Managing risk in DC plan lineups The new alpha?

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1 PERSPECTIVES Managing risk in DC plan lineups The new alpha? October 2013 IN BRIEF Defined contribution (DC) plan participants face a broad range of risks when investing for retirement but, historically, the financial services industry has defined risk in terms of market and asset class. A broader definition of risk is needed that not only considers risk/return profiles, but defines risk more broadly and focuses on possible outcomes, looking at factors such as length of time until retirement and the potential for participants to invest 100% of assets in a single-menu option. A traditional view of risk Investment risk has historically been defined in terms of, which might be measured by traditional Modern Portfolio Theory measures, such as standard deviation. In building investment menus for DC plans, plan sponsors have primarily focused on asset class or investment product risk/return profiles when determining the relative risk levels of various investment options and their potential impact on participants. A typical DC investment lineup might span the risk spectrum, beginning with a conservative, low- option, such as stable value or money market funds, and moving out toward fixed income, balanced and equity funds, or even a brokerage option. EXHIBIT 1: DC PLAN PARTICIPANTS ARE EXPOSED TO A BROAD RANGE OF S Failure to save enough due to lack of growth, low savings rate or unexpected market event AUTHOR Risk that value of principal will be eroded by inflation INFLATION ACCUMULATION Risk is dynamic and multifaceted LONGEVITY Risk of outliving savings John Galateria Head of Defined Contribution Investment Solutions J.P. Morgan Asset Management john.galateria@jpmorgan.com Risk that fixed income securities will lose value if rates rise INTEREST RATE MARKET Risk of capital or investment losses due to market or asset class PARTICIPANT USER Source: J.P. Morgan Asset Management. Shown for illustrative purposes only. Possibility participant will misuse investment options (too conservative or aggressive, or under-diversified) NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 Managing risk in DC plan lineups Risk is dynamic and multifaceted This traditional view of risk focuses almost exclusively on market-related risks. In reality, however, DC plan participants are exposed to a broad range of risks when investing for retirement, as shown in Exhibit 1 on the first page. And, as shown in Exhibit 2, not all participants face the same risks at the same time. For example, risks that participants face include: outliving their savings (longevity risk); erosion of principal value due to inflation (inflation risk); rising rates (interest rate risk); and misusing the investment options (participant user risk) by investing too conservatively, too aggressively or being under-diversified. There is also the risk that participants might not make and sequence asset allocation decisions that are beneficial over the long term. Why age matters If you take a broader view of risk, then you should evaluate risk differently. Focusing on asset class risk/return profiles alone presents an interesting conundrum when looking at different age cohorts on the retirement continuum. Conservative investments such as stable value and money market funds are considered the relatively low-risk options in a plan. If younger workers in the 25-to-35-year-old age cohort, as shown in Exhibit 3 on page 3, were to invest 100% of their money in these options, however, growth of their retirement savings would likely be much lower than a portfolio with a more diversified asset class mix, potentially creating a significant account-balance shortfall. EXHIBIT 2: DC PARTICIPANTS FACE DIFFERENT MAGNITUDES OF OVER TIME 100 Longest time horizon until retirement (Up to age 40) The middle years (Ages 40 65) At and in retirement (Ages 65 and older) Percentage of portfolio allocation ACCUMULATION PARTICIPANT USER MARKET PARTICIPANT USER INTEREST RATE INFLATION MARKET ACCUMULATION MARKET INFLATION INTEREST RATE LONGEVITY Age Source: J.P. Morgan Asset Management. For illustrative purposes only. 2 Managing risk in DC plan lineups: The new alpha?

