The Role of Behavioral Finance in the Development and Evolution of Target Date Funds How To Maximize Participant Outcomes

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1 The Role of Behavioral Finance in the Development and Evolution of Target Date Funds How To Maximize Participant Outcomes A White Paper by Manning & Napier Unless otherwise noted, all figures are based in USD. 1

2 Introduction In many ways the foundation for target date funds on participant choice menus rests in the principles of behavioral finance. It was not until plan sponsors and regulators began to understand that behavioral finance concepts influenced participant behavior that auto enrollment, qualified default investment alternatives, and target date funds began to gain traction in defined contribution plans. This paper will broadly examine several of the participant behaviors that necessitated the creation of target date funds, and discuss ways that well structured target date funds can and should be managed in order to maximize participant retirement outcomes. While many target date fund managers, consultants, and plan sponsors are focused on detailed specifics about the glide path (e.g., debating the merits of to versus through glide paths, landing points, etc.) and adding increasingly complex specialty asset class exposure to their mix, Manning & Napier believes that the best way to help participants meet their retirement goals is to elevate the importance of saving. This includes helping the participant save more and remain committed to a disciplined savings plan, as well as protecting the participants from themselves when they are prone to give in to the behavioral finance traps discussed below. The Case For Target Date Funds Rests in the World of Behavioral Finance Helping Participants Avoid Making Avoidable Mistakes In order to understand the role that target date funds play on a participant directed menu, we have to examine the history of participant and plan sponsor behavior. By far, the most common type of participant directed retirement plan available in the marketplace today is the 401(k) plan. In fact, the Investment Company Institute estimates that as of September 30, 2012, 401(k) plan assets totaled approximately $3.5 trillion and in 2011, 51 million U.S. workers actively participated in a 401(k) plan 1. As the 401(k) plan started to gain popularity in the late 1980s and early 1990s, plan sponsors looked to transfer responsibility for building retirement savings to plan participants. Unfortunately, as we have learned over the last twenty or so years, participants who are left to make their own savings and investment decisions often fall prey to common investment mistakes that can be best understood through the behavioral finance lens. Despite extensive attempts at participant education by both plan sponsors and plan service providers, participants are still prone to making avoidable mistakes. One of the biggest challenges facing participants is to overcome the inertia of making an affirmative decision to participate in the plan and take responsibility for securing their financial independence in retirement. Under early 401(k) plan designs, the decision whether or not to personally save for retirement was framed as a voluntary choice for the plan participant. This structure required the participant to understand the economic implications of choosing to forego current consumption and instead set aside money to meet what many times feels like a distant and obtuse future goal. Not surprisingly, it was (and is) frequently easier for plan participants to not take action rather than attempting to tackle an issue as complex as saving for retirement. This is called the status quo bias. In response to this inertia problem, many plan sponsors (with recent blessing from the government) re-framed the retirement saving question by adopting automatic enrollment features that require plan participants to make an affirmative decision to opt out of participating in the plan, rather than an affirmative decision to opt in to the plan. In general, the result has been an increase in participation rates, not because participants have taken more responsibility for securing their retirement, but because plan designs have been adjusted to make participation in the plan the default. Once we address the issue of getting participants to enroll in the plan, the next hurdle is to help those participants choose which investment options on the menu they should utilize. While plan sponsors may be tempted to believe that more choices are better, behavioral finance has shown that too many choices (choice overload) can actually lead to lower participation rates as employees become overwhelmed by too much information. One compelling example of choice overload came from a study conducted by Iyengar and Lepper where they set up a jam tasting stall in a supermarket. They either displayed a small assortment of six flavors of jam or an assortment of 24 flavors. Customers tasting the jam received a $1 coupon for the jam. Iynengar and Lepper found that while the larger offering (i.e., 24 flavors) attracted more customers, only 3% of the jam tasters of 24 flavors actually bought the jam compared to 30% of those who visited the stall with six jam flavors 2. 2

