Defined contribution plans
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1 Topics in... Defined contribution plans making target retirement date funds work Assessing the Probability of Glidepath Success Target retirement date funds have grown to become one of the most popular qualified default investment alternatives (QDIAs) available to defined contribution (DC) plan sponsors today. As a plan sponsor, having confidence in the glidepath used by your chosen QDIA s investment manager is crucial. Northern Trust s target retirement date funds (Northern Trust Focus Funds) are constructed using a glidepath that is designed to smoothly move participants along an investment spectrum from the start of their careers into retirement. Our glidepath methodology is rigorously tested to help ensure that our asset allocation approach increases the likelihood that plan participants will not outlive their retirement assets. CONSTRUCTING THE GLIDEPATH Northern Trust constructs the glidepath for our target retirement date funds taking into consideration the broad spectrum of investor asset allocation needs from younger participants focused on capital appreciation, to the asset allocation requirements of people focused on preserving capital as they draw closer to and enter retirement. We implement an investment strategy that moves participants systematically from one end of the spectrum to the other. Modeling strategic asset allocation Developing a suitable asset allocation strategy is crucial to meeting a participant s retirement savings goals. In fact, asset allocation accounts for more than 90% of total portfolio performance 1. The foundations of our glidepath are the Northern Trust Investment Policy Committee s strategic asset allocation models, which Providing an Asset Allocation Foundation leverage Northern Trust s more than 30 years of experience developing Developing a suitable asset allocation strategy is crucial to strategic asset allocation models meeting a participant s retirement goals. Northern Trust s in institutional and individual glidepath methodology is rigorously tested to help ensure that client investment programs. These models are designed to provide strong, our asset allocation approach increases the likelihood that plan stable performance over the long participants will not outlive their retirement assets. term by capturing opportunities across multiple asset classes. The glidepath creation begins with a strategic asset allocation model representative of a younger participant concerned primarily with capital appreciation and who has many years remaining until retirement. This asset allocation becomes the basis for the longer vintage year allocations in the glidepath. For the shortest vintage year allocation, we apply a strategic asset allocation model representative of a participant in retirement who is concerned primarily with capital preservation. Finally, for each of these allocations, we maintain established risk budgets to optimize the strategic asset allocation. The risk budgets we ve established for the younger participant, targeted at age 25, is within a portfolio standard deviation range of 12% to 15% based on a portfolio holding between 70% and 90% equities. For the participant in retirement, targeted at age 75, our risk budget is within a portfolio standard deviation range of 4% to 7% based on the portfolio holding between 0% and 30% equities. northerntrust.com Making Target Retirement Date Funds Work 1 of 12
2 We connect these two endpoints through a linear roll-down designed to help provide a smooth transition as each fund advances toward its target date. The glidepath allocation is depicted in Chart 1. (The complete allocation by vintage year for the Northern Trust Focus Funds can be found in Table 4 on page 11.) chart 1: northern trust focus funds glidepath ALLOCATION 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% YEARS TO RETIREMENT CASH FIXED INCOME INFLATION HEDGE INTERNATIONAL EQUITY U.S. EQUITY Source: Northern Trust Developing Risk and Return Expectations A critical element of Northern Trust s glidepath construction is the outlook for each asset class s risk and return. Annually, Northern Trust s senior investment professionals and members of the Investment Policy Committee gather to develop longer-term (five year) forecasts for economic activity and financial market instruments (see Table 1 for the 2012 assumptions). The asset class forecasts resulting from this group s work form the risk and return expectations for each vintage year across the glidepath. Chart 2 graphs the placement of each fund on the risk and return spectrum. Consistent with our glidepath strategy, our funds exhibit a smooth transition across the risk and return spectrum. Providing an Asset Allocation Foundation Northern Trust s Investment Policy Committee for Defined Contribution (IPC-DC) is a sub-committee of the Northern Trust Investment Policy Committee. The IPC-DC is responsible for adapting the investment policy including asset allocation, asset class risk and return forecasts made by the broader Investment Policy Committee for use within the DC Solutions practice. The IPC-DC meets quarterly to review the Focus Funds performance and annually reviews the strategic asset allocation in conjunction with the annual release of the IPC s five-year forward looking capital market assumptions. The group also assesses the potential for newer asset classes that can help enhance investor outcomes on a longer-term strategic basis. northerntrust.com Making Target Retirement Date Funds Work 2 of 12
