Taking Target Date Fund Evaluation to the Next Level

Transcription

1 Taking Target Date Fund Evaluation to the Next Level Lori Lucas Defined Contribution Practice Leader Callan Associates Chicago, Illinois The opinions expressed in this presentation are those of the speaker. The International Society and International Foundation disclaim responsibility for views expressed and statements made by the program speakers. 4B-1

2 Agenda Target Date Fund Prevalence Changing Target Date Fund Landscape Evaluating Target Date Funds Custom Target Date Funds 4B-2

3 Target Date Assets Becoming a Major Force in DC Plans 85% of DC plans offer target date funds When offered, target date funds represent more than a quarter of plan assets. Selection and evaluating target date funds is increasingly important and complex. Source: Callan DC Index 4B-3

4 Target Date Fund Prevalence Slightly fewer plan sponsors intend to offer their recordkeeper s proprietary target date or target risk fund in Most of the plans with custom target date or target risk funds had at least $500 million in assets. The most common reason for selecting custom funds was control over the glidepath. If you offer either a target date or target risk fund, which approach do you use? Source: 2014 Callan DC Trends Survey 4B-4

5 Target Date Fund Prevalence Indexed target date funds are now more prevalent than actively managed target date funds. More than 2/3 of plans offer target date funds with some indexing in the underlying fund allocation. Lower fees are a key reason plan sponsors favor indexing in target date funds. What investment approach does your target date fund use? Source: 2014 Callan DC Trends Survey 4B-5

6 Evolving Target Date Fund Landscape: Immediate Post- Crash Versus Today Slightly fewer providers: 41 today versus 43 in 2010 But more products: collective trusts and passively-implemented products A bit less concentrated: Top 3 managers have 73% market share versus 77% in 2010 Lower fees: average 69 bps today versus 77 in 2009 Lower equity allocation; greater overall diversification 4B-6

7 Equity Allocations Have Changed 100 Average Equity Rolldown: Then and Now % in Equity Participant Age 2014 Pure Equity 2014 Growth Equity 2009 Pure Equity 2009 Growth Equity Note: Growth equity includes emerging market debt, high yield bond, hedge funds, REITS, commodities, and leveraged bank loans. 4B-7

8 Risk-Taking: Then and Now 4B-8

9 Reversing Course? Most recently, several major target date fund managers have announced changes to their glidepaths: Last year, Fidelity announced changes to its methodology that resulted in equity exposure increasing across most of its target date portfolios. This year, BlackRock announced that its target date series will move to a higher equity allocation during the accumulation years, and modestly higher equity at landing point. 4B-9

10 Diversification and Use of Alternatives Asset Class 2014 Prevalence Treasury Inflation Protected Securities 67% High Yield Bond 47% Global REITs 47% Commodities (DJ) 47% International Fixed Income 42% Domestic REITs 28% Emerging Debt 21% Hedge Funds 14% Natural Resources Equity 12% Leveraged Bank Loans 7% Real Estate 5% International Fixed Income Hedged 2% 4B-10

11 Impact of Adding Alternatives Base Case With 5% in Hedge Funds With 5% in Direct Real Estate Income Replacement Ratio 66.7% 66.0% 66.4% $ Weighted Risk Fee Impact on 2050 Fund 0.51% 0.60% 0.54% Fee Impact on 2020 Fund 0.49% 0.53% 0.50% Assumes a glidepath that glides down linearly (large cap + small cap + international + emerging markets + core fixed income + TIPS). The alternatives allocations are taken equally from the other asset classes. 4B-11

12 Target Date Fund Selection More than one-third of plan sponsors report that they intend to make a target date fund change in What are the most important criteria for selecting or retaining target date retirement funds? The most common changes include replacing the target date fund or manager, changing the communication approach to the target date funds, and shifting to either all passive or a mix of active and passive target date funds. Source: 2014 Callan DC Trends Survey 4B-12