3 It is very much part of human nature to create simplification heuristics, or mental shortcuts, to address complex problems. Plan participants are no exception to this tendency to look for shortcuts in allocating their retirement savings. An example of a simplification heuristic commonly used by plan participants to allocate their savings is the one over n shortcut, which explains the tendency of participants to generally allocate equally across all the options offered in their retirement plan. If participants are offered a choice between two funds they tend to split the allocation 50%/50%, but if they are offered five choices they tend to allocate 20% to each option. This tendency means that plan menus with a larger percentage of equity-oriented options may inadvertently be steering participants towards a higher equity allocation. In a 2001 study, two researchers (Shlomo Benartzi and Richard Thaler), asked participants to determine an investment mix when they were given two fund offerings. Participants were presented with one of the following menus: (1) a stock fund and a bond fund, (2) a stock fund and a balanced fund, and (3) a balanced fund and a bond fund. In the case of those offered menu #1, the average stock allocation was 54%, participants offered menu #2 had an average equity allocation of 73%, and participants offered menu #3 had the lowest average equity allocation of 35% 3. Clearly, the menu design (i.e., mix of funds offered) influenced participants asset allocations. Despite all of the research and education efforts on the behalf of plan sponsors and service providers showing that the asset allocation decision is an important decision in the retirement planning process, plan participants often make decisions using the one over n approach, rather than as part of a well reasoned long-term strategic asset allocation strategy. Another trait of human nature that can lead to bad investment decision making is our tendency to seek pleasure and avoid pain. Far too often this kind of thinking leads participants to buy more of securities that are increasing in value and sell securities that are declining in value, which of course leads to performance chasing and a buy high, sell low mentality. This is perhaps best illustrated by the chart to the right that depicts the differences between the median U.S. Large Blend fund Morningstar Investor Return TM for the ten year period ended 09/30/2013 versus the S&P 500 over the same period. The Morningstar Investor Return TM incorporates the impact of cash inflows and outflows from purchases and sales and the growth in fund assets to capture how the average investor performed in a fund. Poor investor timing decisions (e.g., chasing performance) contributed to investors lagging the benchmark index by 1.37%, which compounded over ten years results in approximately a 15% cumulative performance difference over the last decade. In behavioral finance terms, participants are prone to inappropriate extrapolation (also known as recency bias), or the tendency to project forward recent market events and assume that those conditions will continue indefinitely. This damaging behavior was especially prevalent during the late 1990s technology bubble and the mid 2000s real estate bubble (buying high), as well as the resulting and market declines (selling low). Common Mistakes Sacrifice Returns (Annualized Returns 10/01/ /30/2013) Median Large Blend Fund Morningstar Investor Return TM 4 S&P % 7.57% In many ways the advent and growth of target date funds came about as a result of plan sponsors, regulators, and service providers trying to find a solution to address problems such as inertia, choice overload, simplification heuristics, recency bias, and performance chasing. As plan sponsors and regulators looked to address the inertia problems related to savings, auto enrollment helped boost participation rates, but it also created a dilemma for plan sponsors: where should the auto enrolled participants contributions be invested? Fortunately, the Pension Protection Act of 2006 provides plan sponsors with safe harbor protection if they use a Qualified Default Investment Alternative (QDIA) as their default option. 3

4 As the target date fund industry continues to evolve, there is no doubt that improvements will be made to the first generation offerings (much like the 401(k) plan itself has evolved over time). However, it is important to remember that target date funds exist to address a specific need. Specifically, to provide plan participants who generally have not taken an active role in securing their retirement futures with a straightforward investment option that is likely to provide better outcomes than they would achieve on their own by helping them avoid many of the common investing mistakes attributable to behavioral finance concepts. How A Well Structured Target Date Fund Can Help Participants Meet Their Goals Presumably the plan sponsors intent in offering target date funds on the investment menu is to provide a professionally managed option for defaulted participants and participants who proactively decide that they do not have the time, knowledge or inclination to manage the asset allocation and fund selection decisions associated with managing their own funds. Given all of the behavioral finance concepts discussed above that suggest that participants have to overcome human nature to successfully secure their retirement future, it is especially important that plan sponsors select target date funds that are designed to maximize participants outcomes. In order to achieve this lofty goal, we believe that plan sponsors would be well served to select a target date provider that has a disciplined and straightforward mechanism for reducing risk in the face of extreme market conditions. While it may be tempting to view target date funds as an auto pilot-like investment strategy, the reality is that participants want to know that their portfolio is being professionally managed and that there is in fact someone manning the controls. One of the most prominent theories in the behavioral finance field, known as