Off balance. The unintended consequences of prioritizing one risk in target date fund design RETIREMENT INSIGHTS
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- Godwin Leonard
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1 FOR INSTITUTIONAL USE ONLY NOT FOR PUBLIC DISTRIBUTION RETIREMENT INSIGHTS Off balance The unintended consequences of prioritizing one risk in target date fund design
2 ABOUT MULTI-ASSET SOLUTIONS FROM J.P. MORGAN J.P. Morgan Global Investment Management Solutions oversees more than $162 billion in multi-asset solutions worldwide. 1 The Solutions team leverages its specialized asset allocation expertise, together with the vast resources of J.P. Morgan Asset Management and its partners and affiliates, to provide customized solutions across asset classes for institutions, third-party intermediaries and individuals. The team blends its experience in capital markets investing, strategic and tactical asset allocation, portfolio construction and risk management with one of the industry s broadest product offerings to develop and implement optimal portfolio solutions for a wide range of client needs. 1 As of December 31, 2014.
3 TABLE OF CONTENTS 2 FOREWORD THE MULTIFACETED S OF DC INVESTING TARGET DATE FUNDS: SOLVING FOR PARTICIPANT EXPERIENCED S CASE STUDIES: NARROWED VS. DYNAMIC MANAGEMENT ANALYSIS 1: LONGEVITY ANALYSIS 2: MARKET AND EVENT ANALYSIS 3: INFLATION ANALYSIS 4: INTEREST RATE A STRONGER BALANCE 21 CONCLUSION 22 METHODOLOGY
4 FOREWORD WHAT ARE THE BIGGEST S TO PARTICIPANTS RETIREMENT SECURITY? This is one of the most challenging questions plan sponsors and their advisors must address if they hope to position the largest number of participants for retirement funding success. Our most recent research focuses on analyzing the risks inherent in the defined contribution (DC) model. In an effort to help understand and effectively manage each of these risks in plan and investment design, we undertook this research to provide a more comprehensive view of the challenges that may potentially deteriorate participant investing experiences. We were especially interested in evaluating the various risk management approaches utilized by different target date funds, given the broad and rapidly growing adoption of these strategies in 401(k)s and other self-funded, employer-sponsored retirement plans. Today, these professionally managed multi-asset-class portfolios capture approximately 38% of 401(k) contributions, a figure projected to climb to 88% by We continue to believe that target date funds are the most prudent investment choice for the vast majority of participants. However, we believe it is equally important to understand how differences in glide path design may enhance or detract from expected retirement outcomes. This is particularly true in how the strategy handles risk management in its portfolio allocation and construction choices. Given the broad number of factors that go into securing retirement funding success, assessing a glide path s risks entails more than evaluating standard deviations and downside volatility alone. Instead, our analysis examines how different glide paths allocate risk capital and quantifies how these decisions may affect risk/reward trade-offs that could significantly shape participant outcomes. Our research has found: DC risk is dynamic and multifaceted. Participants face an array of DC risks, some of which they can control with a high level of certainty, such as accumulation risk, participant-user risk and withdrawal risk. Other risks are driven more by what participants may experience, where the only degree of control they might have is through their saving and asset allocation choices. These include market and event risk, longevity risk, inflation risk and interest rate risk. The magnitude of each risk can also change over time and in response to different market climates, underscoring the importance of taking a broad risk perspective in target date fund design. Target date funds that emphasize one particular risk over others can introduce unintended participant experiences. Optimizing a portfolio with multiple asset classes is a delicate balance. Constructing a portfolio that focuses primarily on mitigating one risk may over-expose participants to other potential pitfalls. Our research found several areas of concern with target date funds that prioritized a specific risk in their fund design. 2 The Cerulli Report, Retirement Markets 2014, Sizing Opportunities in Private and Public Retirement Plans. 2 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
5 Dynamic risk management offers the potential for steadier performance results through a broader range of investment climates. Some target date funds claim to manage longevity risk better, while others claim to manage market risk or inflation risk better. Still other target date managers focus on the risk of fee erosion in isolation of other potential additive outcome considerations. The truth is that optimizing participant experiences requires all of these risks and others to be closely reviewed and managed through a dynamic risk management approach that is better equipped to more effectively weather all of the potential rigors of retirement investing. The key is to consistently perform relatively well through the widest range of investment climates. This should help deliver the most successful outcomes over the long-term. J.P. Morgan SmartRetirement strategies were specifically created to take a more realistic, all-encompassing approach to managing the multifaceted nature of DC risk. We developed our glide path based on extensive experience managing multi-assetclass portfolios for some of the world s largest, most respected institutions, including numerous public and private retirement plans. We further refined our portfolio design using detailed insights into real-world participant behaviors. The findings of our current research highlight a single conclusion: Dynamically managing risk across all stages of the glide path can enhance protection against the one risk that truly matters whether participants will be able to afford to retire. For more information on evaluating how risk can shape potential retirement outcomes, or about target date fund research, please contact your J.P. Morgan Asset Management representative. Sincerely, Daniel Oldroyd, CFA, CAIA Managing Director Lynn Avitabile Managing Director Katherine Santiago, CFA Executive Director Christie Wootton Associate J.P. MORGAN ASSET MANAGEMENT 3
