Part 4: evaluating target date fund design
The core of our research focused on the type of target date fund design most likely to position more participants for safer levels of retirement funding.
Ready! Fire! Aim? 2018
Our ongoing study of how real-life participant saving patterns interact with target date design continues to show that suboptimal participant behaviors and the consequent increase in cash flow volatility remain much more prevalent than many plan sponsors might expect. In a series of four articles, we discuss our findings and the steps plan sponsors can take to place participants on a path to a more secure retirement.
Getting more participants safely over the retirement finish line
The core of our research focused on the type of target date fund design most likely to position more participants for safer levels of retirement funding, given the wide range of real-world saving and investment behaviors.
Projected retirement outcomes: To put our own JPMorgan SmartRetirement® glide path to the test, we again projected retirement outcomes based on 10,000 portfolio simulations. We took the full assortment of identified participant behaviors in this year’s findings and applied them to a broad mix of market scenarios. This included all types of investment climates, from incredibly strong rallies to potentially devastating market losses, to help gauge how well our glide path design might weather the various conditions and timing that could be experienced across a lifetime of investing.
Measuring success: We then evaluated how well our glide path design held up to these rigors compared with the average target date fund glide path, as measured by the S&P Target Date indices. Our benchmark for success—the retirement finish line—was the account balance at the point of retirement needed to fund at least the minimum amount of adequate replacement income for the average participant.
Underlying market assumptions: J.P. Morgan’s Long-Term Capital Market Assumptions served as the starting point for our market simulations. Keep in mind that these are forward-looking projections. With U.S. markets appearing to be at the top of a cycle, this year’s assumptions reflect the reality that many investments may be entering a more subdued return period with greater volatility, at least over a shorter time horizon. This had a generally dampening effect on the range of outcomes likely to be experienced across participant behaviors, simply because the chances of less favorable market returns have increased.
Results: Based on our analysis, the SmartRetirement glide path consistently outperformed the average target date fund design across the full spectrum of participant behaviors and market conditions. This was because of its broader diversification, more efficient use of risk and greater volatility controls, especially around equity exposure in the years leading up to retirement.
In our projections, the SmartRetirement design:
- Helped more participants reach their replacement income goals
- Outperformed under more ideal participant saving behaviors and more favorable market conditions
- Offered greater protection to participants who had poorer saving behaviors and/or experienced more difficult investment conditions
- Lowered participants’ risk of account losses for the three years prior to retirement, a particularly sensitive time to experience market declines
This overall trend of getting a greater number of participants safely over the retirement finish line with less risk remained consistent with past Ready! Fire! Aim? research.
KEY FINDING: SmartRetirement continued to deliver more participants to safer retirement funding levels—and achieved stronger outcomes at the median as well as downside and upside extremes
EXHIBIT 11: RANGE OF EXPECTED ACCOUNT BALANCES AT RETIREMENT
Looking beyond averages
We also analyzed how glide path design might affect the success rates for the various participant segments discussed earlier at both the engagement level (see Part 1) and the salary level (see Part 2 ).
- Passive participants, who were automatically enrolled in their plans and never made contribution changes beyond their initial default rates
- Subsequent shifters, who were automatically enrolled but had a later rate change (either through automatic contribution escalation or by making a change on their own)
- Active engagers, who both enrolled in their plans and set their contribution rates on their own
KEY FINDING: SmartRetirement helped position more participants for retirement funding success across all levels of engagement
EXHIBIT 12: RANGE OF EXPECTED ACCOUNT BALANCES AT RETIREMENT BY ENGAGEMENT TYPE
These outcomes illustrate how important contribution rates and constructive engagement can be to securing safer retirement funding levels. The only way to be certain to achieve a positive outcome is to save enough, and the relatively low success rates of passive participants show that the typical 3% default contribution rate of many plans is unlikely to result in adequate savings. This presents a strong argument for aggressively increasing starting rate levels for defaulted participants and for implementing automatic escalation programs. Still, there is a silver lining: These participants were better off than if they had contributed nothing to the plan. The SmartRetirement glide path also helped them do more with the assets they did accumulate.
KEY FINDING: SmartRetirement helped position more participants for retirement funding success across all salary levels
EXHIBIT 13: RANGE OF EXPECTED ACCOUNT BALANCES AT RETIREMENT BY SALARY
The much higher success rates for lower-income earners may seem counterintuitive, given that higher-income earners tended to make significantly larger contributions, on average, than the other segments. However, it is important to remember that higher-income earners must replace a much greater level of income—hence, the higher finish-line hurdle and significantly lower success rates. Further, the proportion of retirement income provided by Social Security is much lower for this group than for the other segments, especially the lower-income earners, for whom it represents the vast bulk of replacement income. Consequently, it can be important for higher-income earners not to be lulled into a false sense of security just because many are making relatively larger contributions. Instead, they should assess if they are truly saving enough for realistic retirement income targets.