prospect theory (Kahneman and Tversky), suggests that losses have a much greater negative impact for investors than the positive impact that they feel from the same level of gains. In fact, their research concluded that individuals feel 2.5 times as much disappointment about losses as they do joy from the same dollar value of gains. As such, well designed target date funds should recognize the disparate impact that losses have on participants psyches and should take steps to reduce losses in sustained bear markets. Having an easy to understand process for managing the full impact of extreme market events is essential to minimizing the risk of participants giving in to human nature during volatile market environments and either abandoning their long-term savings plan and/or selling at market lows. In fact, we know that two of the most common and damaging mistakes that participants can make in managing their retirement savings are (1) not saving diligently and (2) making bad timing decisions (e.g., selling at market bottoms, and only getting back in the market after the recovery has taken hold). If the reason for including target date funds on the menu is to give participants a simple, professionally managed option that maximizes their potential of meeting their retirement goals, the target date fund should be designed to reduce the likelihood of the participant short circuiting their long term retirement security. In our opinion, one of the most common behavioral finance concepts that target date fund managers should be careful to guard against is overconfidence or the tendency to place too much value on one s own abilities. Unfortunately, professional asset managers can also overestimate the value of their analytical models. There is probably no better example of failing to appreciate what you don t and can t know than a target date fund manager telling you the very specific asset allocation they would recommend ten years from now for a given participant. If there is any lesson that professional investors should have learned over the last ten to fifteen years, it is that the market environment can change radically and go through extended periods of time that are not at all like long-term average conditions. While the general idea that a portfolio should get more conservative as a participant approaches the target date is valid, the market and economic environment prevailing at the time is impossible to know with certainty. The reality is that there are many variables that go into determining an appropriate asset allocation, including inflation, interest rates, and valuations, that cannot be known years in advance. In other words, programming an auto pilot course (i.e., determining the specific route that will automatically be followed to arrive at the destination) can leave the plane s passengers prone to suffering extreme turbulence when inclement weather pops up unexpectedly. 4

5 Manning & Napier believes that well designed target date funds must maintain flexibility to adjust as market conditions change. As such, we believe that target date funds offering a glide range (i.e., the broad asset allocation range that is generally appropriate for a given time horizon) are more likely to offer the flexibility to pro-actively adjust to changes in the market environment than an approach that relies on a specific asset allocation being right for a given age group regardless of the market environment. As an example, let s consider the late 1990s to mid 2000s time period for a hypothetical participant planning to retire in In general, the participant s planned 2010 retirement date suggests that all else being equal, he/she should be transitioning to a more conservative asset allocation as the target date approaches. However, all else was not equal during this time period. Was the auto pilot course of action to sell equities the best strategy for helping the participant reach his/her retirement goal? While the participant s time horizon was shortening, the risk of owning equities was declining as the market was declining. Thus, a flexible professionally managed target date fund would have someone manning the controls and altering the rate of descent (i.e., how quickly equity exposure would decline) to reflect conditions at the time that could not have been predicted when the glide path was established. Simply put, given the changing nature of the financial markets, there will be times when it makes sense to deviate from the general glide path principle of becoming more conservative as the target date approaches. Likewise, there will be times when the risk in the equity markets warrants taking a more conservative posture than was anticipated when the general glide path was considered. Another behavioral finance concept related to overconfidence is hindsight bias, which is when, with hindsight, we think that we understood things that at the time we did not. For example, many market commentators and even critics of target date funds look back at the credit crisis of and today believe that professional investors should have known that the financial world was on the verge of collapse. Unfortunately, the tendency to forget what we were thinking about an event as it was happening, and instead recall what the outcome was, can lead target date fund managers to believe that future market environments are knowable. Target date fund managers would be wise to remember that true experts have to know enough to recognize the limitations of their own knowledge. 