3 Table 1: Five-Year Risk and Return Assumptions for Year Return Forecast 5-Year Risk Forecast U.S. Equities Large Cap 7.5% 17.1% U.S. Equities Mid Cap 8.0% 19.8% U.S. Equities Small Cap 9.0% 23.2% International Equities Developed International Equities Emerging Markets 7.0% 19.9% 10.7% 27.0% Global Real Estate 9.4% 22.9% Commodities 5.3% 19.4% U.S. TIPS 2.7% 6.5% U.S. Bonds 3.3% 6.4% High Yield Fixed Income 5.6% 10.9% Cash 1.5% 1.6% Source: Northern Trust chart 2: Northern Trust Glidepath Risk and Return Each point on the chart below represents a target date fund, with the lowest point represented by the risk and return forecast for the Northern Trust Focus Income Fund (the allocation found in our short-dated segment). The point with the highest risk and reward forecast represents the Northern Trust Focus 2040 to 2055 Funds, which all share the same asset allocation. 8.0% RETURN 7.0% 6.0% 5.0% 4.0% 2005 Income Fund % 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% RISK (STANDARD DEVIATION) Source: Northern Trust northerntrust.com Making Target Retirement Date Funds Work 3 of 12
4 GLIDEPATH TESTING AND MEASURES OF SUCCESS Now that we have established the forecasted risk and return for each vintage year, we validate our glidepath using a Monte Carlo simulation to run 10,000 portfolio simulations that represent possible retirement asset outcomes at age 65 (or after 40 years of working and saving). In our simulations, we examine the effects different variables have on participant savings behavior including when a participant starts saving, his or her contribution levels, and the consistency with which he or she saves and their impact on outcomes over the long term. This testing helps us determine the range of retirement assets that may be available at age 65, at which point the participant may choose either to buy an annuity or determine his or her own drawdown of the retirement assets over time. Determining How Much Participants Will Need To determine whether a target retirement date glidepath will successfully help prepare participants for retirement, we must understand what their retirement income needs likely will be. One of the key resources for this is the quadrennial Replacement Ratio Study 2 conducted by AonHewitt Consulting and Georgia State University. This study, which was first conducted in 1980, analyzes the replacement ratio employees need to maintain their pre-retirement standard of living after retirement. According to this study, when a person retires he or she should require less gross income to maintain the same standard of living for four main reasons: 1. Income taxes decrease after retirement; 2. Social Security taxes end at retirement; 3. Social Security benefits are partially or fully tax-free; and 4. Saving for retirement is no longer needed. The study uses a replacement ratio methodology to determine a person s post-retirement income needs, based on his or her salary in their final working year (see Table 2). Table 2: replacement ratios Replacement Ratios Pre-Retirement Income Social Security (%) Private and Employer Sources (%) Total (%) $20, $30, $40, $50, $60, $70, $80, $90, Sources: AonHewitt and Georgia State University (2008) northerntrust.com Making Target Retirement Date Funds Work 4 of 12
5 Based on Table 2, for example, a participant whose annual income at retirement was $50,000 would need to replace 30% of his or her pre-retirement income from private sources annually (including pension plan assets, individual retirement accounts [IRAs], DC plans and other savings accounts). For our glidepath analysis, we assume the private source will come entirely from an employer-sponsored DC plan. The goal is to build sufficient savings in the DC plan, through participant contributions, employer contributions and capital appreciation over the participant s working life, to sustain this required annual payout. table 3: BASE-CASE PARTICIPANT PROFILE Testing the Base-Case Scenario For our analysis we examine a single male, age 25, who represents our base-case participant with the characteristics outlined in Table 3. The results of our glidepath analysis will help validate whether this participant will have accumulated enough assets at retirement to purchase an annuity to meet the portion of his retirement