Broader diversification + tight risk controls = greater participant success
Throughout the past decade of Ready! Fire! Aim? research, we have consistently found that the long-term return potential and embedded volatility characteristics of a glide path design are largely shaped by two key portfolio decisions: asset class diversification and equity exposure. How a target date fund manager approaches these fundamental issues can have a significant impact on participants’ ability to reach their retirement income targets.
Our own glide path is designed to work harder to capture attractive levels of return in comparison to more equity-concentrated target date strategies, but with lower levels of volatility and more limited downside risk. This focus on achieving greater risk efficiency is achieved through broad diversification, including asset classes such as emerging market equity, emerging market debt, direct real estate, REITs and high yield fixed income, and closely managed risk controls, such as a relatively rapid reduction in equity exposure in the five to 10 years leading up to retirement when account balances are likely at their highest.
KEY FINDING: Our glide path design—designed for real-world participant behavior—was once again validated to withstand a wide range of market cycles and participant behaviors
EXHIBIT 14: HOW PARTICIPANT BEHAVIOR INFORMS DESIGN
|Participants typically contribute 5% of their paycheck at the start, reach 6% by age 45 and just reach 7% before retirement.||19% borrow, on average, 20% of their account balance.||10% over age 59½ withdraw, on average, 55% of their assets.||About 28% of participants remain in plan three years after retirement.|
|Most investors are not saving enough. Early growth from their investments and protection from loss when approaching retirement are equally crucial to success.||Tight volatility controls are crucial to help manage the amplifying effects of cash flow volatility on market volatility.||Sharp risk reduction in the years leading up to retirement is crucial.||The majority are not using the investment vehicle post-retirement.|
Implications for plan sponsors
A well-designed defined contribution plan—including the right target date fund—offers a compelling opportunity to help position participants for the strongest chance of building their savings into a secure source of retirement income. This year’s updated research once again reiterates how important target date design can be in potentially helping the most participants achieve more secure retirement outcomes.
First, plan sponsors and their advisors and consultants need to understand the wide variances in real-world participant behaviors and carefully weigh the implications of these patterns. Ultimately, no one is really average, and the strongest plans should be designed for participant behaviors on the edges as well as the middle. Second, it is critical to understand how fundamental target date design differences may shape participant outcomes, not just in terms of upside potential but also considering embedded market volatility and cash flow volatility exposures. This may become even more important if investment returns begin to enter a more subdued period with greater volatility, as we expect.
Finally, when analyzing outcome projections from a fiduciary perspective, it is crucial to focus on the participants who end up below the median, particularly below minimum replacement income targets. Raising the bar for these groups—by encouraging more constructive behaviors and taking a more sophisticated approach to glide path risk efficiency—can notably increase overall plan success. In our analysis, a glide path that invests at controlled levels of risk without overly curtailing long-term return potential, through broader diversification and relatively rapid reduction in equity exposure in the years leading up to retirement, continued to increase the potential number of participants reaching their retirement income goals.
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.
Monte Carlo methods are a broad class of computational algorithms that rely on repeated random sampling to obtain numerical results. Their essential idea is using randomness to solve problems that might be deterministic in principle.
JPMAM Long-Term Capital Market Assumptions: Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. Please note that all information shown is based on qualitative analysis. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class and strategy assumptions are passive only – they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts 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, but do not warrant its accuracy or completeness. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The outputs of the assumptions are provided for illustration/discussion purposes only and are subject to significant limitations. “Expected” or “alpha” return estimates are subject to uncertainty and error. For example, changes in the historical data from which it is estimated will result in different implications for asset class returns. Expected returns for each asset class are conditional on an economic scenario; actual returns in the event the scenario comes to pass could be higher or lower, as they have been in the past, so an investor should not expect to achieve returns similar to the outputs shown herein. References to future returns for either asset allocation strategies or asset classes are not promises of actual returns a client portfolio may achieve. Because of the inherent limitations of all models, potential investors should not rely exclusively on the model when making a decision. The model cannot account for the impact that economic, market, and other factors may have on the implementation and ongoing management of an actual investment portfolio. Unlike actual portfolio outcomes, the model outcomes do not reflect actual trading, liquidity constraints, fees, expenses, taxes and other factors that could impact the future returns. The model assumptions are passive only – they do not consider the impact of active management. A manager’s ability to achieve similar outcomes is subject to risk factors over which the manager may have no or limited control. The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield are not a reliable indicator of current and future results.