13 DOL Target Date Fund Tips In February 2013, the Department of Labor issued Target Date Retirement Funds Tips for ERISA Plan Fiduciaries. General guidance geared to assist plan fiduciaries in selecting and monitoring TDFs and other investment options in 401(k) and similar participant-directed individual account plans. Establish a process for comparing and selecting TDFs that involves consideration of how well the TDF s characteristics align with eligible employees ages and likely retirement as well as other characteristics of the participant population. Establish a process for the periodic review of selected TDFs at a minimum examining whether there have been any significant changes. Understand the fund s investments the allocation in different asset classes (stocks, bonds, cash), individual investments, and how these will change over time. Review the fund s fees and investment expenses. Inquire about whether a custom or non-proprietary target date fund would be a better fit for your plan. Develop effective employee communications. Take advantage of available sources of information to evaluate the TDF and recommendations you received regarding the TDF selection Document the process. 4B-13

14 Standard Performance Evaluation Information overload, and doesn t create a complete picture. 4B-14

15 Creating a Snapshot that Leads to Decision-Making Aggregate View 25% 20% 15% Target Date Family Performance vs. Peer Families (Cheapest Net) (36) (77) 10% 5% 0% (58) (26) (85) (74) (8) (81) (40) (81) Last Quarter Last Year Last 2 Years Last 3 Years Last 5 Years 10th Percentile th Percentile Median th Percentile th Percentile Manager X CAI Consensus Glidepath B-15

16 Delving Deeper into Target Date Returns 3 Year Annualized Returns Manager X Callan Consensus Callan Peer Group Glidepath Return 17.8% 18.1% 16.5% Implementation (0.9%) N/A 0.9% Return Total Return 16.9% 18.1% 17.4% Total Return = Glidepath Return + Implementation Return 16 4B-16

17 Understanding the Glidepath Equity Rolldown and Macro Level Analysis 4B-17

18 Understanding the Glidepath Relative Allocations Relative Macro Asset Allocation - Manager X vs. CAI Consensus Glidepath 20% % R e la tive W e ig hts 15% 10% 5% 0% -5% Domestic Broad Eq Intl Equity Real Estate Domestic Fixed Intl Fixed-Inc Cash Equiv Other Alternatives -10% Years Until Retirement Retirement B-18

19 Getting the Glidepath Right Choosing the Appropriate Glide Path Plan Characteristics and Glide Path Risk Plan Characteristics Glide Path Risk Level Moderate Retirement age Low High Moderate Contribution rate Low High Moderate Outside assets Low High Moderate Retiree health care Low High Moderate Risk aversion Low High Moderate Plan sponsor paternalism Low High Moderate Existing defined benefit plan Low High Moderate Emphasis on accumulation Low High 4B-19

20 A Better Way to Evaluate Target Date Funds: Retirement Income Adequacy To understand the potential outcomes of glidepaths, we will use Monte Carlo simulation and projects the retirement income replacement potential for target date fund glide paths (asset allocations) over various time periods. The following assumptions are used in Callan s Monte Carlo simulations: 1,000 scenarios Starting salary of participant: $25,000 at age 25 Annual salary growth rate: 3.5% Aggregate annual contribution rate (plan sponsor and participant): 12% Life-only annuity: A static 5.5% interest rate and a 2.75% cost of living adjustment (COLA). We compare the glide paths to the average or consensus target date glide path. We also examines the potential risk of each glide path. 4B-20

21 The Analysis: Income Replacement Potential Using Monte Carlo Simulation, We Project Shortfall Risk at Retirement Annuitized Income Replacement Ratio (%) Target 65% 140% 120% 100% 80% 60% 40% 20% 0% Age 65 Manager A Manager B Manager C Callan Consensus 10th Percentile th Percentile Expected Case (50th) Unfavorable 95th Percentile th Percentile Source: Callan TDVantage. Assumes retirement at age 65 and a target income replacement ratio of 65% and excludes Social Security. 4B-21

22 What About Risk? Callan Projects the Range of Weighted Standard Deviations at Pre-Retirement Dollar Weighted Risk (%) 16% 14% 12% 10% 8% 6% 4% 2% 0% Later Savings (age 50-65) Manager A Manager B Manager C Callan Consensus 1st Percentile th Percentile Median th Percentile th Percentile Source: Callan TDVantage 4B-22