3 EXHIBIT 3: PARTICIPANT SCENARIO 1: 25-TO-35-YEAR-OLD AGE COHORT Return Conservative Options Fixed Income Target Date Funds * Equities Brokerage Stable Value Core Bond/Barc Agg Income Fund Large Cap Growth Self-directed Money Market Short-term Bond 2015 Fund Large Cap Value 2020 Fund Large Cap Core 2025 Fund Mid Cap Growth 2030 Fund Mid Cap Value 2035 Fund Mid Cap Core 2040 Fund Small Cap Growth 2045 Fund Small Cap Value 2050 Fund Small Cap Core 2055 Fund International Equity 2060 Fund Low Moderate Higher Highest Risk Less likely Less likely Most likely More likely Least likely * Volatility level and outcome are contingent upon how much risk a particular target date fund manager is taking. ** Outcome probability is defined as the probability of participants in the specified age cohort achieving a desired retirement outcome. This assumes that participants invest 100% of their assets in the specified investment option. The chart above is shown for illustrative purposes only. OUTCOME PROBABILITY** In the most conservative investment option, it s likely that participants savings will not grow at an appropriate level, an opportunity cost that could put them in danger of not saving enough to meet their retirement goals. Looking at the traditional core menu, with fixed income, equity and brokerage options, there s a broad range of risk represented, from moderate to high risk. Depending on the participant s level of skill and engagement, he or she might do relatively well or have substandard results with these options. When you consider the potential outcomes of investing 100% of a participant s retirement money in one investment option, we believe that professionally managed, diversified options such as target date funds are one of the best options for younger investors (those with a 40-to-50-year investment time horizon), given the funds potential for diversification and growth over time. Of course, even among target date managers, relative risk levels can differ significantly. For older workers in the 55-to-65-year-old age cohort, as shown in Exhibit 4 on page 4, the risk of having 100% of their funds invested conservatively is not as large; however, they may be more susceptible to market conditions, given their shorter time horizons to retirement. An aggressive weighting in equities, whether in a traditional core menu or brokerage option, could have an extremely negative impact on retirement savings and income if the asset class declines sharply. Like younger plan participants, older workers also may benefit greatly from professionally managed, diversified options such as target date funds. Taking a broader view of risk Considering the many different risks participants are exposed to and the inability of many participants to manage these risks effectively, we believe that options in a DC plan s investment menu should be evaluated not based on their risk/return profiles alone but on the potential outcomes that might result should a participant invest 100% of his or her assets in any J.P. Morgan Asset Management 3

4 Managing risk in DC plan lineups EXHIBIT 4: PARTICIPANT SCENARIO 2: 55-TO-65-YEAR-OLD AGE COHORT Return Conservative Options Fixed Income Target Date Funds * Equities Brokerage Stable Value Core Bond/Barc Agg Income Fund Large Cap Growth Self-directed Money Market Short-term Bond 2015 Fund Large Cap Value 2020 Fund Large Cap Core 2025 Fund Mid Cap Growth 2030 Fund Mid Cap Value 2035 Fund Mid Cap Core 2040 Fund Small Cap Growth 2045 Fund Small Cap Value 2050 Fund Small Cap Core 2055 Fund International Equity 2060 Fund Low Moderate Higher Highest Risk More likely Less likely Most likely Less likely Least likely * Volatility level and outcome are contingent upon how much risk a particular target date fund manager is taking. ** Outcome probability is defined as the probability of participants in the specified age cohort achieving a desired retirement outcome. This assumes that participants invest 100% of their assets in the specified investment option. The chart above is shown for illustrative purposes only. OUTCOME PROBABILITY** one option. 1 This new way of thinking about risk has major implications for the way DC investment menus should be designed and evaluated. If investment menu options are evaluated based on potential outcomes, then we believe target date funds should be considered relatively low risk, compared with other options in the plan, because of the portfolio manager s ability to manage the many different types of risk that DC participants must contend with as they strive to reach their long-term retirement goals. Target date funds have a built-in ability to manage asset allocation along their glide paths based on how their managers prioritize different market-related risks, such as inflation, rising interest rates, asset class, and changing market conditions. As diversified, professionally managed solutions, they also reduce the potential for participant user risk. The target date fund advantage We believe that target date funds provide a real advantage to DC plan participants over the do-it-yourself approach required for investing in either a core menu of funds or brokerage option. Exhibit 5 on page 5 shows how participants in target date funds have fared relative to participants in other DC menu investment strategies. Looking at standardized fiveyear personal rates of return, target date fund users had the best performance, on average. Target date funds can provide the professional management of a glide path, broad diversification across asset classes and active asset allocation, all key components for delivering strong riskadjusted return. We believe these attributes make them one of the best investment menu options for all age cohorts and throughout a plan participant s entire savings and investment cycle. Once again, relative risk levels can differ significantly among target date funds. 1 DC plan participants may be exposed to a broad range of risks, including but not limited to market risk, participant user risk, inflation risk, interest rate risk and longevity risk. 4 Managing risk in DC plan lineups: The new alpha?

