for participant-user risk. EXHIBIT 5: STANDARDIZED 3 FIVE YEAR RETURNS: HIGHS, LOWS AND AVERAGES BY INVESTMENT STRATEGY Rate of return (%) Target date fund users Source: J.P. Morgan Retirement Plan Services proprietary research. Analysis measurement period is December 31, 2007, through December 31, The above data represents a sampling of participant data. It does not represent the returns of any individual product or portfolio. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular manner. Rate of return for the measurement period is aggregated by investment strategy. Historical rate of return is not a guarantee of and may not be indicative of future results. Source: J.P. Morgan Asset Management. Returns are standardized using the Interquartile Methodology Do it yourselfers See the Important Disclosures for Personal Rate of Return Methodology for additional information Managed accounts users Brokerage users 4 Redefining the safety option: Target date funds and risk management

5 The target date fund advantage We believe target date funds provide a real advantage to DC plan participants over the do-it-yourself approach required for investing in a core menu of funds or the brokerage option. Exhibit 5 shows how participants in target date funds have fared relative to other DC menu investment strategies. Looking at standardized five-year personal rates of return, target date fund users had the best performance on average. Target date funds can provide the professional management of a glide path, broad diversification across asset classes and active asset allocation, all key components for delivering strong riskadjusted return. We believe these attributes make them viable as a safety option within defined contribution plans across all age cohorts and throughout a plan participant s entire savings and investment cycle. Once again, safety level is contingent upon the target date manager s approach to risk management. Selecting and evaluating target date funds Different managers may have vastly different philosophies for how they structure glide paths, implement asset allocation and select securities. With such a wide range of approaches to risk management in target date funds, it is critical that plan sponsors and advisors understand how the target date fund managers they are using approach and manage risk within their solutions. Some key considerations are: What is the target date manager s approach to managing risk and what is the process for managing it within the glide path? What is the extent of the manager s ability to diversify fixed income exposure along the glide path? Are underlying strategies actively managed or do they provide passive-only exposure? Does the manager have expertise in managing lowercorrelated, extended asset classes, such as high-yield and emerging market debt? Best practices for target date asset allocation Strategic and tactical asset allocation can also have a positive impact on investment outcomes for managers that maintain strict risk controls along the glide path and institutionalcaliber diversification. We believe a combination of quantitative and qualitative inputs that incorporate sec ular and structural trends over a multi-year time horizon, as well as the flexibility to react to changing market conditions, are essential components for managing risk. Target date managers that successfully build these components into their investment process may be able to balance return and along the glide path while delivering incremental alpha. Exhibit 6 illustrates the role of strategic and tactical asset allocation strategies in an active management process. Target date managers that successfully build these components into their investment processes may be able to balance return and along the glide path while delivering incremental alpha. Risk management best practices J.P. Morgan Asset Management is dedicated to helping DC plan participants reach their retirement goals. We believe target date funds should be considered a viable safety option within a DC investment line-up. Their unique combination of characteristics professional management, diversification and glide path construction and active asset allocation enable them to effectively manage the many risks participants must contend with when investing for retirement. EXHIBIT 6: FRAMEWORK FOR A DISCIPLINED ACTIVE MANAGEMENT PROCESS 1. Strategic Allocation Strategic Allocation Asset Glide Path 2. Manager Selection Select underlying managers Ongoing due diligence 3. Portfolio Construction & Implementation Determine optimal allocations within portfolios Tactical Asset Allocation Source: J.P. Morgan Asset Management. Shown for illustrative purposes only. J.P. Morgan Asset Management 5

6 Redefining the safety option Please contact For more information about specific J.P. Morgan Defined Contribution solutions and services, including our broad range of investment solutions, retirement thought leadership, tools and insights, please contact your J.P. Morgan representative. 6 Redefining the safety option: Target date funds and risk management

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8 Redefining the safety option 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. These views and strategies described may not be suitable for all investors. 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. Past performance is no guarantee of future results. IMPORTANT DISCLOSURES FOR PERSONAL RATE OF RETURN METHODOLOGY. Rate of return is calculated for active participants by an investment strategy using the Modified Dietz method and is based upon between the highest rate of return and the lowest rate of return associated with each investment strategy among such participants. Services associated with the identified investment strategies were available as of the last day of the measurement period, but may not have been available throughout the measurement period. Target date fund users are participants with at least 70% of their account balance invested in target date funds as of the first and last day of the measurement period. Do-it-yourselfers are participants with less than 70% of their account balance invested in target date funds as of the first and last day of the measurement period and also includes participants using online advice services, if applicable. Managed account users are participants with at least 70% of their account balance managed by a discretionary investment service as of the first and last day of the measurement period. Brokerage users are participants with at least $1 in a brokerage account as of the last day of the measurement period. 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. IRS Circular 230 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. JPMorgan Distribution Services, Inc. is a member of FINRA/SIPC. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. JPMorgan Chase & Co. September 2013 PERSPECTIVES_Redefining the safety option: Target date funds and risk management RET-DCIP- NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE jpmorganfunds.com/retirement