23 Downside Risk Another View of Risk is Worst-Case Single Year Return Near Retirement Worst-Case Single Year Return (%) 5% 30% 0% 25% -5% 20% -10% 15% -15% 10% -20% 5% -25% 0% Age 55 Manager A Manager B Manager C Callan Consensus 75th Percentile th Percentile th Percentile th Percentile Source: Callan TDVantage 4B-23

24 Inflation Risk Retirees Worry About Their Assets Failing to Keep Up with Inflation Endpoint (Age) % of IP assets at age 65 % of IP assets at age 70 # of IP Assets Manager A 65 13% 13% 2 Manager B 95 0% 0% 0 Manager C 85 8% 8% 2 Source: Callan TDVantage 4B-24

25 Longevity Risk It is also Important to Consider the Risk of Running out of Money During Retirement Spending Longevity Risk (65% Income Replacement) % Probability of Spending Until Various Ages Manager A Manager B Manager C Callan Consensus 90% 90% 80% 80% 70% 70% 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% Age Source: Callan TDVantage 4B-25

26 Putting It All Together A simple table highlighting different risks allows investment committees to come to decisions. Shortfall Risk Volatility/ Downside Risk Inflation Risk Longevity Risk Manager A Low High Low Low Manager B Moderate Moderate High Moderate High Moderate Low Manager C High Low Moderate High 4B-26

27 Pros and Cons of Custom Target Date Funds Pros Allows plan sponsor to tailor the asset allocations to the participant population. Provides control over glidepath and underlying managers. Allows best-in-class investments to be used in the portfolios, and leverages due diligence efforts of core options. Can include non-core asset classes for improved diversification. Preserves pricing power of core funds. Mix may create significantly lower fee structure than an off-the-shelf product. Cons Considerable resources required for setup. Plans must have significant scale for custom target date funds. More moving pieces to consider, including trust & custody, rebalancing, fund fact sheets, etc. Administration can be challenging some recordkeepers have limited capabilities. No long-term performance history. May involve additional set-up costs. 4B-27

28 Case Study: Midwestern Corporation vs. Global Corporation How Plan Sponsors Decide to Go Custom: Midwestern Corp Private company, has grown significantly over the past several years. Majority of the employees will depend entirely on the 401(k) plan as their employer-sponsored retirement vehicle. For a variety of reasons, the company currently requires participants to withdraw their assets from the plan upon retirement. At the same time, the company feels a responsibility to provide adequate retirement income for employees and has historically provided a generous match as well as profit sharing contributions to the plan. Selecting the best set of target date funds was a high priority and Midwestern Corporation was willing to devote significant time to the effort. 4B-28

29 Case Study: Midwestern Corporation vs. Global Corporation Global Corporation Global Corporation is a public company that has grown significantly through acquisitions. Has historically offered both DB and DC plans. However, the DB plans are now closed. Global recognized that TDFs were becoming increasingly central to the retirement income adequacy of DC plan participants; investment committee decided to reevaluate the TDF option in their plan, which is their recordkeeper s off-the-shelf offering. 4B-29

30 Two Different Paths to Retirement Income Adequacy RIR Analysis Leads to Two Different Conclusions The analysis projected that Midwestern could attain its income replacement objective with a conservative glidepath that reduced equity exposure to 25% at retirement. A primary determinant of Midwestern achieving its objective with a conservative path was its generous profit-sharing contributions. Global found it was best suited to a glidepath that maintained an equity allocation of 50% at retirement. The differences in appropriate glide paths for Global and Midwestern translated into whether available off-the-shelf TDFs would meet plan needs. Global: several off-the-shelf products were similar to their optimal glidepath, and merited serious consideration. Midwestern: virtually all the available off-the-shelf glidepaths maintained higher equity allocations near and at retirement than their desired conservative path. The investment committee therefore leaned toward custom TDFs. 4B-30

31 Conclusions The stakes are higher than ever in evaluating target date funds Greater asset levels Greater complexity DOL Tips Fortunately, evaluation tools have improved Ability to view target date fund families in the aggregate Parse out glidepath ad implementation returns Understand the role of the glidepath Custom target date funds are growing in prevalence, but have their pros and cons. 4B-31