5 EXHIBIT 5: STANDARDIZED FIVE-YEAR RETURNS: HIGHS, LOWS AND AVERAGES BY INVESTMENT STRATEGY Rate of return (%) -8 Target date fund users Do-ityourselfers Managed accounts users Brokerage users Source: J.P. Morgan Retirement Plan Services proprietary research. Analysis measurement period is December 31, 2007, through December 31, The above data represents a sampling of participant data. It does not represent the returns of any individual product or portfolio. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular manner. Rate of return for the measurement period is aggregated by investment strategy. Historical rate of return is not a guarantee of and may not be indicative of future results. Returns are standardized using the Interquartile Methodology. Source: J.P. Morgan Asset Management. See Important Disclosures for Personal Rate of Return Methodology for additional information. Selecting and evaluating target date funds Different managers may have vastly different philosophies for how they structure glide paths, implement asset allocation and select underlying managers. With such a wide range of approaches to risk management in target date funds, it is critical that plan sponsors and advisors understand how the managers they are using approach and manage risk within their solutions. Some key considerations are: What is the target date manager s approach to managing risk and what is the process for managing it within the glide path? What is the extent of the manager s ability to diversify fixed income exposure along the glide path? Are underlying strategies actively managed or do they provide passive-only exposure? Does the manager have expertise in managing lowercorrelated, extended asset classes, such as high-yield and emerging markets debt? The role of asset allocation in risk management Strategic and tactical asset allocation can also have a positive impact on investment outcomes for managers that maintain both strict risk controls along the glide path and institutionalcaliber diversification. We believe that a combination of quantitative and qualitative inputs that incorporates sec ular and structural trends over a multi-year time horizon, as well as the flexibility to react to changing market conditions, is an essential component for managing risk. Target date managers that successfully build these components into their investment process may be able to balance return and along the glide path while delivering incremental alpha. Exhibit 6 illustrates the role of strategic and tactical asset allocation strategies in an active management process. Risk management best practices J.P. Morgan Asset Management is dedicated to helping DC plan participants reach their retirement goals. We believe target date funds should be the foundation on which DC investment menus are built. Their unique combination of characteristics professional management, diversification, glide path construction and active asset allocation enable them to effectively manage the many risks participants must contend with when investing for retirement. EXHIBIT 6: FRAMEWORK FOR A DISCIPLINED, ACTIVE-MANAGEMENT PROCESS 1. Strategic Allocation Strategic Allocation Asset Glide Path 2. Manager Selection Select underlying managers Ongoing due diligence 3. Portfolio Construction & Implementation Determine optimal allocations within portfolios Tactical Asset Allocation Source: J.P. Morgan Asset Management. Shown for illustrative purposes only. J.P. Morgan Asset Management 5

6 Managing risk in DC plan lineups Please contact For more information about specific J.P. Morgan defined contribution solutions and services, including our broad range of investment solutions, retirement thought leadership, tools and insights, please contact your J.P. Morgan representative. 6 Managing risk in DC plan lineups: The new alpha?

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8 Managing risk in DC plan lineups Opinions, estimates, forecasts and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable. These views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results. IMPORTANT DISCLOSURES FOR PERSONAL RATE OF RETURN METHODOLOGY. Rate of return is calculated for active participants by an investment strategy using the Modified Dietz method and is based upon between the highest rate of return and the lowest rate of return associated with each investment strategy among such participants. Services associated with the identified investment strategies were available as of the last day of the measurement period, but may not have been available throughout the measurement period. Target date fund users are participants with at least 70% of their account balance invested in target date funds as of the first and last day of the measurement period. Do-it-yourselfers are participants with less than 70% of their account balance invested in target date funds as of the first and last day of the measurement period and also include participants using online advice services, if applicable. Managed account users are participants with at least 70% of their account balance managed by a discretionary investment service as of the first and last day of the measurement period. Brokerage users are participants with at least $1 in a brokerage account as of the last day of the measurement period. TARGET DATE FUNDS. Target date funds are funds with the target date being the approximate date when investors plan to start withdrawing their money. Generally, the asset allocation of each fund will change on an annual basis, with the asset allocation becoming more conservative as the fund nears the target retirement date. The principal value of the fund(s) is not guaranteed at any time, including at the target date. IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties. JPMorgan Distribution Services, Inc. is a member of FINRA/SIPC. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. JPMorgan Chase & Co. October 2013 PERSPECTIVES_Managing risk in DC plan lineups: The new alpha? RET-DCIP- NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE jpmorganfunds.com/retirement