6 The multifaceted risks of DC investing The DC industry has experienced a great deal of innovation over the past 10 years as plan sponsors, their advisors, regulators, investment managers and other service providers have continually looked for new and effective ways to help position participants for self-funded retirement success. Many of the resulting solutions have revolved around helping participants either avoid or better manage the potential pitfalls that could lower the odds that they will be able to retire with an adequate level of retirement assets. The challenge of putting participants many of whom may be new to investing on a safe retirement savings path is a complicated one, given the multifaceted nature of risk in a DC investment program. As illustrated in EXHIBITS 1 and 2 (next page), risks fall into two general categories: participant-controlled risks and participant-experienced risks. Participant-controlled risks cover areas that hinge on participant behavior. These include accumulation risk, participant-user risk and withdrawal risk. These types of risks are usually the largest determinants of whether participants will secure safe retirement funding, since even the most innovative DC programs still require participants to save enough and invest appropriately. While plan sponsors cannot completely control participant decisions around how much to contribute, how to invest those assets and when to make EXHIBIT 1: SOME S ARE BEST ADDRESSED THROUGH PLAN DESIGN Possibility that the participant misuses investment options (e.g., too conservative or aggressive, under-diversified) PARTICIPANT- USER Participantcontrolled risks ACCUMULATION Failure to save enough to retire Risk of needing to withdraw funds prior to retirement WITHDRAWAL Source: J.P. Morgan Asset Management. For illustrative purposes only. 4 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
7 THE MULTIFACETED S OF DC INVESTING withdrawals, smart plan design can help facilitate constructive behaviors through strategies such as automatic enrollment, contribution matching, automatic contribution escalation and plan re-enrollment. In contrast, participant-experienced risks are caused by factors that are largely out of the participants control. These include longevity risk, market risk, event risk, inflation risk and interest rate risk. These types of risks are usually best addressed through participants asset allocation choices and a plan s target date fund. Over the course of any individual participant s working years, all of these risks may be experienced to some degree. While it is true that not all will encounter a 2008 market drawdown, hyperinflation or rapidly rising interest rates, an effective asset allocation framework must be structured to weather each of these scenarios reasonably well given the often surprising nature of investing. No one really knows what the future holds, either in terms of how long any individual might live or what the performance of markets will be, especially short term. What is clear, however, is that participants are retiring all the time and are highly likely to be exposed to one of these risks right as they most need their assets. This highlights the necessity to extract the most prudent risk-adjusted performance potential from a glide path over the long-term, but equally important is the consistency of returns to help stabilize outcome security over shorter time horizons. Moreover, this emphasis on short-term risk becomes increasingly vital as retirement draws closer and participants prepare to access their investments. The evolving nature of risk Participant-controlled and participant-experienced risks can change over time, as can regulatory requirements and expectations for capital markets. Consequently, a target date fund s glide path requires ongoing monitoring to assess if it may also need to evolve in response to these changes. EXHIBIT 2: PARTICIPANT-EXPERIENCED S ARE BEST ADDRESSED THROUGH PLAN INVESTMENT LINEUP MARKET Risk of drawdown as one approaches retirement Risk of outliving savings LONGEVITY Participantexperienced risks EVENT Risk of severe loss due to a single extreme market event Risk that value of principal will be eroded by inflation INFLATION INTEREST RATE Risk that fixed income securities will lose value if rates rise Source: J.P. Morgan Asset Management. For illustrative purposes only. J.P. MORGAN ASSET MANAGEMENT 5
8 TARGET DATE FUNDS Solving for participant-experienced risks One of the most significant achievements in managing participant-experienced risks continues to be the introduction of target date funds. These professionally managed multi-asset-class portfolios vastly simplify the retirement investment process for a large and growing number of participants, many of whom have been defaulted into these strategies. For plan sponsors, however, selecting the most effective target date fund has become increasingly complex. There are more than 50 target date mutual fund series available in the market place, 3 and the managers of each can employ significant differences in asset allocation, portfolio construction and equity exposure at the point of retirement, all of which can have implications for a strategy s risk/reward characteristics and expected potential retirement outcomes. Plan sponsors must carefully evaluate the potential ramifications of these differences on participants retirement investing experiences. Fiduciary responsibilities around target date fund selection extend beyond comparing relatively short-term one-, three- and even five-year performance numbers. Saving for retirement can entail a lifetime of investing, and plan sponsors must consider how a specific target date fund design might respond to the many types of market cycle fluctuations that can occur across a 40-plus-year time horizon. For example, participants investing