Rethinking Target-Date Fund Design:

Transcription

1 Rethinking Target-Date Fund Design: Managing Participant Risks Srinivas D. Reddy, CFA Senior Vice President Full Service Investments Prudential Retirement Clint Barker, CIMA Senior Vice President Retirement Investment Solutions Prudential Investments LLC Stephen Brundage, CFA Managing Director Quantitative Management Associates

2 Introduction Americans are anxious about retirement, a fact that should come as no surprise. A 2014 study by Prudential revealed that to not run out of money in retirement was the top financial goal for 75% of respondents higher even than being able to afford medical care. 1 More telling was that of these respondents, only about one third were confident in their ability to meet this goal. 2 Similarly, a 2015 National Institute on Retirement Security (NIRS) study found that 74% of those surveyed were concerned about their retirement outlook. 3 Exhibit 1 Retirement Confidence 1% 16% 10% Retirement Confidence Very Concerned 55% Somewhat Concerned 74% 30% Not too concerned 8% 41% Not at all concerned 6% Source: NIRS 2013 Opinion Researcs 41% Very concerned 33% Somewhat concerned 16% Not too concerned 10% Not at all concerned 1% Don t know 33% Source: NIRS 2015 Opinion Research Many Americans are facing a potential retirement income gap a 2014 Prudential Retirement Financial Literacy and Retirement Readiness Study found that most employees are falling short in saving what they need for retirement 4 and a variety of solutions are being contemplated both in Washington, DC and in the private sector to help solve this retirement crisis. For example, features such as auto-enrollment and auto-escalation have been implemented in many defined contribution plans to help combat participant inertia. These features make it increasingly important for plan sponsors to choose a qualified default investment alternative (QDIA) for participants who do not otherwise make an investment selection. Target-date funds (TDFs), which attempt to put participants in an appropriate asset allocation mix and glidepath based on their estimated retirement date, have become an increasingly popular option especially as a QDIA due to their design and ease of use. 75% of respondents rank Not running out of money in retirement as top concern. Prudential Retirement, Financial Literacy and Retirement Readiness Study, Prudential Retirement, Financial Literacy and Retirement Readiness Study, Ibid 3 National Institute on Retirement Security, Pensions & Retirement Security 2015: A Roadmap for Policy Makers, Prudential Retirement, Financial Literacy and Retirement Readiness Study, 2014.

3 With this widespread use of TDFs, it is important for plan sponsors and other plan fiduciaries to recognize that despite their automatic features, TDFs are not all created equal. This is precisely why in February of 2013, the Department of Labor issued a fact sheet containing tips for ERISA plan fiduciaries on factors to consider when choosing a target-date fund. 5 Among the primary considerations for plan sponsors to evaluate are the design of the target-date fund and how the fund construction attempts to manage various risks. Exhibit 2 Target-Date Asset Growth (Dollars in Millions) $800,000 $700,000 $677,243 $600,000 $500,000 $400,000 $300,000 $335,184 $200,000 $100,000 $116,473 $0 $9,246 $15, Q Source: Strategic Insight Simfund Database, Life Cycle Fund IS (Target-Date) Assets, Q 2014 We ve conducted significant research both on the retirement risks that Americans are facing and how TDFs can help to mitigate those risks. The remainder of this paper will discuss this research as well as how Prudential approached the construction of its own TDFs, the Day One SM Fund Suite. The target date is the approximate date when investors plan to retire and may begin withdrawing their money. The asset allocation of the target-date funds will become more conservative as the target date approaches by lessening the equity exposure and increasing the exposure in fixed income type investments. The principal value of an investment in a target-date fund is not guaranteed at any time, including the target date. There is no guarantee that the fund will provide adequate retirement income. A target-date fund should not be selected based solely on age or retirement date, is not a guaranteed investment and the stated asset allocation may be subject to change. It is possible to lose money by investing in securities. Investments in the Funds are not deposits or obligations of any bank and are not insured or guaranteed by any governmental agency or instrumentality. 5 Target Date Retirement Funds Tips for ERISA Plan Fiduciaries, accessed July 16,

