Getting the target date right: What plan sponsors need to know
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- Dayna Powell
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1 February 2014» White paper Key takeaways Getting the target date right: What plan sponsors need to know Target date funds are the fastest-growing fund category in workplace retirement plans. Plan sponsors and their intermediaries (advisors and consultants) focus attention on target date performance and expenses, but frequently overlook other important features of target date funds. Sequence-of-returns risk is a common blind spot for both plan sponsors and their advisors. The more plan sponsors focus on state-of-the-art risk mitigation for participants, the likelier they are to consider the inclusion of alternatives in their target date funds structure. PUTNAM INVESTMENTS putnam.com In 2013, Putnam Investments, in partnership with Brightwork Partners, conducted a survey of for-profit organizations that offer a 401(k) plan with assets of $25 million or more. One of the survey s goals was to determine how much these organizations relied on and understood the structure, objectives, and potential benefits of target date funds. Conducted online between November 8, 2013, and December 13, 2013, the survey compiles data provided by 254 senior executives involved in evaluating investments available to participants in their organization s retirement plan. This research supports several conclusions. First, it shows that target date funds are widely expected to play an increasingly important role in workplace retirement plans. Second, the survey uncovered evidence that in evaluating target date funds, plan sponsors tend to focus on metrics such as performance and expenses while placing less emphasis on an investigation of the workings of the glide path, or dynamic asset allocation, that the funds employ to achieve their objectives. Third, and perhaps most importantly, we found that plan sponsors generally desire to reduce risk to participants retirement income, but they have not adopted a disciplined approach for implementing relevant safeguards. A more disciplined approach would be quite valuable, since plan participants who choose target date funds tend to rely on them for adequate risk diversification. Lastly, we found that plan sponsors who work with a paid financial intermediary tend to evolve their plans more flexibly, allowing for the incorporation of alternative investments, such as absolute return strategies, within the structure of their target date funds or as stand-alone options in their plans. Target date funds poised for continued growth The survey began by establishing some of the basic features of the retirement plans commonly offered to plan participants. Familiar asset classes lead the list of available investments, including domestic fixed-income vehicles, stable value funds, and guaranteed investment contracts. We also found that employer stock plans and in-plan guaranteed income solutions were at the bottom of the list of available investments (Figure 1). Notably, target date funds ranked very high on the list of available investments, and the largest share of plan assets tended to be allocated to these funds.
2 FEBRUARY 2014 Getting the target date right: What plan sponsors need to know Figure 1. Target date growth is perceived to lead all other investment categories Investment type in 401(k) plans % of plan sponsors that offer % of plan assets invested Over next three years, % of sponsors that expect assets to Increase Domestic fixed-income investments 68% 11% 26% 21% Stable value funds, GICs, or other cash equivalents Target date funds Domestic equity core fund investments International equity investments International fixed-income investments Target risk funds Domestic equity specialty fund investments such as socially responsible funds or sector funds Exchange-traded funds (ETFs) apart from other passively managed funds Passively managed investments apart from exchange-traded funds Employer stock In-plan guaranteed income solutions Decrease As the table in Figure 1 shows, plan sponsors expect to offer virtually every type of investment to their participants in the future, but more than half (54%) of plan sponsors currently offering target date funds expect the proportion of dollars invested in these funds to increase. This segment of plan sponsors outnumbers, by almost 2 to 1, the proportion of plan sponsors who expect either domestic equity core funds (28%) or domestic fixed income (26%) to increase. Similarly, 45% of plan sponsors currently offering in-plan guaranteed income solutions expect the proportion of dollars invested in these vehicles to rise, albeit from a relatively low base. Breaking plans down by size, we discovered some differences in expectations (Figure 2). Smaller plan sponsors ($25M to <$50M) are likelier to see the proportion of dollars increasing in 9 of 12 investment types tested, particularly target date funds. Larger plan sponsors ($1B+) reveal different expectations: They show little anticipation of increases to nine asset classes, including target date funds. For larger plan sponsors, the exception is ETFs, where