Target-date funds: the to versus through dilemma

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1 November 14 Target-date funds: the to versus through dilemma Leo M. Zerilli, CIMA Head of Investments John Hancock Investments Recent U.S. Department of Labor guidance on target-date funds provides helpful support, but leaves unaddressed a key question facing today s sponsors; namely, which glide path is preferable? Key takeaways Target-date funds continue to surge in popularity, with more than $64 billion in assets, up from $ billion in The selection of a to retirement or a through retirement objective has been commonly overlooked in the due diligence process. While there is no objectively right answer, the question of which glide path is right for a retirement plan comes down to whether participants are encouraged to keep assets in plan past the point of retirement and the preparedness and sophistication of the employee base. Executive summary Since their introduction in the early 199s, target-date funds have offered a turnkey retirement savings solution that has resonated with plan sponsors and their participants: a broadly diversified portfolio that automatically becomes more conservative as it approaches its stated target retirement date. As a result, defined contribution plans now hold an estimated 89% of the $641 billion in target-date fund assets, and the funds are commonly used as qualified default investment alternatives. 1 Recent U.S. Department of Labor (DOL) guidance on target-date funds provides helpful support to plan fiduciaries choosing target-date funds but leaves a key question facing today s sponsors unaddressed 2 : Which glide path, or change in asset allocation, is preferable one that adjusts to retirement or one that continues to adjust through retirement? The difference in equity exposure between these two approaches can be significant, and plan sponsors are seeking guidance in selecting the appropriate funds for their employee bases.

2 Target-date funds: a one-step solution for retirement savers Since their introduction years ago, target-date funds have exploded in popularity. The goal of the to retirement funds was to provide a glide path that would suit most investors in the retirement plan from the first day of their participation until they were ready to retire. In the early years, when participants need exposure to growth and can withstand the risks, the portfolios are allocated more heavily to equities. In the later preretirement years, when participants need preservation of capital and have less risk tolerance, the allocation shifts to one that is predominantly fixed-income and cash based. The rationale behind the to retirement funds was that once retired, most participants take a distribution from their accounts and invest in other types of retirement products (such as IRAs and annuities). However, these funds do not fully address the following concerns: Low contribution rates: Many participants don t contribute significant assets in their retirement plans, particularly in the early years of their working careers, so they may need more growth through their retirement years to help boost their earnings. Investment sophistication: Many do-it-yourself investors lack the time or inclination to assemble a properly diversified portfolio in retirement; thus, extending the lifespan of these one-step portfolios would enable investors to benefit from portfolio diversification well into retirement. Longevity: People are living longer and many may need a larger growth component to help generate more income throughout retirement. Which leads us to through retirement target-date funds. Like the to retirement funds, the through retirement portfolios are geared more toward equities in the early years. However, in the later preretirement years, they generally tend to shift less toward fixed-income- and cash-based investments, keeping a higher percentage of assets in equities. Target-date funds are almost ubiquitous 3 72% of 41(k) plans currently offer target-date funds 41% of participants invest in the funds, making up 1% of plan assets Distinctions between the strategies Regardless of its investing strategy, a target-date fund s glide path can be segmented into three key phases: the accumulation phase, the period immediately preceding a fund s maturity date, and the extended period following the maturity date. The past-maturity-date phase is frequently described as the decumulation, or in-retirement phase. There are important distinctions between to retirement and through retirement strategies in the preretirement and retirement years, and these distinctions have important implications regarding the risk levels and expected growth associated with each strategy. 2

3 November 14 To retirement With this investment objective, a target-date manager assumes a more conservative asset allocation as the fund approaches its stated target maturity date and an almost static asset allocation once it has reached or surpassed its maturity date. The flattening of a target-date fund s glide path past its maturity date is an indicator of the to retirement approach. These funds are intended to meet retirement income needs for investors and are focused on capital preservation and protecting the investment from market risk. Proponents of this strategy say it is best for those participants who will withdraw all of their assets soon after retiring to invest in other retirement products or who want a steady base from which to regularly withdraw their assets. Through retirement With this investment objective, a targetdate manager has a different approach. Through retirement funds are intended to help protect against longevity risk or the risk of running out of money in retirement, which could extend for more than years for a large portion of retirees. To help protect against longevity risk, through retirement funds typically have higher equity allocations than to retirement funds. These funds have glide paths with equity allocations that may continue to decline 1 to years before they reach a static and more conservative final allocation. Proponents of this strategy say it is ideal for participants who want to pursue further growth of their assets in retirement and protect against the risk of running out of money or who prefer the ease of the one-step, fully diversified approach. To vs. through example: 3 target-date funds To retirement 1 8 n Cash n Bonds n Stocks Through retirement It is important to note that both to retirement and through retirement objectives are managed to meet unique goals; therefore, one approach is not necessarily better than the other. Understanding the distinctions between the two approaches will help you identify which approach is more suitable to a plan s needs Charts are for illustrative purposes only. Not indicative of any performance. 3