4 A hard look at hard data At Prudential, we are dedicated to uncovering and understanding the underlying historical drivers of retirement unpreparedness. As part of this commitment, we conducted a detailed analysis of the actual savings and investing behaviors of retirement plan participants. We analyzed participant savings rates and employer contribution rates from over 850,000 participants in nearly 2,000 defined contribution plans recordkept by Prudential Retirement. We also looked at demographic data and academic research to examine income replacement ratios that would represent the amount of retirement income needed to maintain a pre-retirement standard of living. All of these factors are important to creating realistic and data-driven cash flow assumptions, which we used to influence the glidepath designs and construction. In 2009, Prudential was among the first in the industry to adopt this type of research but it s not the only factor driving our target-date fund design. We have also pioneered research on what we call The Retirement Red Zone, the critical years prior to and just after a participant s target retirement date, when poor investment performance can quickly lead to negative participant outcomes. Since developing the concept in 2005, Prudential has studied the effects of market fluctuations on investors in The Retirement Red Zone. Our research confirms that losses in this period can have a significant impact on a participant s ability to retire when planned and to live comfortably throughout retirement. Poor investment performance in The Retirement Red Zone can have a lasting effect on a participant s investment portfolio, often leaving little time to recover. The findings from this research further informed the construction and design of our target-date fund suite. Finally, to complement our quantitative research, we ve looked at the behavioral characteristics of plan participants and focused on the choices they ve made. We assessed attitudes concerning their likelihood of living longer, their tendencies to procrastinate, and common behavioral biases such as anchoring and overconfidence. These insights led us to develop unique tools that motivate and teach participants to better prepare for retirement. And while behavioral implications are important to understand, participants still face major risks that can be addressed through target-date fund design, such as: Investment Risk the risks associated with insufficient or inappropriate diversification/asset allocation Inflation Risk the risk that participant incomes won t keep pace with inflation, a particularly worrisome concern given the skyrocketing cost of healthcare Sequence of Returns Risk the risk that negative returns either just before or after retirement can have a dramatic adverse impact on the ability of retirement savings to last throughout a participant s lifetime Longevity Risk the risk of participants outliving their assets While all target-date funds address some of these risks, we believe there is one risk that has been historically overlooked yet stands out above all: longevity. For this reason, we have created our suite of target-date funds to have two distinct glidepath designs that can help manage or even eliminate 6 longevity risk. 4 6 When invested and Locked-In to the Prudential Day One IncomeFlex Target Funds. Guarantees are based on claims-paying ability of Prudential Retirement Insurance and Annuity Company (PRIAC), and are subject to certain limitations, terms, and conditions. Withdrawals in excess of the lifetime annual withdrawal amount will reduce further guaranteed withdrawals proportionately and may even eliminate them entirely.

5 Constructing target-date funds that address increased longevity In 2010, there were 5.8 million Americans age 85 or older. By 2050, that number is projected to soar to 19 million. 7 With this in mind, conventional industry wisdom around a 20-year average retirement lifespan is simply inadequate for long-term retirement planning. Retirement industry experts are ringing the warning bell that without a systemic change in how the industry calculates participants retirement savings needs, each year more and more individuals will be faced with the very real risk of outliving their assets. To help close this significant retirement income gap, we believe that participants will need to plan for a lifespan that may very well extend to age 95 or beyond. Why an additional 12 years when the U.S. Census Bureau estimates the average American life expectancy to be only 83 by 2050? 8 Because we see an obligation to help participants prepare for the possibility of a longer life in retirement than expected after all, an average is just that, and some will far surpass it. The first person to live to 150 is most likely alive today. Source: Forbes.com, John Nosta: The First Person to Live to 150 Has Already Been Born Revisited!, The assessment of the TDF landscape suggests that a greater number of providers have constructed a through glidepath design to help guard against longevity risk. We believe going beyond the labels and deep into glidepath construction is necessary. To Versus Through Glidepaths Historically there have been two schools of thought around TDF glidepaths; To funds, which manage the reduction of equity exposure up to the target date, when it lands at its most conservative point. Through funds, which manage the reduction of equity exposure through retirement, continuing to decrease until 10, 20, or even 30 years after the target date. These naming conventions can be misleading, because they imply significant simplification of a fundamentally complex concept. For example, in broad terms to funds are generally perceived to have a very conservative allocation at the target date, because it is designed to be the final equity landing point. However, if you look at the universe of through funds, there are a number of them that are just as conservative in their allocations at the target date as the to funds. Rather than focusing merely on the concept of to versus through, it is important for plan sponsors and advisors to identify the risk profile they are solving for. Then evaluate the various target-date fund options and the intricacies of their individual glidepaths based on the ability to address the needs of their plan and participants, rather than simply including or excluding funds because of a to or through label. 7 U.S. Census Bureau, The Next Four Decades: The Older Population in the United States 2010 to 2050, May U.S. Census Bureau, Population Division, Projected Life Expectancy at Birth by Sex, Race, and Hispanic Origin for the United States: 2015 to 2060 (NP2012-T10C), May