income needed from private income sources. We also test an alternate scenario should a participant decide to forego an annuity and instead drawdown his retirement assets directly over time. Income Income Replacement Ratio Beginning income age 25 $45,000 Required replacement ratio 81% Ending income age 65 $142,516 Social Security 50% Ending income (in current dollars) $53,077 Private savings 31% Growth Cash Flows Inflation 2.5% Preretirement savings deposited End of year Real growth in income 0.5% Retirement income withdrawn Beginning of year Median value of assets at age 65 $1,235,900 Savings Patterns Single Life Immediate Annuity Information (as of 9/2011)* Year one participant contribution 3% Annual income received from $100,000 annuity $7,248 Savings increase 0.5%/year Maximum participant contribution 10% Required single life immediate annuity to Employer match 3% replace 31% of $142,516 $609,500 Savings period 40 years Sources: Northern Trust, unless otherwise noted. * Annuityshopper northerntrust.com Making Target Retirement Date Funds Work 5 of 12
6 RETIREMENT DRAWDOWN: ANNUITY PURCHASE Our first scenario analysis involves the assumption that our base-case participant (based on the participant profile established in Table 3) will choose to purchase an annuity. Our profile states that we start with a salary of $45,000 at age 25 and increase it over time based on inflation and a conservative estimate of real wage growth. After 40 years, our base-case participant would be earning a salary of $142,516 at retirement (at age 65). We also need to determine the participant s pre-retirement income (in current dollars). To do so, we identify his replacement ratio requirements from Table 2. To find his pre-retirement income, we increase his salary at only the real-wage growth rate, which becomes $53,077 after 40 years. Based on the ratios in Table 2, using a salary of $53,077, our base-case participant requires a total replacement ratio that is slightly less than 81%. We arrived at this replacement ratio because his salary at retirement (in current dollars) falls between $50,000 and $60,000. He will require approximately 31% from private sources. (For this example, we also assume approximately 50% will come from Social Security.) To model investment savings as an input into the glidepath validation, our base-case participant begins contributing 3% of his salary at age 25, increasing it 0.5% each year until he reaches a contribution level of 10% per year. The employer also contributes a 3% match for a participant s 40-year working life. We assume the participant will choose a single-life immediate annuity at retirement, because this best represents a payout stream similar to what might be received from a typical defined benefit (DB) plan in the United States. We can now determine the actual annual cash flow required Drawdown Decisions for this participant to replace his income based on the data presented Participants in a DC plan have the option to either draw down their retirement in Table 3. The required cash flow plan balance after retirement on their own, or manage this drawdown by purchasing that needs to be replaced by private an annuity that will provide a set payment each month throughout their life. Retirees income sources is $142,516 x 31%, can choose from a variety of annuity options, including inflation-adjusted annuities which is $44,180 per year. Our next step is to determine or those with survivor benefits that would pass on to a surviving spouse after the the cost of an annuity to replace this retiree s death. annual cash flow. We capture an The determination of current annuity values is a critical input into our average annuity price from approximately 20 insurance companies scenario analysis. Annuity rates change frequently, which can make pinpointing to determine this cost for our what a participant may pay at retirement for his required income replacement testing. Based on this average price, somewhat challenging. For our scenario analysis, we used an average of 20 a $100,000 annuity will provide of the top insurance companies current annuity rates 3. Some of the companies a $7,248 cash flow annually. If providing quotes were MetLife, Nationwide, New York Life and Jackson National. we apply this market pricing to our desire to replace $44,180 per All of these firms, at the time of the quotes in the summer of 2011, were rated year, we determine that we need single A or better by S&P and Moodys. In pricing the annuity, we applied the to purchase an annuity with a demographics of our base-case participant, who is a 65 year old, single male premium of about $609,500 from the state of Illinois. ($44,180 /$7,248 x $100,000). Please see the sidebar on Drawdown Decisions for more information. northerntrust.com Making Target Retirement Date Funds Work 6 of 12