4 Key differences of to retirement vs. through retirement To retirement Conservative allocation helps protect against market risk and sequence of return risk Allows for a stable and predictable base for retirement income withdrawals Subject to longevity risk due to extended retirement periods A more conservative glide path as the fund approaches maturity date sacrifices growth and future income potential as investor balances are reaching their peaks Through retirement Aims to maximize growth potential of investments to help protect against longevity risk Retirees with an insufficient investment may require a more substantial growth component to fund retirement More assets are subject to market risk Retirees may not be able to recover from a sharp market decline when approaching or in retirement In 13, the DOL issued guidance for plan fiduciaries relating to selecting and monitoring target-date funds in retirement plans. Among the tips it advised them to adhere to was the following: Understand the fund s investments and how its glide path or change in asset allocation will progress over time. 2 But nowhere in its guidance were any tips on determining which type of strategy is right for each plan. Many factors can impact the decision The unprecedented market correction of 8 and the associated losses suffered by target-date funds led many to believe that a to retirement strategy was the most appropriate strategy to help protect investors from downside risk. This may now present an opportunity for advisors and plan sponsors to evaluate if this was a knee-jerk reaction to sharp market declines over a short-term period, as the selection of a to retirement versus a through retirement strategy is more involved than only focusing on downside protection. More importantly, even if downside protection was the sole evaluation factor in selecting a target-date strategy, not all to retirement strategies provide greater downside protection than through retirement strategies. When thinking ahead to a participant s retirement, two important factors to consider are sequence of return risk and longevity risk. Sequence of return involves the order in which positive and negative investment returns occur. This can have a significant impact on a retiree s ability to generate retirement income. Weak or negative returns early in the retirement cycle may have a more severe impact on a portfolio than negative returns later in the cycle because the portfolio s value is reduced by any losses and withdrawals made, leaving a smaller amount left to grow. Longevity risk is the risk that a participant will outlive his or her retirement income sources. The average life expectancy of a 6-year-old today is 84.3 years old, but 2% of those 6-yearolds can expect to live to 9, and 1% can expect to live past 9. Without planning, a longer-than-expected life could easily lead to a retiree outliving his or her savings, meaning a growth component could play an impactful role. There are additional factors to consider when selecting a target-date option, including the traditional due diligence metrics, such as performance, fees, asset allocation, and diversity of managers. Participants are happy with target-date funds % believe a target-date fund will alleviate the stress of retirement planning 68% believe a target-date fund will increase their confidence in having a successful retirement 6% of target-date fund investors and 3% of non-target-date fund investors say they prefer a to retirement glide path but often don t understand them 6 62% of participants invest in target-date funds in addition to other mutual funds 74% of all target-date fund participants hold less than half of their account balances in target-date funds 32% of partial target-date fund participants hold too much risk in the rest of their portfolios 4

5 November 14 Understanding the nuances of participant behavior past fund maturity dates is important to understanding the asset allocation strategies utilized during this period. Determining the right amount of equity exposure at retirement requires some assumptions about the investors in the plan. Document the steps you take and make sure your examination of the options includes the following data. What is the median employee salary? What is the median plan deferral rate? What is the company match? How financially savvy are the employees? How conservative/aggressive are their investing styles? What other retirement benefits does the company offer? What percentage of employees is eligible for those benefits? What are the plan s distribution options? What percentage of participants withdraws their assets soon after retiring? The answers to these questions are likely to be as varied as the participants in the plan themselves. As a result, a fund s glide path must be robust enough to account for a broad range of withdrawal assumptions, limiting market risk for those with large account balances, but also providing enough equity exposure to limit longevity risk for those with smaller balances. Fee disclosure adds another wrinkle Be aware that fee disclosure and transparency in defined contribution plans could play an important role in future retirement-age participant behavior and thus impact the utilization of to retirement versus through retirement strategies. With the more detailed fee disclosures they have now, participants will have a better understanding of the fees they are paying for their 41(k) investments. As a result, they will be better positioned to compare the costs of their 41(k) plan investments versus equivalent costs incurred in a retail or non-41(k) account. In a large proportion of cases, participants will not be able to match the extremely competitive pricing they are receiving from their 41(k) plans with the pricing in a non-41(k) structure. This could result in a larger proportion of participants choosing to keep their assets in the plan rather than removing them at retirement. Early losses have a larger negative effect on income-producing portfolios Account balances for income-producing portfolios $1, 8, 6, n Losses early in a portfolio n Losses later in a portfolio Balances shown are at year end, reflect annual gains of %, and show losses in the magnitude of those experienced in 8. 4,, Year 1 Year 2 Year 3 Year 4 Year Year 6 Year 7 Year 8 Year 9 Year 1 Year 11 Year 12 Year 13 Year 14 Year 1 Year 16 Year 17 Year 18 Year 19 Year This hypothetical example has an average compounded annual return of % over years and a year-to-year volatility that is consistent with a portfolio predominantly consisting of stocks. The example assumes a starting value of $1, at age 6, $, annual withdrawals, and is net of all fees and expenses.