6 The findings around longevity were factored into the construction of the Prudential Day One target-date fund suite 9 in two ways and through two distinct glidepath designs. 1. The Prudential Day One Funds glidepath design initially has a high equity as well as non-traditional allocation to help increase the potential for asset accumulation. Approximately 10 years prior to the target date, the glidepath slope starts getting much steeper, transferring out of equities and into fixed income investments at a quicker pace to reduce downside equity risk when investors can least afford to experience significant losses. This glidepath design may allow participants an opportunity to accumulate more assets for retirement when they are younger and can afford to take on risk, but reduces downside equity risk as they near retirement. However, while the Day One Funds glidepath design is constructed to seek to mitigate longevity risk, it does not provide guaranteed income. That is why we have also designed another version of the Day One Funds. Ten years prior to the target date, we incorporate The Retirement Red Zone concept into our glidepath. At this point, we begin to significantly shift from riskier assets to more conservative ones. Because addressing longevity risk is so important, the glidepath starts with a 97% allocation to domestic and foreign equities, as well as commodities and real estate (non-traditional investments) to help provide for potential growth. 97 % EQUITY & NON-TRADITIONAL EXPOSURE (%) As the target date approaches, equity exposure decreases. -10 YEARS TARGET DATE Because the Day One Funds have a through retirement glidepath, the exposure to equities continues to decrease to provide additional protection against equity market declines. This allocation stabilizes 10 years after the target date at 25% equities, 10% commodities and real estate, and 65% fixed income. +10 YEARS 35 % 0 YEARS TO RETIREMENT -40 yrs -30 yrs -20 yrs -10 yrs +10 yrs TARGET DATE DAY ONE FUNDS Income As shown in the chart, each target-date fund s asset allocation follows a glidepath that becomes more conservative as the applicable target date approaches by reducing exposure to equity investments and increasing exposure to fixed income investments. The glidepath continues to adjust allocations in this manner for approximately 10 years past the target date, at which point the asset allocation of each target-date fund will be similar to that of the Day One Income Fund, which maintains a static asset allocation. The glidepath assumes retirement at approximately age 65 and contributions beginning at approximately age 18. Each Day One Fund s underlying asset allocation is reviewed periodically to determine whether the glidepath (or, in the case of the Day One Income Fund, the prescribed asset allocation) and underlying funds in which such Fund invests remain suitable to meet the Fund s investment objective. As a result of this review, the glidepath and/or the allocation of the Fund s assets among the underlying funds may be modified. The Day One 2010 Fund is only available as an insurance company separate account under group variable annuity contracts issued by Prudential Retirement Insurance and Annuity Company. Allocations as of January 2, Prudential Day One Funds are offered in the following structures: (i) insurance company separate accounts available under group variable annuity contracts issued by Prudential Retirement Insurance and Annuity Company (PRIAC), Hartford, CT, a Prudential Financial company, and (ii) collective investment trust funds established by Prudential Trust Company, as trustee, a Pennsylvania Banking Corporation located in Scranton, PA, and a Prudential Financial company. Each of PRIAC and Prudential Trust Company is solely responsible for its own contractual obligations and financial condition. Offers of the collective trust funds may only be made by sales officers of Prudential Trust Company. PRIAC and Prudential Trust Company have each engaged Quantitative Management Associates LLC, an SEC registered investment adviser and a Prudential Financial company, to perform asset allocation and certain other services. The Day One Funds, as insurance company separate accounts or collective investment trusts, are investment vehicles available only to qualified retirement plans, such as 401(k) plans and government plans, and their participants. Unlike mutual funds, the Day One Funds are exempt from federal securities laws and not entitled to the protections of those laws.instead they are subject to regulation under applicable bank or insurance laws.