during strong, extended bull markets will have a much different experience than those investing during volatile or severe bear markets, but the reality is that participants may experience both on their paths to retirement. Participants retiring in periods of shorter-term market cycles may see their retirement balances significantly impacted. Remember, different glide paths can perform dramatically different year by year as investing conditions change. Further clouding this issue is the growing trend of some target date fund managers to differentiate their offerings by emphasizing a specific risk over others. For example, some prioritize longevity risk, while others stress market and event risk. All target date funds offer important diversification benefits, but skewing a glide path to focus more heavily on a particular risk may elevate risks in other key areas, which, in turn, can introduce unintended consequences that may result in greater uncertainty around retirement outcomes as market cycles change. Our research shows that this idea of balance is crucial in managing the diverse range of participantexperienced risks. We believe plan sponsors should carefully evaluate how a target date fund manager approaches this risk balance within the context of what the plan seeks to achieve. In our opinion, the most prudent goal of a target date fund is to deliver safe levels of retirement income to as many participants as possible as they enter retirement. Market, event, longevity, inflation and interest rate risk management are all important inputs for this goal, but they should be managed collectively through a dynamic risk management approach. This will help determine the target date fund design that performs consistently well against all of these areas collectively, rather than performing best in any one scenario at the risk of falling short in others. Our findings, presented in the sections that follow, illustrate that applying this more expansive view of risk management could help secure stronger outcomes across a broader range of market cycles. 3 Morningstar Direct; data as of December 31, OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
9 CASE STUDIES Narrowed vs. dynamic risk management In our past target date fund design research, we evaluated the effectiveness of different types of glide path strategies by employing the framework of J.P. Morgan Asset Management s Target Date Compass SM. This framework maps actual funds in the marketplace into one of four quadrants based on asset class diversification and equity exposure at the point of retirement. We applied similar evaluation parameters for our risk evaluation, but this time focused on how various popular glide paths approach managing participant-experienced risks and how this may affect outcome potentials, both positively and negatively. It is important to note that participant risks can change over time and across age cohorts, a fact that should be reflected in a more robust glide path design. For example, market and event risk is less of a threat in the early years but grows increasingly important as retirement approaches and participants have less time to regain any portfolio losses. The later years closer to retirement are also when the amount of assets in the retirement account should be at their highest. Interest rate risk and inflation risk increase as fixed income allocations rise in the later stages of the glide path and into retirement. Additionally, longevity risk is a factor as participants near retirement. Conversely, accumulation risk remains high in both the early and middle years. One of the most powerful things participants can do to ensure retirement funding success and to maximize the benefits of investment compounding is to start contributing as much as possible early on and to continue to do so steadily throughout their working years. Participant-user risk continues to remain high during the early and middle years, as asset allocations that are too conservative in the early years can mean participants are missing the substantial larger gain potential of higher risk/reward asset classes. Asset allocations that are too risky in the later stages, however, may fail to lock in these gains and may expose participants to downside losses just when they may need to begin making withdrawals. The magnitude of these risks can evolve as market cycles change. Interest rate risk, for example, has remained a relatively low practical investment concern for the past few decades but has recently started to weigh more heavily on general market expectations. J.P. MORGAN ASSET MANAGEMENT 7
10 CASE STUDIES: NARROWED VS. DYNAMIC MANAGEMENT With this in mind, we began to categorize different target date fund designs based on how their glide paths address various risks. Through our evaluation we found that some of the most popular target date fund managers tend to over emphasize one risk in their glide path design, with varying implications for exposure to others. We identified four general groups that had adapted their glide path design to focus more narrowly on a particular risk, as well as a fifth segment that applied a more dynamic, balanced approach to managing the full range of participant risks. Funds prioritizing longevity risk tend to maintain greater allocations to equities and other higher risk/reward asset classes in the years leading up to and through retirement, based on the belief that participants must maintain greater exposure to these potentially higher return investments to lower their risk of outliving retirement assets. The downside to this approach is that higher equity exposure increases portfolio vulnerability in other areas, such as market and event risk. Funds prioritizing market and event risk tend to maintain greater allocations to fixed income and other lower-risk asset classes throughout the glide path in order to protect against negative market events before retirement. The downside is that these funds are then more susceptible to accumulation risk, interest rate risk and longevity risk. Funds prioritizing inflation risk tend to maintain greater allocations to inflation-sensitive asset classes in an effort