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Taking Target‐Date Fund Evaluation to the Next Level

Lori LucasDefined Contribution Practice Leader Callan Associates Chicago, Illinois

4B-1

Agenda

●Target Date Fund Prevalence

●Changing Target Date Fund Landscape

●Evaluating Target Date Funds

●Custom Target Date Funds

4B-2

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

Target Date Fund Prevalence

●Slightly fewer plan sponsors intend to offer their recordkeeper’sproprietary target date or target risk fund in 2014.

●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

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

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

Equity Allocations Have Changed

0

10

20

30

40

50

60

70

80

90

100

Average Equity Rolldown: Then and Now

2014 Pure Equity 2014 Growth Equity 2009 Pure Equity 2009 Growth Equity

% in

Equ

ity

Participant Age

Note: Growth equity includes emerging market debt, high yield bond, hedge funds, REITS, commodities, and leveraged bank loans.

4B-7

Risk-Taking: Then and Now

4B-8

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

Diversification and Use of Alternatives

Asset Class2014

PrevalenceTreasury 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

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 11.0 10.8 10.9

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

Target Date Fund Selection

● More than one-third of plan sponsors report that they intend to make a target date fund change in 2014.

● 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.

What are the most important criteria for selecting or retaining target date retirement funds?

Source: 2014 Callan DC Trends Survey

4B-12

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

Standard Performance Evaluation

Information overload, and doesn’t create a complete picture.

4B-14

Creating a Snapshot that Leads to Decision-Making

Aggregate View

0%

5%

10%

15%

20%

25%

Last Quarter Last Year Last 2 Years Last 3 Years Last 5 Years

(58)(85)

(81)(8)

(74)(26)

(77)(36)

(81)(40)

10th Percentile 9.24 4.68 9.14 19.06 3.6825th Percentile 8.96 4.34 8.88 18.66 3.38

Median 8.22 3.67 8.12 17.42 2.5775th Percentile 7.85 2.50 7.50 16.93 2.0590th Percentile 7.18 1.17 6.63 16.40 1.18

Manager X 8.12 2.21 7.55 16.89 1.98

CAI ConsensusGlidepath 7.40 4.70 8.83 18.07 2.92

Target Date Family Performance vs. Peer Families (Cheapest Net)

4B-15

16

Delving Deeper into Target Date Returns

3 Year Annualized Returns

Manager X Callan Consensus

Callan PeerGroup

Glidepath Return 17.8% 18.1% 16.5%

Implementation Return

(0.9%) N/A 0.9%

Total Return 16.9% 18.1% 17.4%

Total Return = Glidepath Return + Implementation Return

4B-16

Understanding the Glidepath

Equity Rolldown and Macro Level Analysis

4B-17

Understanding the GlidepathRelative Allocations

Relative Macro Asset Allocation - Manager X vs. CAI Consensus Glidepath

% R

elat

ive

Wei

ghts

-10%

-5%

0%

5%

10%

15%

20%

40 30 20 10 0Retirement

-10 -20Years Until Retirement

Domestic Broad EqIntl EquityReal EstateDomestic FixedIntl Fixed-IncCash EquivOther Alternatives

4B-18

Plan Characteristics Glide Path Risk Level

Retirement age Low High

Contribution rate Low High

Outside assets Low High

Retiree health care Low High

Risk aversion Low High

Plan sponsor paternalism Low High

Existing defined benefit plan Low High

Emphasis on accumulation Low High

Moderate

Moderate

Moderate

Moderate

Moderate

Moderate

Moderate

Moderate

Getting the Glidepath RightChoosing the Appropriate Glide Path—Plan Characteristics and Glide Path Risk

4B-19

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

The Analysis: Income Replacement Potential

48 37 9 40

0%

20%

40%

60%

80%

100%

120%

140%

Age 65

Manager A Manager B Manager CCallan

Consensus10th Percentile 133.1 96.4 64.5 101.025th Percentile 93.9 73.5 54.6 77.1

Expected Case (50th) 63.5 56.1 44.9 57.5Unfavorable 95th

Percentile 27.2 29.4 28.7 28.699th Percentile 20.4 24.1 24.5 23.2

Using Monte Carlo Simulation, We Project Shortfall Risk at Retirement

Source: Callan TDVantage. Assumes retirement at age 65 and a target income replacement ratio of 65% and excludes Social Security.

Target 65%

Annuitized Income Replacement Ratio (%)

4B-21

What About Risk?

0%2%4%6%8%

10%12%14%16%

Later Savings (age 50-65)

Manager A Manager B Manager CCallan

Consensus1st Percentile 16.5 13.1 9.7 13.25th Percentile 14.9 11.9 8.4 12.1

Median 10.9 9.0 6.0 9.175th Percentile 9.7 7.9 5.2 8.090th Percentile 8.4 6.9 4.5 7.0

Source: Callan TDVantage

Dollar Weighted Risk (%)

Callan Projects the Range of Weighted Standard Deviations at Pre-Retirement

4B-22

Downside RiskAnother View of Risk is Worst-Case Single Year Return Near Retirement

Source: Callan TDVantage

Manager A Manager B Manager CCallan

Consensus

75th Percentile -0.58 0.64 1.85 0.25

90th Percentile -7.82 -5.29 -1.15 -5.47

95th Percentile -13.09 -9.33 -3.07 -9.75

99th Percentile -20.63 -15.52 -7.25 -15.87

0%

5%

10%

15%

20%

25%

30%

Age 55-25%

5%

0%

-5%

-10%

-15%

-20%

“Worst-Case” Single Year Return (%)

4B-23

Inflation RiskRetirees 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

Longevity RiskIt is also Important to Consider the Risk of Running out of Money During Retirement

Source: Callan TDVantage

Spending Longevity Risk (65% Income Replacement)

% P

roba

bilit

y of

Spe

ndin

g U

ntil

Vario

us A

ges

Age

0% 0%

10% 10%

20% 20%30% 30%40% 40%

50% 50%

60% 60%

70% 70%

80% 80%

90% 90%

75 80 85 90 95 100 105

Manager A Manager B Manager C Callan Consensus

4B-25

Putting It All Together

Shortfall Risk

Volatility/Downside

RiskInflation

RiskLongevity

Risk

Manager A Low High Low Low

Manager B Moderate Moderate High Moderate

Manager C High Low Moderate High

HighModerate

Low

A simple table highlighting different risks allows investment committees to come to decisions.

4B-26

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 set-up.

●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

Case Study: Midwestern Corporation vs. Global Corporation

●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.

How Plan Sponsors Decide to Go Custom: Midwestern Corp

4B-28

Case Study: Midwestern Corporation vs. 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.

Global Corporation

4B-29

Two Different Paths to Retirement Income Adequacy

●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.

RIR Analysis Leads to Two Different Conclusions

4B-30

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