7 2. The Prudential Day One IncomeFlex Target Funds (available for an additional fee) are designed to provide guaranteed retirement income by incorporating Prudential IncomeFlex Target, offered by Prudential Retirement Insurance and Annuity Company. 10 This glidepath design starts out in the same fashion as the Day One Funds glidepath but, at 10 years prior to the target date when income guarantees become active, it stabilizes at a high allocation to equities and non-traditional asset classes (60%) and maintains this allocation beyond the target date. This product design allows participants to maintain the high equity allocation and participate in equity rallies while protecting future retirement income stream from market declines. Research has found that as many as three out of four participants believe traditional target-date funds already include guaranteed income. 11 Given this widespread misconception, we feel it is important to offer a product that also offers a lifetime retirement income solution % -10 YEARS Target Date EQUITY AND NON-TRADITIONAL EXPOSURE (%) % 0-40 yrs -30 yrs -20 yrs -10 yrs Target Date +10 yrs YEARS TO RETIREMENT As shown in the illustration above, each target-date fund s asset allocation follows a glidepath that becomes more conservative as the applicable target date approaches by reducing exposure to equity investments and increasing exposure to fixed income investments. The glidepath continues to adjust allocations in this manner until approximately 10 years prior to the target date, at which point the asset allocation of each target-date fund will be similar to that of the Day One IncomeFlex Target Balanced Fund, which maintains a static asset allocation. Each Fund s underlying asset allocation is reviewed periodically to determine whether the glidepath (or, in the case of the Day One IncomeFlex Target Balanced Fund, the prescribed asset allocation) and underlying funds in which such Fund invests remain suitable to meet the Fund s investment objective. As a result of this review, the glidepath and/or the allocation of the Fund s assets among the underlying funds may be modified. Allocations as of January 2, Guarantees are based on claims-paying ability of Prudential Retirement Insurance and Annuity Company (PRIAC), and are subject to certain limitations, terms, and conditions. Withdrawals or transfers (other than transfers between Active IncomeFlex Target Funds) proportionately reduce guaranteed values prior to locking-in. After Lock-In, withdrawals in excess of the Lifetime Annual Withdrawal Amount will reduce future guaranteed withdrawals proportionately and may even eliminate them entirely. 11 AllianceBernstein, 2011, What Workers Get And Don t Get About Target-Date Funds. 7

8 Hedging against sequence of returns risk A retirement risk that is often overlooked is the critical importance of investment returns in the years just before and after a participant transitions into retirement and begins drawing income from his/her savings. While average returns may even out over time, they can vary widely over the short-term. Older participants who are closer to retirement can t afford the short-term losses that a younger participant can, because they likely will not have enough time to recover from them. Just a few years of below-average returns right before or after a participant begins to take distributions in retirement can quickly erode their retirement savings to the point that they ll be unable to generate enough income to last a lifetime. For evidence, look no further than the devastating effects of the 2008 financial crisis. To further illustrate this point, consider the two hypothetical scenarios depicted in Exhibit 3. Both participants had accumulated $250,000 in savings at retirement. Both experienced a 5% average annual return and took annual 4% withdrawals throughout the ensuing 30 years. The only difference between the two is that Participant A experienced negative returns during the first three years of retirement (-18.9%, -14.1% and -4.8%), while Participant B experienced positive returns (15.3%, 6.1% and 10.7%) during those same years. As you can see, Participant B still retained a portfolio valued at over $207,212 after 30 years, while Participant A ran out of retirement savings after 28 years. While a portfolio achieving a sufficient average annual return to meet retirement goals is important, the sequence of those returns may also have a significant impact. Because we know the sequence of returns risk is magnified in The Retirement Red Zone, the Day One Funds reflect an accelerated shift from riskier assets Exhibit 3 Recovering from early losses can be challenging 4% Withdrawals Begin in Year 1 Hypothetical Annual Net Return Hypothetical $250,000 Portfolio Value (Negative Returns Early) Hypothetical Annual Net Return Hypothetical $250,000 Portfolio Value (Positive Returns Early) Beginning Value Participant A $250,000 Participant B $250, % $194, % $276, % $158, % $281, % $142, % $299, % $141, % $317, % $141, % $310, % $152, % $319, % $136, % $311, % $134, % $313, % $144, % $325, % $141, % $356, % $139, % $356, % $142, % $353, % $146, % $358, % $144, % $355, % $148, % $322, % $128, % $338, % $120, % $343, % $114, % $361, % $105, % $379, % $85, % $381, % $94, % $381, % $87, % $419, % $76, % $422, % $61, % $381, % $49, % $411, % $33, % $416, % $19, % $412, % $3, % $367, % $0-14.1% $289, % $0-18.9% $207,212 Average Annual Net Return for 30-Year Period Sequence of Returns to more conservative ones, in order to coincide with the participant s move into The Retirement Red Zone. As the participant enters The Retirement Red Zone, 10 years before the fund s target date, a significant shift occurs. At the target date, there is another significant shift to more conservative assets, and the glidepath continues to shift downward until 10 years post target date. This kink in the glidepath works to help manage risk by shifting from equities to fixed assets, thereby subjecting a lesser portion of the portfolio to risk at a time when participants most need to preserve their assets for retirement income. 5% Negative Returns early deplete savings 5% Positive Returns early can extend savings more than 30 years despite the same average annual net return 8