7 Comparing this number with the projected range of account values at retirement, generated from Monte Carlo simulation, we are able to determine whether the account will be sufficient to cover the private income source requirement. The Likelihood of Success The Monte Carlo analysis of our base-case investor provides a range of possible outcomes for the retirement account values. Examining this range of outcomes, we observe a high probability of being able to purchase the required annuity. The blue line in Chart 3 indicates the level of retirement assets needed to buy the appropriate annuity (which replaces private income sources). For the basecase saver, a significant number of retirement asset outcomes are above this required annuity line. Mathematically, our scenario analysis indicates the base-case participant has a 94% probability of being able to buy the annuity he will need to replace his income at the level indicated by the replacement ratio. The chart shows the range of outcomes for other scenarios we consider, including the delayed saver (who starts contributing to the DC plan at age 35), the intermittent saver (who stops contributing for a time, perhaps to buy a house or save for a child s college education, then begins again) and the minimal saver (who contributes to achieve a rate of only 6% with the employer contribution). chart 3: probability of success with annuity purchase This chart shows a range of outcomes. The top line of the green box represents the top quartile outcome while the bottom line of the red box represents the bottom quartile outcome. The line intersecting the boxes is the median outcome. The whiskers at the top and bottom of each line represent the 95th percentile and 5th percentile, respectively. RETIREMENT ACCOUNT BALANCES $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 $0 Base Case Delayed Intermittent Minimal SAVING SCENARIOS northerntrust.com Making Target Retirement Date Funds Work 7 of 12
8 The Benefits of Steady Saving Investors tend to fall into four categories in their saving habits with their 401(k) plans. To account for these differences, we examine the retirement savings scenarios effect on glidepath success for: Steady savers (our base-case scenario) begin contributing early and continue to steadily contribute throughout their working lives. As our analysis shows, this saver has a 94% probability of being able to purchase the single life immediate annuity to replace private income at retirement. Delayed savers get off to a later start with their contributions. In our analysis, the delayed saver shares the same characteristics as the base-case participant, with the exception that the delayed saver begins saving at age 35 at a rate of only 3% per year (and receives the employer match of 3% for a total savings rate of 6%), increasing savings by 0.5% per year until his savings contribution peaks at 13% (including employer contributions) at age 49. The delayed saver, in our analysis, has a 63% probability of being able to purchase the single life immediate annuity to replace private income at retirement. Intermittent savers take breaks in their saving, or save at a variable rate. In our analysis, we assume the intermittent saver does not save for the first five years, then increases his contributions consistently for the next 13 years to a rate of 12.5% (including the employer contributions). He then drops back to a combined contribution level of 6% for the next 8 years, then ramps up again to peak at a combined level of 12.5% just prior to retirement at age 65. Our analysis shows that this saving pattern provides the participant with a 60% probability of being able to purchase the single life immediate annuity at retirement to replace private income at retirement. Minimal savers in our analysis only save enough to receive the company match over the course of 40 years. Minimal savers never have a total combined contribution level of more than 6% in any year. Our analysis shows that minimal savers will only have a 48% probability of being able to purchase the single life immediate annuity at retirement to replace private income at retirement. participant s annual contribution to DC plan $25,000 $20,000 $15,000 $10,000 $5, AGE These differences in savings patterns have a large effect on retirement balances. The Monte Carlo analysis shows that the base-case (steady) saver has a projected median account balance of almost twice that of the minimal saver $1.2 million versus $681,000. BASE CASE DELAYED SAVER INTERMITTENT SAVER MINIMAL SAVER northerntrust.com Making Target Retirement Date Funds Work 8 of 12