to fortify purchasing power and protect against high inflation and low-growth markets. This increases interest rate risk and longevity risk. Funds with concentrated, fee-sensitive glide paths use passively managed strategies to gain specific asset class exposure in portfolio construction rather than actively managed strategies, based on the belief that this offers a more efficient way to invest long-term. However, this means that portfolio managers are often more constrained in asset class choices, since some types of investments are difficult or costly to manage passively. We have included this analysis in the study because the resulting less diversified glide path allocation can increase market and event risk, longevity risk and inflation risk. Funds that manage risks dynamically, which includes J.P. Morgan SmartRetirement, pursue a more balanced approach, adjusting over time as various risks rise and fall in magnitude across the glide path. These strategies tend to provide broader asset class diversification, with greater exposure to extended and alternative assets. They also maintain tighter risk controls, particularly in the years leading up to retirement, through a sharp reduction in equity exposure. EXHIBIT 3 (next page) summarizes how these various approaches to risk translate into glide path designs, highlighting key differences in asset class allocations based on representative funds in each category. Our evaluations of how each might be expected to perform in various investment climates against different, individual risk metrics, as well as the overall effectiveness of each, are presented in the sections that follow. The potentially destructive interaction of risk Our Ready! Fire! Aim? research highlights that a significant driver of DC success is how the size and timing of cash inflows and outflows interact with the size and timing of portfolio returns. We began analyzing real-world participant usage of 401(k) plans in 2005 and have now gathered a decade of behavioral findings through vastly different market cycles. This research consistently shows that saving and withdrawal patterns are much more varied and volatile than most typical DC models incorporate. This volatility in participant-controlled cash flows, particularly in terms of accumulation and withdrawal risks, can amplify the volatility a participant experiences. Plan sponsors can help mitigate this potentially negative magnifying effect by introducing strategies that reduce volatility in both participant-controlled and participant-experienced risks. 8 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
11 CASE STUDIES: NARROWED VS. DYNAMIC MANAGEMENT Comparing glide paths and their focus on risk U.S. Large Cap U.S. Small/Mid Cap EAFE Emerging Markets Equity Global Natural Resources REITs Commodities Direct Real Estate Emerging Markets Debt High Yield Core Fixed Income International Fixed Income TIPS Cash Alternatives EXHIBIT 3A: FUND THAT PRIORITIZES LONGEVITY 100 3B: FUND THAT PRIORITIZES MARKET AND EVENT 100 % of portfolio allocation MARKET AND EVENT LONGEVITY INFLATION % of portfolio allocation MARKET AND EVENT LONGEVITY INFLATION Age EXHIBIT 3C: FUND THAT PRIORITIZES INFLATION Age 3D: FUND THAT PRIORITIZES LOW FEES % of portfolio allocation INFLATION LONGEVITY MARKET AND EVENT Age % of portfolio allocation U.S. EQUITY FEES Age EXHIBIT 3E: FUND THAT MANAGES DYNAMICALLY: JPMORGAN SMARTRETIREMENT 100 Early years: High allocation to diversified risk assets allows for higher growth potential Middle years: As participant cash flow volatility increases, portfolios de-risk quickly, adding allocations to diversified fixed income asset classes to combat rate risk At and in retirement: Portfolio seeks to preserve participant balances and purchasing power reaching most conservative asset allocations and adding inflation-sensitive asset classes % of portfolio allocation MARKET AND EVENT MARKET AND EVENT INTEREST RATE LONGEVITY MARKET AND EVENT INTEREST RATE LONGEVITY INFLATION Age Source: J.P. Morgan Asset Management; data for Exhibits 3A 3D as of September 20, 2014; data for Exhibit 3E as of December 31, For illustrative purposes only. J.P. MORGAN ASSET MANAGEMENT 9
12 ANALYSIS 1 Longevity risk Longevity risk refers to the very real concern that retirees might outlive their assets. Declining mortality rates and rapidly rising health care costs are creating even more pressure in this area. Average American life expectancies continue to expand, and many participants can anticipate spending 25 years or more in retirement. Adequately maintaining living standards over these lengthening time horizons requires higher retirement funding levels. There are two ways participants can address this: First, they can increase the amount they save for retirement to levels that ensure they do not run out of money once they start to make withdrawals. Second, they can increase exposure to higher risk/reward assets in the hopes of securing greater investment gains that grow assets more aggressively. Although, investing more aggressively strictly to compensate for a savings shortfall is never a good idea given the considerable risks of possibly losing value in the few assets that may be contributed. Still, most participants are not saving enough for retirement and will need to maintain a larger allocation to higher risk/reward assets to help manage longevity risk. The question is, of course, how much risk is appropriate? Target date funds that prioritize longevity risk in their glide path designs usually maintain significantly greater allocations to equities and other higher risk/reward assets in the years leading up to and through retirement. Unfortunately, this can also lead to greater market and event risk when participants may be least able to afford any portfolio losses. To help quantify this potential trade-off, we analyzed how each of the five glide path designs might perform once participants began to pull assets out of their accounts post-retirement. 