9 Participants who elect the Prudential Day One IncomeFlex Target Funds gain additional protection from sequence of returns risk once the IncomeFlex Target guarantees are activated (10 years prior to the target date). As participants move into The Retirement Red Zone, the presence of the income guarantee allows for a greater allocation to equities and non-traditional assets (60%) to capture market highs, but protects against sequence of returns risk at a time when participants need to preserve their assets for retirement income. On the day a participant decides to Lock-In his or her guaranteed benefit, the participant s Market Value (a daily value that is not guaranteed and fluctuates based on fund performance) and Income Base (set when guarantees are activated, increases with contributions as well as gains from fund performance every birth day) are compared. If the Market Value is higher, the Income Base automatically adjusts upwards to match. A participant s Income Base is used to determine his or her lifetime annual withdrawal amount. Prudential Retirement guarantees that the participant can withdraw this amount each year for the rest of his or her life. Unlike Market Value, which is available as cash or lump sum, the amount reflected as the participant s Income Base is never available as a withdrawal. With Day One IncomeFlex Target Funds, participants receive downside market protection for retirement income and income that will never decrease even in poor markets. Protecting against the dangers of inflation Despite the absence of broad-based inflationary pressures in the current economic environment, the effects of even low inflation rates can add up and compound over time to have a significant impact. Consider that over the past 30 years, consumer prices have more than doubled. That means that participants retiring today at age 65, who could be looking at 30 years or more in retirement, could see nearly everything they need to purchase double in cost. Exhibit 4 Cumulative Inflation from 1984 to 2013 $24,000 $22,000 An average inflation rate of 2.8% in the last 30 years means that prices increased 130% since 1984 $20,000 $18,000 $16,000 $14,000 $12,000 $10, YEAR Source: Calculated by Prudential Investments LLC using data presented in Morningstar Software products. All rights reserved. Used with permission. Inflation is measured by the Consumer Price Index (CPI), which is a measure of the average price of consumer goods and services purchased by households. All data as of December 31st of each year. 9

10 This exemplifies the erosive effect inflation can have on the purchasing power of retirement savings accounts. Clearly, inflation protection is a crucial piece of the retirement income puzzle. Inflation protection can be achieved through exposure to a variety of asset classes. Equities, for instance, have proven to be one of the best after inflation asset classes but can exhibit higher volatility than some other asset classes. Alternatively, a diversified portfolio of real assets, those that have a physical or tangible value, provides inflation protection while reducing portfolio volatility. Treasury Inflation Protected Securities (TIPS) can play a valuable role both in protecting against the impact of potential inflation that can arise from negative supply shocks or weak monetary policy and helping to manage downside risk. When equity markets are crashing, investors historically have moved into safe haven asset classes such as treasuries. Prudential s research shows that by diversifying the Day One Fund suite with allocations to asset classes such as commodities and real estate, we may be able to seek to mitigate the effects of the broad-based inflation that often accompanies a strong global economy. As noted in Exhibit 5 below, holding a diversified basket of real assets may not only help combat the impact of inflation on investment portfolios, but may also improve overall returns. The Day One Fund suite is constructed with a portion of the allocations devoted to TIPS, commodities, and real estate in an effort to moderate risk as well as outpace inflation during both the accumulation years and in retirement. In addition, as the funds approach their target dates, the allocation to TIPS meaningfully increases, adding an additional strategy to attempt to mitigate potential inflation. Exhibit 5 Average Annual Real Returns During High Inflation % % 10 Average Annual Real Returns During High Inflation REAL AVERAGE RETURNS Real Estate Securities 11.9% Commodities 11.3% 7.9% Stocks 7.1% Bonds 3.9% 3.9% 2 0 COMMODITIES REAL ESTATE STOCKS BONDS Source: Calculated by Prudential Investments LLC using data presented in Morningstar Software products. All rights reserved. Used with permission. Reflects annualized rates of return for the high inflationary periods. High inflation periods are calendar years when inflation was 3% or more ( , , 1996, 2000, 2004, 2005, 2007, and 2011). Average annualized returns were calculated by taking the average of all 21 years. Real estate securities are represented by the equal portions of the FTSE NAREIT All Equity REITs Index and the NCREIF Property Index, except for years 1976 and 1977, which pre-dates the NCREIF Property Index, thus only the FTSE NAREIT All Equity REITs Index is used. Both indexes are unmanaged and measure the performance of all real estate. Commodities are represented by the S&P Goldman Sachs Commodity Index, which is unmanaged and is a world-production weighted index composed of 24 commodity futures contracts. Stocks are represented by the S&P 500 Index, which is a market-weighted, unmanaged index of 500 of the largest U.S. stocks in a variety of industry sectors. Bonds are represented by the Barclays U.S. Aggregate Bond Index, which is unmanaged and covers the U.S. dollardenominated, investment-grade, fixed-rate, taxable bond market of Securities and Exchange Commission (SEC) registered securities. These returns do not assume share price changes or the compounding effect of reinvested dividends and capital gains. An investment cannot be made directly in an index. Past performance is not a guarantee or reliable indicator of future results. 10