they expect a substantial increase. Figure 2. Plan sponsor expectations sometimes vary by plan size Over the next three years, percentage of plan sponsors who expect assets to increase Total $25M to < $50M Plan size by assets $50M to < $250M $250M to < $1B $1B or more Target date funds 54% 63% 48% 49% 31% In-plan guaranteed income solutions Employer stock Passively managed investments apart from exchange-traded funds (ETFs) Exchange-traded funds apart from other passively managed funds Stable value funds, GICs, or other cash equivalents International equity investments Target risk funds International fixed-income investments Domestic equity specialty fund investments such as socially responsible funds or sector funds Domestic equity core fund investments Domestic fixed-income investments
3 PUTNAM INVESTMENTS putnam.com The spotlight is on performance and expenses In our research, we also sought to determine the criteria by which plan sponsors most often evaluate target date funds. As for virtually all investment product choices, plan sponsors emphasized the importance of performance and expenses. A third of plan sponsors describe as absolutely essential a three-year track record and a relatively low total expense ratio in their selection of a target date fund (Figure 3). Second-tier concerns include participant education support; brand, including an absolute return sleeve; the slope of the glide path; and the mix of proprietary and outside funds in the offering. To versus through asset allocation models Figure 3 shows how an asset allocation model that takes participants to retirement is generally recognized as more important than one that gets them through retirement. However, while 68% describe the to model as very important or absolutely essential, 58% ascribe the same level of importance to the through asset allocation model. This result is telling in that it shows a large segment of respondents appear not to differentiate between these two asset allocation models, assigning them relatively similar levels of importance. To us, this suggests a potentially significant misunderstanding of target date funds, as the to and through models are radically different in the way their glide paths change near the target retirement year. With to asset allocation models, the allocation to core equities generally drops significantly as the fund approaches its target year. A through asset allocation model, by contrast, tends to keep a larger portion of assets in equities, taking into account the period of years now estimated to be decades that participants may be in retirement, and the consequent need for generating growth and inflation protection. It is hard to overemphasize the difference that allocation structure can make. The through structure has a higher allocation to equities around the point of transition to retirement. This allocation translates into a greater Figure 3. Target-date criteria ranked in order of perceived importance The availability of at least a three-year track record The availability of at least a three-year track record Having a relatively low total expense ratio Having a relatively low total expense ratio The extent of participant education support from the manager The extent of participant education support from the manager Having a well-known brand Having a well-known brand Having an asset allocation model that adjusts until participants reach retirement from the plan ( to retirement) ving an asset allocation model that adjusts until participants reach retirement from the plan Including an absolute return sleeve within a target date fund to help protect participants from market volatility ute return sleeve within a target date fund to help protect participants from market volatility The slope of the glide path from equities to fixed income The slope of the glide path from equities to fixed income Having an asset allocation model that continues to adjust beyond when participants retire from the plan ( through retirement) sset allocation model that continues to adjust beyond when participants retire from the plan Having a mix of proprietary and outside funds in the offering Having a mix of proprietary and outside funds in the offering The flexibility to create a custom target date fund just for your participants The flexibility to create a custom target date fund just for your participants The use of specialty or alternative investments, The use of specialty or alternative investments, not not just just plain plain vanilla vanilla asset asset classes classes Being available in multiple share classes Being available in multiple share classes Having only outside funds in the offering Having only outside funds in the offering Being available through a collective investment trust Being available through a collective investment trust 0% 20% 40% 60% 80% 100% 120% n Not important at all/not sure n Not very important n Somewhat important n Very important n Absolutely essential 3