4 Simulating a range of market environments and a constant annual 6.5% withdrawal rate, we projected median outcomes of when account assets should be depleted. While higher than what might be expected, this 6.5% rate reflects the withdrawal amount necessary to provide 40% of pre-retirement salary to keep pace with inflation. As shown in EXHIBIT 4 (next page), the fund that prioritized longevity risk had an account balance that lasted the longest, until participant age 97.5, but this was not materially better than the other glide path designs. The fund that prioritized market and event risk predictably ran out of funds earliest, at participant age 93, given its substantially lower exposure to higher risk/reward assets. But the range tightened considerably for the other designs: The fund with a concentrated, fee-sensitive glide path lasted until participant age 95. The fund that prioritized inflation risk lasted until participant age 96. J.P. Morgan SmartRetirement lasted until participant age 97, only 6 months short of the fund that prioritized longevity risk. 4 Our simulation grows assets with inflation. 10 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
13 ANALYSIS 1: LONGEVITY How long will retirement assets last... EXHIBIT 4A:... FOR THE AVERAGE PARTICIPANT? MEDIAN OUTCOMES 4B:... FOR THOSE WITH THE SMALLEST ACCOUNT BALANCES AT RETIREMENT? 95TH PERCENTILE $1,600,000 $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,000 Median account balance$1,400,000 $0 SmartRetirement Longevity Concentrated Market and event Inflation th percentile account balance $1,400,000 $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,00 $0 SmartRetirement Longevity Concentrated Market and event Inflation The modest, potential 6-month increase in retirement income from the fund that prioritized longevity risk does not seem worth the significantly higher exposure to both market and event risk, compared with J.P. Morgan SmartRetirement s more effective balance of market and event risk and longevity risk. Source: J.P. Morgan Asset Management; data as of September 30, For illustrative purposes only. This is because J.P. Morgan SmartRetirement maintained comparably higher risk/reward exposure at the point of retirement (only 14.2% less than the fund that prioritized longevity risk), but is much more diversified across asset classes, including an 18% smaller exposure to equities. This broader diversification helps to better manage overall expected volatility, should equity markets in particular become difficult. Moreover, these age differences became even more negligible for participants who fell into the bottom 95th percentile of outcomes. This is an important group to evaluate for plan sponsors concerned with providing retirement security for as many participants as possible, not just for those fortunate enough to enjoy strong markets or optimal saving behaviors. Considering the notable market drawdown exposure of the fund that prioritized longevity risk (presented in the next section: Market and event risk), this seems like a small potential reward at a sizable risk cost. Our Ready! Fire! Aim? research also shows that more than 90% of participants withdraw assets at or soon after retirement. Based on this behavior, it is clear that the vast majority of participants are using their 401(k) plans to get to, not through, retirement. With this in mind, why skew market and event risk unnecessarily higher with the argument of managing post-retirement longevity risk? Instead, focus on a glide path design that better balances longevity risk with market and event risk in an effort to deliver more consistent performance through the widest range of market climates, not just when equities are rising. This should help secure higher balances for a broader range of participants at the point of retirement, most of whom will withdraw their assets then anyway. In our opinion, adding less than 6 months in potential retirement income does not seem worth taking the substantial added market and event risk throughout the glide path. Risk scorecard Over emphasizing longevity risk by significantly increasing equity exposure in the years leading up to and through retirement... Reduces risk of asset depletion but... Increases market risk Increases event risk Increases inflation risk J.P. MORGAN ASSET MANAGEMENT 11
14 ANALYSIS 2 Market and event risk Market risk and event risk generally refer to declines in both equity markets and other higher risk assets that can negatively affect returns. These risks entail both frequency and magnitude of potential losses, encompassing general day-to-day volatility, as well as severe events that might drive markets sharply lower, such as the burst of the tech bubble in 2000 or the more recent credit crisis. Plan sponsors need only recall how different target date funds fared in 2008 and early 2009 to remember the impact portfolio design can have on this type of downside exposure. The average peak-to-trough performance across target date 2015 vintages during that period ranged from % to % for some of the riskiest target date designs. 5 Target date fund glide paths typically begin with a majority of holdings in higher risk/reward assets that become increasingly conservative as participants move toward their final target allocation. The timing and steepness of this trajectory can vary significantly, however. The fund that prioritizes market and event risk begins this glide path descent very early and ends at a much lower level of higher risk/reward assets, with 56% of its portfolio in conservative holdings at the point of retirement, almost all represented by core fixed income. Compare that with the 49.2%, 36.5% and 41.8% of conservative holdings at the point of retirement for the funds that prioritize inflation risk and longevity risk, as well as those with concentrated, fee-sensitive glide path, respectively, as well as the 48% for the dynamic, risk-focused J.P. Morgan SmartRetirement. J.P. Morgan SmartRetirement is generally more diversified across cash, core fixed income, Treasury Inflation-Protected Securities (TIPS) and credit, although specific allocations can be markedly different across and even within different vintages. To evaluate how effectively each design protects against market and event risk, we examined how susceptible each was to potential portfolio losses in the years leading up to retirement. This is a critical period with heightened sensitivity to both market and event risk, since participants are getting ready to tap into their portfolios to solve their income needs in retirement and do not have significant time to recoup any potential losses. As shown in EXHIBIT 5 (next page) we first ran simulations projecting the frequency of any loss based on historical asset class returns. We then reviewed the expected probability of loss using J.P. Morgan s 2015 Long-Term Capital Market Return Assumptions. 5 Morningstar Direct; data as of December 31, OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