11 Enhancing returns while controlling investment risk According to Modern Portfolio Theory, the most effective way to mitigate risk is to diversify. But left to their own devices, participants often fail to adequately diversify their retirement plan investments. For example, a 2011 Prudential Retirement Book of Business survey found that almost 40% of DC plan participants age 50 and over who were not enrolled in a target-date fund were invested entirely in either equity or fixed income funds. Whether due to inertia, fear, or lack of investment knowledge, the result is the same: participants who are not diversified are taking an unnecessary chance with their retirement savings. TDFs are generally constructed to help correct those poor investing habits and help improve diversification, which is one reason they are increasingly being adopted by plan sponsors. Asset class inclusion and allocation decisions for the Day One Fund suite are based on analysis of expected returns, risks, and correlations. The specific analysis is described below. Exposure to emerging markets, real estate, and commodities AVERAGE ANNUAL RETURN (%) Exhibit Year Risk/Return for DM and EM Here s an example of how diversification helps. On the international front, our research showed that by taking 25% from a developed international equity allocation and moving it to emerging markets, the portfolio s risk as measured by standard deviation went up 0.9 points (or 5%), while the overall portfolio return went up from 4.5% to 6.3% (40% increase). 100% Developed Markets 75% Developed Markets / 25% Emerging Markets 100% Emerging Markets STANDARD DEVIATION (%) Source: Calculated by Prudential Investments LLC using data presented in Morningstar Software products. As of 9/30/2013. All rights reserved. Used with permission. Past performance is not a guarantee or reliable indicator of future results. Exhibit 7 Risk/Reward (1/1999 9/2013) 6.0 In a similar fashion, by moving just 10% from the equity allocation of a typical 60/40 portfolio to commodities and real estate, overall portfolio returns were enhanced while overall risk was simultaneously reduced. 5.5 AVERAGE ANNUAL RETURN (%) STANDARD DEVIATION (%) 100% Stocks 50% Stocks / 40% Bonds / 5% Real Estate / 5% Commodities 60% Stocks / 40% Bonds Source: Morningstar. The statistics stated above and the accompanying tables are derived from Morningstar Direct and Barclays. Calculated by Prudential Investments using data presented in Morningstar. All rights reserved. Used with permission. As of 9/30/2013. Annualized returns and standard deviation for risk/return are based on indexes. Allocations are rebalanced annually. Stocks are represented by the S&P 500 Index. Bonds are represented by the Barclays U.S. Aggregate Bond Index. Real estate securities are represented by the equal portions of the FTSE NAREIT All Equity REITs Index and the NCREIF Property Index. Commodities are represented by the S&P Goldman Sachs Commodity Index. Index performance is not representative of the performance of a specific security. An investment cannot be made directly in an index. 11

12 Common volatility concerns associated with both REITs and equity strategies may be mitigated by incorporating a private real estate component to the asset mix, as in the Day One Fund suite. Private real estate has historically had a significantly lower correlation to stocks and bonds than public real estate, thus increasing its potential portfolio diversification benefits and potentially improving risk and return characteristics. Exhibit 8 The Value of Private Real Estate 1.0 Historical Correlation: Public Real Estate Private Real Estate CORRELATION TO U.S. STOCKS 0.16 CORRELATION TO U.S. BONDS Note: Correlation refers to the relationship between two variables, in this case private real estate to equities (represented by the S&P 500 Index) and bonds (represented by Barclays U.S. Aggregate Bond Index). Correlations can vary from +1 to 1, with +1 representing a high degree of positive correlation, and 1 a high degree of negative (opposite) correlation. Indexes are not available for direct investment. Source: As of December 31, Public real estate is represented by the FTSE NAREIT All Equity REITS Index. Private real estate is represented by the NCREIF Property Index. Employing both active and passive strategies At Prudential, we adhere to the strong fundamental belief that active management adds value. Target-date funds that are structured to passively track an index do so with the opportunity cost of missing out on the potential upside that skilled active management can provide. Conversely, TDFs that rely exclusively on active management may assume a higher degree of manager risk by exposing participants to potentially greater security selection risk. As a result, we ve opted to combine both active and passive strategies within our Day One Fund suite in an effort to capture some degree of upside potential while attempting to constrain volatility and deliver a more cost-effective investment mix for participants. In addition, the Day One Fund suite utilizes several active but risk-controlled equity strategies in an effort to further reduce portfolio volatility. Risk-Controlled Active Equity Large Cap Mid Cap Emerging Markets Non-Traditional Real Estate Commodities Passive S&P 1500 Index Russell Developed Ex-North America Large Cap Index Fundamental Active Equity Small Cap Fixed Income Core Bond TIPS Short-Term Bond 12