4 FEBRUARY 2014 Getting the target date right: What plan sponsors need to know Figure 4. Plan sponsors confused about risks to retirement income: Negative investment returns are more devastating early rather than late in retirement When it comes to factors that may diminish a retired participant s income, how serious a risk do you consider Health-care expenses Negative investment returns late in in retirement Market volatility Negative investment returns early in in retirement Inflation High energy prices Low interest rates rates Declining home values 0% 20% 40% 60% 80% 100% 120% n Not serious at all n Not very serious n Somewhat serious n Very serious risk of a market drawdown for participants approaching retirement, and subjects recent retirees to a significant sequence-of-returns risk, or the risk of exposing retirement principal to negative returns in the early stages of retirement (see sidebar illustration on page 5). As many plan sponsors seek to do more to minimize investment risks for their participants, looking closely at target date allocation structure can be an important step. Alongside other risks, such as health-care expenses in retirement, plan sponsors tend to downplay the significance of sequence-of-returns risk (Figure 4). What s more, assigning a greater significance to returns late in retirement rather than to negative returns early in retirement (Figure 4) shows that plan sponsors have more to learn about one of the major risks participants face. Identifying alternatives for minimizing risk Plan sponsors profess a clear desire to reduce risks to their participants retirement income, but appear to need some help in implementation. Our survey results show that plan sponsors believe they help participants minimize the risk to their incomes in retirement. More than eight plan sponsors in ten (84%) say they place a great deal (27%) or some emphasis (57%) on helping participants minimize risk (Figure 7), and this figure varies only slightly across larger and smaller plan sponsors. However, only about half of our survey respondents report having taken a more disciplined approach to understanding risk in their investment offerings (54%), instituted routine review of the risk profiles of their funds (50%), or swapped out funds that posed unusual or unnecessary risks to participants (49%) (Figure 5). Figure 5. Risk management discipline has been lax Since the market meltdown in 2008, which of the following steps, if any, have plan sponsors taken? 54% 50% 49% 44% 31% 2% Taken a more disciplined approach to understanding risk in our investment offerings Instituted routine review of the risk profiles of our funds Swapped out funds that posed unusual or unnecessary risk to participants Installed tighter risk management controls across our 401(k) fund line-up Imposed a more conservative glide path in our target date funds Nothing 4
5 PUTNAM INVESTMENTS putnam.com Imposing a more conservative glide path in target date offerings arguably one of the most important risk-mitigation steps that a plan sponsor can take comes in near the bottom of the list of steps taken, with only 31% reporting they have implemented this change. In this respect, we did note some differences based on plan size. Sponsors of larger plans, with $1 billion+ in retirement plan assets, are likelier to have swapped out funds (58%) and smoothed their target date funds glide path (40%). The desire to mitigate risks for participants may also be driving more plan sponsors to consider the use of alternative investments. These alternatives run the gamut of investment styles and objectives, from conservative Treasury Inflation-Protected Securities (TIPS) to commodities, real estate, and more exotic instruments such as structured products all of which are offered by about a quarter of plan sponsors. Distressed securities, go anywhere alternatives, and precious metals are the least prevalent alternatives. About one fifth of plan sponsors currently offer long/short strategies, private equity, or absolute return strategies (Figure 6). What is sequence-of-returns risk? W. Van Harlow, Ph.D., CFA Director of Retirement Solutions Putnam Investments Sequence-of-returns risk or exposing savings to negative investment returns in the early stages of retirement can have devastating effects on a portfolio. Consider this hypothetical scenario: Two portfolios, A and B, each begin with $100,000. From each, $7,000 is withdrawn per year. Each portfolio experiences exactly the same returns over a 20-year period only in inverse order or sequence. Average return and volatility of each portfolio is the same, but the timing of returns is different. Year Portfolio A Balance Portfolio B Balance 0 $100,000 $100, % 73, % 120, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,290 Arithmetic mean 10.34% 10.34% Geometric mean 9.25% 9.25% Standard deviation 15.33% 15.33% Portfolio A has the misfortune of having a sequence of negative returns in its early years and is completely depleted by year 12. Portfolio B, in stark contrast, has the good luck of strongly positive returns in its early years and ends up two decades later with more than triple the assets with which it began. 5