9 RETIREMENT DRAWNDOWN: SELF-MANAGED Some participants will choose to draw down their retirement account balances after retirement, rather than purchase an annuity. For this reason, we run Monte Carlo simulations to test whether the Northern Trust glidepath will prepare these participants for drawdown success. For our analysis, we define the probability of success for the drawdown scenario as not having a zero balance at any time during retirement while the participant draws down his assets. We begin using the same base-case investor assumptions established in Table 3, but we focus on the median retirement asset outcome $1,235,900 established by 10,000 Monte Carlo simulations as a conservative measure of the retirement account balance. We also assume that, after retirement, the balance remains in the Northern Trust Focus Funds. Using the replacement ratio information and our capital market assumptions to determine drawdown and portfolio growth from age 65 through age 110, we test the glidepath to determine the likelihood of a participant outliving his retirement assets at certain age intervals. While the participant s retirement account balance is reduced by the drawdowns he takes each year, it is also increased by the continuing returns from the account s ongoing investments throughout the remainder of the participant s life. For our simulations, we use the replacement ratio to determine the participant s drawdown and base the expected portfolio return projections on the glidepath allocations. The drawdown rate becomes an implied percentage each year as the required income depletes the remaining retirement account balance. The implied drawdown rate at age 65 was 4%, but grows to a 5% drawdown at age 80, 6% at age 90 and 12% at age 100. chart 4: probability of success Drawing Down Retirement Assets This chart shows a range of outcomes. The top line of the green box represents the top quartile outcome while the bottom line of the red box represents the bottom quartile outcomes. The line intersecting the boxes is the median outcome. The whiskers at the top and bottom of each line represent the 95th percentile and 5th percentile, respectively. $5,000,000 $4,000,000 RETIREMENT ACCOUNT BALANCES $3,000,000 $2,000,000 $1,000,000 ($1,000,000) ($2,000,000) ($3,000,000) ($4,000,000) AGE Source: Northern Trust northerntrust.com Making Target Retirement Date Funds Work 9 of 12
10 Treasury Discussing Annuity Options As the Department of Labor (DOL) looks to help workers plan for retirement, it has become involved in the discussion about annuitizing DC benefits. On February 2, 2012, The Department of the Treasury and the Internal Revenue Service announced a package of four regulatory actions designed to encourage annuitization of defined contribution plan assets. The actions are a result of a multi-year study that followed a joint Treasury Department-DOL request for information on lifetime income products. 4 Our analysis indicates that through age 85, investors choosing to draw down their account balances have about a 99% chance of not facing a zero account balance (see Chart 4). By age 95, that drops to 80%; at age 100 the probability of success drops to 65%; and by age 105, investors only have a 50% probability of maintaining a balance in their retirement account. IMPLEMENTATION: A SOUND BASIS FOR SUCCESS The Northern Trust Focus Funds are built on the foundation of our investment expertise and our capital market outlook. Our straightforward construction and index-based investment process provide transparency and maintain low costs. Further, our robust glidepath scenario testing validates that our asset allocation approach can increase the likelihood of more successful retirement outcomes. If you would like to learn more about the Northern Trust Focus Funds or our glidepath methodology and testing, please contact your Northern Trust relationship manager or go to northerntrust.com/dc_solutions. Notes: 1) Determinants of Portfolio Performance, Gary P. Brinson, L. Randolph Hood, and Gilbert Beebower; Financial Analysts Journal, July-August 1986 Determinants of Portfolio Performance II: An Update, Gary P. Brinson, B.D. Hood, and Gilbert Beebower; Financial Analysts Journal, ) AonHewitt Consulting (formerly Aon Hewitt), 2008 Replacement Ratio Study : A Measurement Tool for Retirement Planning 3) 2011 Annuity pricing source Annuity Shopper which reports on immediate annuities and fixed-interest deferred annuities 4) northerntrust.com Making Target Retirement Date Funds Work 10 of 12
11 Table 4: The Northern Trust Focus Funds Glidepath Participant Age < >75 Years to Retirement > Vintage Year Income EQUITY U.S. S&P U.S. S&P U.S. Russell Sub-total U.S. Equity Int l MSCI ACWI ex-u.s. IMI Total Equity INFLATION HEDGE Global Real Estate Commodities U.S. TIPS Total Inflation Hedge FIXED INCOME U.S. Bonds High Yield U.S. Bonds Aggregate Total Fixed Income CASH Source: Northern Trust northerntrust.com Making Target Retirement Date Funds Work 11 of 12
12 Northern Trust, 50 South La Salle Street, Chicago, Illinois U.S.A. Incorporated with limited liability in the United States. IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see northern trust 2012 the northern trust company northerntrust.com Making Target Retirement Date Funds Work 12 of 12 Q (3/12)
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