6 Our belief is that the best way to address overconfidence and hindsight bias is to invest with a target date fund manager that has experience making decisions in the face of uncertainty, and embraces the uncertainty as part of the normal investment environment. While many target date funds have limited track records, and in some cases the target date fund managers do not have extensive experience making asset allocation decisions, plan sponsors would be well served by looking for target date funds that are managed by professionals that have experience making asset allocation decisions across the full spectrum of market environments. Conclusion Plan sponsors, regulators, and managers have recently made strides in helping adjust defined contribution plans to the behavioral finance challenges that have prevented many participants from pursuing a prudent path to financial security in retirement. The advent of automatic enrollment, default options, and target date funds were all important first generation steps in addressing the problem. Given the increasing importance that target date funds play on the menu, it is important that plan sponsors ensure that they are utilizing a target date provider that avoids the mistakes that participants would make on their own. As the 401(k) plan and target date funds continue to evolve, it will be important that the focus remains on maximizing the potential for positive participant outcomes. This specifically entails emphasizing the importance of saving, the participant staying committed to a disciplined savings plan, and the professionally managed target date fund protecting the participant from the damage associated with the behavioral finance concepts discussed above. Manning & Napier believes that the best way to maximize participants outcomes is to embrace the inevitable uncertainty that will come with future market environments and utilize an investment process that offers a proactive and disciplined mechanism for adjusting the portfolio to fundamental changes in the market and economic environment. 5

6 Glossary of Behavioral Finance Terms Choice Overload The tendency for individuals to disengage when they are faced with numerous choices. Framing The way in which a decision is presented. Hindsight Bias The tendency to look at past events with 20/20 vision and view them based on what we know eventually happened rather than what we thought at the time the event was unfolding. Inertia The difficulty individuals face in making an initial decision to take a specific action. Overconfidence The tendency of individuals to place too much emphasis on one s own abilities or analysis. Prospect Theory The theory developed by Kahneman and Tversky identifying that individuals experience a greater negative impact with losses than they experience a positive impact with the same level of gains. Recency Bias (Inappropriate Extrapolation) The tendency to place too much emphasis on recent events and assume that those events will continue into the future. Status Quo Bias The tendency to avoid taking action when a change in course is warranted. Simplification Heuristics The use of mental shortcuts to help make complex decisions quickly. Because target date funds may invest in both stocks and bonds, the value of your investment will fl uctuate in response to stock market movements and changes in interest rates. Investing in target date funds will also involve a number of other risks, including issuer-specifi c risk, foreign investment risk, and small-cap/mid-cap risk. In addition, some target date funds invest in other mutual funds and therefore, such funds may have additional risks associated with the underlying funds. Principal value is not guaranteed at any time, including at the target date (the approximate year when an investor plans to stop contributions and start periodic withdrawals). Manning & Napier s target date offerings include mutual funds (the Manning & Napier Fund, Inc. Target Series) and affi liate collective investment trust funds (the Manning & Napier Retirement Target Collective Investment Trust Funds). For more information about any of the Manning & Napier Fund, Inc. Series, you may obtain a prospectus at www. manning-napier.com or by calling (800) Before investing, carefully consider the objectives, risks, charges and expenses of the investment and read the prospectus carefully as it contains this and other information about the investment company. Manning & Napier Advisors, LLC (Manning & Napier) provides investment advisory services to Exeter Trust Company (ETC), Trustee of the Manning & Napier Collective Investment Trust funds. The Collectives are available only for use within certain qualifi ed employee benefi t plans. The Manning & Napier Fund, Inc. is managed by Manning & Napier. Manning & Napier Investor Services, Inc., an affiliate of Manning & Napier and ETC, is the distributor of the Fund shares. 1 Investment Company Institute (ICI) Frequently Asked Questions, 2 Journal of Personality and Social Psychology, When Choice is Demotivating: Can One Desire Too Much of a Good Thing?, Iyengar, Sheena and Lepper, Mark 3 The Wharton Financial Institutions Center, Lessons from behavioral Finance for Retirement Plan Design, Mitchell, Olivia and Utkus, Stephen 4 Source: Morningstar, Inc. Analysis: Manning & Napier Advisors, LLC. The performance results represent median returns for all mutual funds within the current Morningstar mutual fund universe for the respective categories and time periods shown Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. 5 The S&P 500 Total Return Index (S&P 500) is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-the-Counter market. The Index returns assume daily reinvestment of dividends and do not refl ect any fees or expenses. Index returns provided by Morningstar, Inc. 6 Unexpected Economics, Timothy Taylor Approved CAG-LC018 (12/13) 6