6 FEBRUARY 2014 Getting the target date right: What plan sponsors need to know Figure 6. Alternatives are relatively unusual in DC plans today Percentage of plan sponsors who offer the following alternative asset classes in their 401(k) plan Treasury Inflation-Protected Securities (TIPS) Commodities Structured products Real estate Long/short strategies Private equity Absolute return strategies Precious metals A go anywhere mutual fund Distressed securities None of these 0% 5% 10% 15% 20% 25% 30% More than a quarter (27%) of plan sponsors say they place a great deal of emphasis on helping participants minimize the risk to their income in retirement (Figure 7). Among this group, the availability of alternatives is much higher (Figure 8), and alternatives use is generally but not universally higher among advised plan sponsors. Figure 7. Nearly everyone says they emphasize minimizing risk How much emphasis plan sponsors say they place on helping participants minimize risk to their income in retirement: 1% 15% 57% 27% A great deal Some but not a great deal Not very much No emphasis at all Figure 8. Those who say they care about risk are more likely to offer alternatives Percentage of plan sponsors who offer the following alternative asset classes in their 401(k) plan Treasury Inflation-Protected Securities (TIPS) Commodities Structured products Real estate Long/short strategies Private equity Absolute return strategies Precious metals A go anywhere mutual fund Distressed securities 0% 10% 20% 30% 40% 50% n All plan sponsors n Sponsors who care a great deal about minimizing risk 6
7 PUTNAM INVESTMENTS putnam.com Our survey respondents generally believe that alternatives are poised for growth within workplace savings plans. In general, the availability of a broad variety of alternatives within DC plans could increase in the coming years (Figure 9), as many plan sponsors report they are actively considering everything from TIPS to private equity and absolute return. Figure 9. Plan sponsors are willing to broaden their menu of alternatives Which of the following alternative asset classes, if any, do plan sponsors consider appropriate to offer within a 401(k) plan, and which, if any, are they considering offering in their plan within the next three years? Currently offered Deemed appropriate and under consideration to add Currently offered plus considering Distressed securities 7% 4% 11% Absolute return strategies Private equity Treasury Inflation-Protected Securities (TIPS) Precious metals Structured products A go anywhere mutual fund Long/short strategies Commodities Real estate Irrespective of current alternatives use, almost all plan sponsors are at least somewhat receptive to considering alternatives if such strategies are recommended by an intermediary, including 68% who are absolutely certain (15%) or very likely (53%) to do so. In addition, receptivity to alternatives is consistently strong across all plan sponsor size ranges. Absolute return strategies, commodities, and TIPS are the most attractive vehicles for plan sponsors receptive to alternatives; structured products, go anywhere mutual funds, and distressed securities are the least attractive (Figure 10). Figure 10. A quick ranking of preferences for alternatives Percentage of plan sponsors who would consider the following alternatives Absolute return strategies Commodities Treasury Inflation-Protected Securities (TIPS) Precious metals Real estate Private equity Long/short strategies A go anywhere mutual fund Structured products Distressed securities 0% 10% 20% 30% 40% 50% 7
8 FEBRUARY 2014 Getting the target date right: What plan sponsors need to know Conclusion Almost all plan sponsors say they are concerned about their participants probability of achieving an adequate and secure income in retirement. For most, however, this means encouraging participants to save as much as they can rather than helping participants understand how much income they are buying with their 401(k) contributions. Saving, in other words, is well understood as one of the keys to accumulating assets, but it may also be ascribed too much power and relevancy as a safeguard for retirement income. In our view, bringing risk to the forefront in evaluating target date funds is an important next step for plan sponsors and intermediaries to take. Above all, sequence-of-returns risk has tended to be a blind spot for many plan sponsors. The sooner plan sponsors understand how this risk functions, the sooner they may be able to make more informed decisions regarding their target date funds. In addition, sponsors and intermediaries need to turn intentions into action when it comes to adding strategies that are best equipped to manage retirement income risk. In particular, absolute return and low-volatility equity strategies, which can be more effective than the more popular alternatives to date, such as TIPS and commodities, should be considered as potential elements in target date allocation. Next steps: Questions for evaluating target date funds Does the fund employ a to or a through asset allocation in its glide path? How does the fund manage sequenceof-returns risk? What alternatives for risk mitigation are included in the glide path? Consult with your financial intermediary regarding the optimal target date strategy for your plan(s). Putnam Retail Management One Post Office Square Boston, MA putnam.com DC /14
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