13 Modifying behavior to overcome accumulation/withdrawal challenges Recent studies such as a 2013 Pensions and Retirement Security study by the National Institute on Retirement Security continue to warn of sizeable retirement shortfalls on the horizon, with little traction being gained in motivating participants to save more. According to the NIRS study, The road to retirement has deteriorated dramatically...and Americans just aren t saving enough in their individual accounts at a time when their retirement income needs are increasing due to rising longevity and costs. The situation has grown more dire with the double whammy of the global financial crisis and Baby Boomers reaching retirement age with inadequate retirement income. 12 Thanks to the behavioral finance work of a new generation of psychologists and economists, though, we re now better able to understand and overcome some of the key psychological hurdles that lead plan participants to delay financial decisions, or worse, make bad ones. Inertia, for example, is a very real threat. Left to their own devices, those who are either not participating or participating at low deferral rates will typically tend to value their current state (higher take-home pay) more than a future state that can potentially result in greater retirement savings. That preference for the status quo is reinforced by a strong present bias for short-term benefits over long-term rewards. In fact, numerous studies have shown that offered the choice between $50 now and $100 a year from now, most participants would choose the smaller immediate benefit (a tendency known as hyperbolic discounting). There is also a natural tendency for the newly retired to significantly overspend. Retirement is a big lifestyle change and the freedom associated with it can be very expensive. Despite a sea of financial advisors counseling retirees to strive for a sustained 3.5% 4% annual withdrawal rate, we found that when it came time to retire, those participants not invested in an in-plan guaranteed retirement income option (such as IncomeFlex Target) actually withdrew an average of 7% to 15% of their market value from their plan each year. 13 One means of addressing inertia is by using automatic features such as auto-enrollment and qualified default investment alternatives (QDIAs). The Prudential Day One Funds and Day One IncomeFlex Target Funds can both be used as QDIAs. At Prudential, we believe that the industry needs to engage plan participants differently to communicate with them in ways that will not only resonate but will trigger behaviors that overcome negative tendencies. Since more than one third of pre-retirees expect to draw the majority of their retirement income from employer-sponsored plans, 14 we try to give plan sponsors the tools they need to educate employees and help them reach their Day One of retirement with confidence. The extensive behavioral research we ve conducted into longevity, procrastination, and emotional decision-making has, we believe, not only allowed us to design a more comprehensive target-date fund suite, but to communicate with and educate participants in a more compelling manner. These critical insights have led us to develop a host of mission-critical participant education tools including our Bring Your Challenges website (bringyourchallenges.com), featuring the Prudential Challenge Lab, as well as our Prepare with Pru planning solutions website (preparewithpru.com) and our Experience Day One Funds site (experiencedayonefunds. com), all of which have helped to create a stronger, more visceral, and emotional connection between plan participants and their Day One of retirement and beyond. 12 National Institute on Retirement Security, Pensions & Retirement Security: A Roadmap for Policy Makers, Prudential Retirement Book of Business, Prudential Retirement, Financial Literacy and Retirement Readiness Study,