15 ANALYSIS 2: MARKET AND EVENT How likely is it the portfolio will suffer losses as participants approach retirement? EXHIBIT 5A: HISTORICAL FREQUENCY OF LOSS Frequency of occurance 14% SmartRetirement Longevity Concentrated 12% Market and event Inflation 10% 8% 6% 4% 2% 0% 1 year to retirement 3 years to retirement 5 years to retirement 5B: EXPECTED PROBABILITY OF LOSS Frequency of occurance 25% 20% 15% 10% 5% 0% SmartRetirement Longevity Concentrated Market and event Inflation 1 year to retirement 3 years to retirement 5 years to retirement There is a wide 16.3% to 24.0% probability range for potential loss in the year prior to retirement, with funds that prioritized longevity risk and with concentrated, fee-sensitive glide paths being most susceptible to declines. Source: J.P. Morgan Asset Management; data as of September 30, For illustrative purposes only. Next, we focused on the worst-case magnitude of past losses, as well as the probability of varying degrees of a three-year decline in portfolio value based on our forward-looking market projections (EXHIBIT 6). The fund that prioritized market and event risk offered strong defensive characteristics across all of these simulations, as did the fund that prioritized inflation risk. This would be expected given the larger fixed-income allocations of each of these portfolios. The funds that prioritized longevity risk and those How large might these losses be? EXHIBIT 6A: WORST HISTORICAL RETURN PRECEDING RETIREMENT 5% 0% with concentrated, fee-sensitive glide paths were the most vulnerable to declines, both in frequency and magnitude, again as expected, based on their heavier reliance on outsized equity exposure and fewer diversifying asset classes, respectively. J.P. Morgan SmartRetirement placed firmly in the middle, notably it s because the strategy maintained a relatively larger allocation to higher risk/reward assets in an effort to enhance risk-adjusted performance, even as retirement approached. Its much broader asset class diversification, however, allowed the 6B: PROBABILITY OF A NEGATIVE 3-YEAR RETURN PRECEDING RETIREMENT >15% SmartRetirement Longevity Concentrated Market and event Inflation Annualized return -5% -10% -15% -20% -25% -30% SmartRetirement Longevity Concentrated Market and event Inflation 1 year to retirement 3 years to retirement 5 years to retirement Size of loss >10% >5% 0% 2% 4% 6% 8% Frequency of occurence Funds that prioritized longevity risk and with concentrated, fee-sensitive glide paths were three and four times more likely, respectively, to experience negative three-year returns immediately prior to retirement than was the fund that over emphasized market and event risk. Source: J.P. Morgan Asset Management; data as of September 30, For illustrative purposes only. J.P. MORGAN ASSET MANAGEMENT 13
16 ANALYSIS 2: MARKET AND EVENT design to reduce reliance on equity performance significantly in the years leading up to retirement, offering attractive downside protection but without overly constraining upside potential. This reiterates the importance of balancing risk in glide path design. Our Ready! Fire! Aim? research shows that target date funds that tightly control volatility can play a powerful role in positioning a greater number of participants for retirement funding success, but only if the design does not excessively restrict long-term return potential. More aggressive equity allocations may result in greater losses when participants are most sensitive to balance declines, but playing it too safe can leave them falling short in potential long-term retirement outcomes. exposure to higher risk/reward assets when markets are normalized. In addition, managing market and event risk exposure by sharply increasing conservative fixed-income allocations intensely elevates interest rate risk, as well as longevity risk if the emphasis is purely on core fixed income. History has also shown that all but the highest quality bonds tend to decline during periods of extreme market stress, making it unrealistic to base a long-term glide path around this possibility; the lost return opportunity costs are simply too great. That is why we believe the defensive attributes of broader diversification offer more prudent protection against market and event risk when it comes to pursuing optimized, long-term retirement outcomes. Hence, over emphasizing market and event risk in design results in far greater accumulation risk, as participants must save more to overcome the lost return potential of less Risk scorecard Over emphasizing market and event risk by sharply elevating core fixed-income allocations... Reduces frequency and magnitude of portfolio loss but... Increases accumulation risk Increases interest rate risk Increases longevity risk Are low-fee target date funds less risky? Some plan sponsors focus on passive, or indexed, target date funds because they think these typically lower-cost strategies are somehow less risky. The only components that can be indexed in a target date fund, however, are the underlying strategies used in portfolio construction. There is no such thing as an indexed glide path. All glide paths have been actively built by the manager, and each comes with unique risk/reward characteristics. Indeed, these low cost strategies may actually increase participant risk. In an effort to keep cost low, managers with a bias towards fee sensitivity may rely strictly on easily indexed asset classes to drive returns. The unintended consequence of this is their glide paths are usually less diversified. This has historically reduced longterm outcome potential and increased volatility exposure in areas such as market and event risk, and longevity risk. Low cost also usually means buy-and-hold, which eliminates any ability to implement tactical asset allocation shifts that may add return potential by taking advantage of opportunistic short-term market dislocations. 14 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