6 Communication is vital Target-date funds vary widely from provider to provider. With the DOL s focus on fiduciary responsibility, it is important for plan sponsors to document their procedures. Their documentation should include the following: A process for comparing, selecting, and reviewing target-date funds, including a comparison of custom and proprietary versus nonproprietary funds An understanding of the fund s investments and their glide paths A review process of the fund s fees and investment expenses and periodic benchmarking Summary Target-date funds and asset allocation products are expected to continue capturing market share in 41(k) plans, with the inevitable result that plan sponsors will increasingly seek guidance in understanding and selecting target-date funds. Understanding the objective of a to retirement versus a through retirement strategy is increasingly important as baby boomers begin to retire and establish retirement income plans. When deciding between these two retirement approaches, there is no right or wrong answer; however, understanding the implications and nuances of each approach is essential. The development of effective employee communications That last point is something many plan sponsors neglect to do. Plan sponsors and their advisors should review all participant communication materials to ensure they accurately represent the funds they describe and to enable participants to make informed decisions. Materials should include the following education and information: A discussion of the asset allocation and glide path, including a visual representation of how a glide path works Information on the underlying asset classes, including the fund names and allocation percentages The risks inherent in target-date funds, including the fact that they can lose money The past performance, including any benchmarking data The fund s fees and expenses 6

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8 1 The U.S. Retirement Market, First Quarter 14, Investment Company Institute, June Target Date Retirement Funds Tips for ERISA Plan Fiduciaries, U.S. Department of Labor, Employee Benefits Security Administration, February Investment Company Fact Book, Investment Company Institute, May Participant Preferences in Target Date Funds: An Update, Voya Investment Management and ING Retirement Research Institute, February 14. Life Expectancy Calculator, socialsecurity.gov. 6 Help in Defined Contribution Plans: 6 through 12, Financial Engines and AON Hewitt, May 14. This material does not constitute tax, legal, or accounting advice, and neither John Hancock nor any of its agents, employees, or registered representatives are in the business of offering such advice. It was not intended or written for use, and cannot be used, by any taxpayer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Anyone interested in these transactions or topics should seek advice from independent professional advisors based on his or her particular circumstances. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. The information contained herein is based on sources believed to be reliable, but it is neither all inclusive nor guaranteed by John Hancock Investments. Diversification does not guarantee investment returns and does not eliminate risk of loss. The portfolio s performance depends on the advisor s skill in determining the strategic asset class allocations, the mix of underlying funds, and the performance of those underlying funds. The underlying funds performance may be lower than the performance of the asset class that they were selected to represent. Each portfolio s name refers to the approximate retirement year of the investors for whom the portfolio s asset allocation strategy is designed. The portfolios with dates farther off initially allocate more aggressively to stock funds. As a portfolio approaches its target date, the allocation will gradually migrate to more conservative, fixed-income funds. The principal value of each portfolio is not guaranteed and you could lose money at any time, including at, or after, the target date. For additional information on these and other risk considerations, please see the portfolio s prospectuses. A fund s investment objectives, risks, charges, and expenses should be considered carefully before investing. The prospectus contains this and other important information about the fund. To obtain a prospectus, contact your financial professional, call John Hancock Investments at , or visit our website at jhinvestments.com. Please read the prospectus carefully before investing or sending money. John Hancock Funds, LLC Member FINRA, SIPC 61 Congress Street Boston, MA jhinvestments.com Not FDIC insured. May lose value. no bank guarantee. not insured by any government agency. MF3467 tvtwp 11/14