14 The Prudential Challenge Lab explores five key challenges that participants face in planning for retirement: Challenge 1 I might live how long? Challenge 2 I ll do it later Challenge 3 It won t happen to me Challenge 4 I just can t resist Challenge 5 I want it now These behaviors and thought patterns get in the way of people s planning for their future, which is why the Day One Fund suite tries to address and solve for them by setting and following glidepaths that take into account factors like longevity and long-range goal planning. Other common scenarios also get in the way of sound planning. Our Fuzzy Logic video specifically explores the effect on decision-making (namely, inertia) when we are faced with too many choices. It s an entertaining and informative look at the way in which too many choices, complexity, and uncertainty can create emotional overload and hinder participants ability to make good decisions especially in regard to retirement income planning. To watch the Fuzzy Logic video or view a time-traveling retirement journey, visit dayonefunds.com Another innovative participant tool is the Experience Day One Funds website. Using plain-english, eye-catching graphics, and the latest Internet animation capabilities, this site takes participants on a journey where they can: Understand how life changes and milestones can have an impact on their retirement plans, and the actions they might consider Learn about important considerations in relation to investment choices Get insights on some of the ways target-date funds can be a useful part of a retirement-savings strategy Realize that small, actionable steps may be all they need to get on the right path Conclusion Our intention for this paper is to create a better understanding of the research and philosophy underpinning our suite of Day One target-date funds, especially the design of the glidepaths. As you have seen, our primary drivers were the need to design target-date funds that address the retirement risks that all people face investment risk, inflation risk, sequence of returns risk, and longevity risk with a particular focus on reducing, or even eliminating, longevity risk. We hope this paper has helped explain the thought process behind the construction of Prudential s Day One Fund suite and how it helps to address the emotional and analytical aspects of saving and investing. Based on our more than 85 years of experience working with thousands of retirement plans, millions of plan participants, and leading investment managers and behavioral experts, our Day One Fund suite is a reflection of our belief that we at Prudential have the insight and commitment to help participants reach their Day One of retirement with confidence. 14

15 Investors should carefully consider a fund s investment objectives, risks, charges, and expenses before investing. As with all investments, there are a number of factors and risks to consider in selecting a target date fund. In addition to anticipated retirement date, relevant factors for Fund selection may include age, risk tolerance, other investments owned, and planned withdrawals. In addition, participants should carefully consider the investment objectives, risks, charges, and expenses of any Fund before investing. It is possible to lose money in a Fund including near or following retirement and there is no guarantee that the Funds will provide adequate retirement income. Investments in the Funds are not deposits or obligations of any bank and are not insured or guaranteed by any governmental agency or instrumentality. Prudential Day One Funds are offered in the following structures: (i) insurance company separate accounts available under group variable annuity contracts issued by Prudential Retirement Insurance and Annuity Company (PRIAC), Hartford, CT, a Prudential Financial company, and (ii) collective investment trust funds established by Prudential Trust Company, as trustee, a Pennsylvania Banking Corporation located in Scranton, PA, and a Prudential Financial company. Each of PRIAC and Prudential Trust Company is solely responsible for its own contractual obligations and financial condition. Offers of the collective trust funds may only be made by sales officers of Prudential Trust Company. PRIAC and Prudential Trust Company have each engaged Quantitative Management Associates LLC, an SEC registered investment adviser and a Prudential Financial company, to perform asset allocation and certain other services. The Day One Funds, as insurance company separate accounts or collective investment trusts, are investment vehicles available only to qualified retirement plans, such as 401(k) plans and government plans, and their participants. Unlike mutual funds, the Day One Funds are exempt from Securities and Exchange Commission registration under both the Securities Act of 1933 and the Investment Company Act of 1940, but are subject to oversight by state banking or insurance regulators, as applicable. Therefore, investors are generally not entitled to the protections of the federal securities laws. The Prudential Day One IncomeFlex Target Funds were designed for use with Prudential IncomeFlex Target, an in-plan guaranteed retirement income product, and are available as insurance company separate accounts under group variable annuity contracts issued by Prudential Retirement Insurance and Annuity Company (PRIAC), Hartford, CT. PRIAC does not guarantee the investment performance or return on contributions to those separate accounts. Availability and terms may vary by jurisdiction, subject to regulatory approvals. Guarantees are based on claims-paying ability of the insurance company and are subject to certain limitations, terms, and conditions. For more information, participants should access the participant service center or call for a copy of the Prudential IncomeFlex Target Important Considerations before investing. PRIAC is a Prudential Financial company. Annuity contracts contain exclusions, limitations, reductions of benefits, and terms for keeping them in force. Contract form #GA-2020-TGWB or state variations thereof.

16 280 Trumbull Street Hartford, CT prudential.com For more information contact your Prudential representative or the contributing authors: Michael Rosenberg Senior Vice President, IODC Prudential Investments Scott Boyd Vice President, Strategic Relationships Prudential Retirement Kurt Mansfield Vice President, Product Marketing Prudential Retirement Julia Salnikova Director, Investment Marketing Prudential Retirement Visit dayonefunds.com and experiencedayonefunds.com 2015 Prudential Financial, Inc., and its related entities. Prudential, the Prudential logo, the Rock symbol, and Bring Your Challenges are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide RSWP012 For Intermediaries and Plan Sponsors Public Use Permitted