17 ANALYSIS 3 Inflation risk Managing a fund with an eye toward inflation involves protecting the purchasing power of retirement assets. Most target date funds have been successful in safeguarding against the erosive effects of inflation over the long-term by helping participants keep ahead of generally rising prices. The fund that prioritizes inflation risk places even greater weight on this goal, with its glide path emphasizing assets that have a direct relationship with inflation, such as TIPS, real estate and commodities. Of note is its particularly large allocation to TIPS more than 30% of its conservative holdings in the years leading up to retirement, when participants typically become more sensitive to higher inflation. To help assess the effectiveness of this approach, we first evaluated the frequency with which each glide path design delivered historical returns above inflation in the years preceding retirement. While there were moderate differences in success across shorter time frames, all produced positive real returns 100% of the time over 10-year periods, although the fund with a concentrated fee-sensitive glide path lagged somewhat (EXHIBIT 7, next page). We then reviewed how each design might be expected to perform specifically during inflationary environments. We simulated periods when inflation was rising and also when it was high and falling, both of which can be restrictive to investment performance. As shown in EXHIBIT 8 (next page), the fund that prioritized inflation risk delivered positive real returns slightly more frequently, with the fund that prioritized market and event risk and J.P. Morgan SmartRetirement following close behind. Interestingly, this modest outperformance was the result of securing stronger real returns when inflation was rising. When inflation was high and falling, J.P. Morgan SmartRetirement actually outperformed the fund that prioritized inflation risk, as did the fund that prioritized market and event risk. This is because the fund that prioritized inflation risk relies heavily on TIPS. TIPS tend to perform best when inflation is rising, but can lag when it is falling; these securities also tend to be more volatile than other traditional fixed-income assets. The net result was that the fund that prioritized inflation risk was highly effective at handling inflationary shocks, but less so across the entire cycle. Therefore, to address inflation risk and maintain purchasing power, we believe it is important to hold a diversified basket of inflationsensitive securities such as commodities, natural resources and real estate, in addition to TIPs. This broader approach may perform better in multiple inflationary environments, not just when inflation is rising. J.P. MORGAN ASSET MANAGEMENT 15
18 ANALYSIS 3: INFLATION Has the portfolio outpaced inflation? EXHIBIT 7: HISTORICAL RETURNS ABOVE INFLATION How will the portfolio perform in inflationary periods? EXHIBIT 8: FREQUENCY OF REAL RETURNS Frequency of real returns 100% 95% 90% 85% 80% 75% SmartRetirement Longevity Market and event Concentrated Inflation 10 year 5 year 3 year 1 year Years preceeding retirement Frequency of real returns 90% 85% 80% 75% 70% 65% 60% 55% 50% SmartRetirement Longevity Concentrated Market and event Inflation All inflation Rising inflation High and falling Inflation environment The fund with a concentrated fee-sensitive glide path fell behind inflation more frequently than the other funds in the years leading up to retirement. The fund that prioritized inflation risk actually under-performed other strategies when inflation was high and falling. Source: J.P. Morgan Asset Management; data as of September 30, For illustrative purposes only. Source: J.P. Morgan Asset Management; data as of September 30, For illustrative purposes only. Risk scorecard Over emphasizing inflation risk by mainly increasing TIPS exposure... Reduces risk when inflation is rising but... Less effective when inflation is high and falling Increases interest rate risk Increases longevity risk 16 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
19 ANALYSIS 4 Interest rate risk Interest rate risk refers to a portfolio s sensitivity to rising interest rates. Given the fixed-income exposure inherent across all glide paths, interest rate risk progressively grows as participants move closer toward retirement. After years of extremely low interest rates, many expect higher rates ahead as the Federal Reserve (Fed) unwinds its quantitative easing efforts. Similar to the risks discussed earlier, the key to managing this threat appears to be through broader diversification. To help quantify interest rate sensitivity, we examined how the five designs performed during the past nine Fed interest rate increases. Predictably, the funds that prioritized market and event risk and inflation risk fell the most in value due to their larger fixed-income holdings, while the fund that prioritized longevity risk was the only one to rise in value as a result of its lower fixed-income exposure. In the middle was the fund with a concentrated fee-sensitive glide path, as well as J.P. Morgan SmartRetirement, both of which limited losses relative to other glide paths by as much as 200 bps (EXHIBIT 9, next page). Next, we simulated how much each design might lose in value for every 1% rise in interest rates. Again, the funds that prioritized market and event risk and inflation risk would be expected to decline the most. J.P. Morgan SmartRetirement, the funds that prioritized longevity risk and the funds with a concentrated, feesensitive glide path were less vulnerable. All three funds delivered comparable results, falling only about half as much as the more sensitive designs. Keep in mind, however, that the funds that prioritized longevity risk and those with a concentrated feesensitive glide path both accomplished this mainly because of their larger allocations to equities and other higher risk/reward assets, which, in turn, increased their market and event risk exposure. In comparison, the J.P. Morgan SmartRetirement better managed both market and event risk and interest rate risk through broader diversification within higher risk/reward assets, as well as within fixed-income holdings that include asset classes less susceptible to climbing interest rates, such as emerging market debt and high yield bonds. J.P. MORGAN ASSET MANAGEMENT 17
20 ANALYSIS 4: INTEREST RATE What happens to performance if interest rates rise? EXHIBIT 9A: GLIDE PATH PERFORMANCE DURING EXHIBIT 9B: PERCENTAGE LOST WITH 1% RISE IN RATES RISING RATE ENVIRONMENTS SmartRetirement Longevity Concentrated Market and event Inflation 1% 1% Annualized real return 0% -1% -2% -3% -4% Annualized real return 0% -1% -2% -3% -4% -5% Historical return over past 9 rate hikes -5% Isolated loss with 100bps rise in interest rates Funds that prioritized market and event risk and inflation risk might lose more than double compared with other designs when interest rates rise. Source: J.P. Morgan Asset Management; data as of September 30, For illustrative purposes only. Risk scorecard Larger allocation to more concentrated domestic equities and other risk/reward assets can... Lower interest rate sensitivity but... Increase market risk Increase event risk Increase inflation risk 18 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
21 A stronger risk balance The key takeaway from this research is the intricate nature of risk management in target date fund design. Over emphasizing one risk may better address that particular risk, but it often elevates exposure to other risk areas when a more diverse set of circumstances is considered. This narrow risk focus may result in less optimal retirement outcomes over the many types of economic cycles that can occur over a lifetime of investing. The fact is that any type of target date fund is usually more effective for participants, when compared to the results most retail investors achieve when left on their own to allocate their assets. Still, our findings once again highlight that differences in glide path design can greatly affect the quality of outcomes that participants experience. As such, plan sponsors must consider the ramifications of the various approaches to target date fund design if they hope to help as many participants as possible reach adequate retirement saving levels. We created a risk ranking (EXHIBIT 10) to help summarize the relative ranking of each glide path s effectiveness based on simulations replicating each individual risk scenario. Viewed collectively, these results show that the overall asset allocation of the glide path can have more of an impact on participant outcomes than the underlying holdings making up the portfolio. EXHIBIT 10: RANKINGS BASED ON MARKET SIMULATIONS Market and event risk Longevity risk Inflation risk Interest rate risk Market & event Longevity Inflation Longevity Inflation SmartRetirement Concentrated SmartRetirement Inflation Market & event SmartRetirement SmartRetirement Concentrated Concentrated Longevity Market & event Longevity Market & event Concentrated Inflation A dynamic risk management approach appears to deliver more consistent, expected returns across changing market cycles by navigating all of these risks reasonably well, rather than excelling in one area to the detriment of another. Source: J.P. Morgan Asset Management. For illustrative purposes only. J.P. MORGAN ASSET MANAGEMENT 19
22 A STRONGER BALANCE J.P. Morgan SmartRetirement performed consistently well across each risk aspect by applying a dynamic approach to risk management, rather than prioritizing any one area that may skew negative results in another. The benefits of this balanced risk focus are more consistent, expected investment results through all market cycles. This is in stark contrast to the other four designs, which tended to offer attractive defensive characteristics in specific risk scenarios but performed dramatically worse in others. The extent of this variability is reflected in each design s position on the risk ranking. Given its stronger, comprehensive risk management approach, J.P. Morgan SmartRetirement appears to offer the most optimal risk/reward balance. EXHIBIT 11 shows the strategy s historical and forward-looking expected 10-year returns. In both cases, J.P. Morgan SmartRetirement delivered expected returns above or comparable to other target date strategies, but with less volatility. Using this design helps to keep participants assets working as hard as possible, but with substantially less overall risk across a fuller range of investment cycles. Historical and forward-looking expected risk/reward characteristics 11A: FORWARD-LOOKING GLIDE PATH PERFORMANCE 11B: 10-YEAR HISTORICAL GLIDE PATH PERFORMANCE 8% 8% SmartRetirement Annualized returns 7% 6% SmartRetirement Inflation Concentrated Market and event Longevity Annualized returns 7% 6% Market and event Inflation Concentrated Longevity 5% 8% 9% 10% 11% 12% 13% 14% Annualized volatility 5% 8% 9% 10% 11% 12% 13% 14% Annualized volatility Source: J.P. Morgan Asset Management; data as of September 30, For illustrative purposes only. Performance is an aggregate of all vintages in the series. For additional information on the research findings and performance methodology refer to Off Balance The unintended consequences of prioritizing one risk in target date design. For illustrative purposes only. Evaluating target date fund risk management J.P. Morgan s Selecting Target Date Funds: The RFP developed through independent legal research to Process can help plan sponsors evaluate the wide range help plan sponsors meet ERISA s prudent process of available target date fund designs. This sample requirement for target date fund selection. request-for-proposal structure includes questions 20 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE IN TARGET DATE FUND DESIGN
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