<p>Target Date Funds are a popular solution for planning retirement income. In this edition of Masterclass, our panel of experts discusses the DNA of their respective glidepaths, debate the merits of to versus through plans, and outline how retirement investing will change in a rising rate environment.</p>
<ul>
<li><p>Nick Nefouse - Co-Head of the LifePath Franchise - BlackRock</p></li>
<li><p>Christie Wootton - Client Portfolio Manager for Multi-Asset Solutions - J.P. Morgan Asset Management</p></li>
<li><p>Derek Beane - Director & Investment Product Specialist - MFS</p></li>
<li><p>John Cuniff - Lifecycle Portfolio Manager - TIAA Global Asset Management</p></li>
</ul>
Video Image:
Duration:
0000 - 00:57
Display Date:
Wednesday, December 7, 2016
Transcript:
<center><b>MASTERCLASS: Target Date Funds - December 2016</b></center>
Gillian: Welcome to Asset TV, I’m Gillian Kemmerer. Target Date Funds are an increasingly popular tool for retirement planning. So how are experts positioning in the current financial climate and what determines the DNA of a Target Date glide path. Asset TV has assembled a panel of experts to help us understand best practices, so welcome to this edition of Masterclass. Thank you all so much for joining us here today on this rainy afternoon, yeah, we’re thrilled to have you. So I want to get started with a short term viewpoint. I think originally when we were going to have this discussion, we may have started long term but we have had a very interesting turn of events. And for those who are at home watching this at a later date, we are just after the pivotal US presidential election. Obviously Donald Trump is rising to the presidency and has changed a lot of forecasts. So, John, starting with you, broad strokes, how have you reoriented positioning between maybe two weeks ago and now?
John Cuniff: Well, I mean the past couple of weeks it’s shown events are uncertain and the market’s reaction to known events in advance is also uncertain. So it’s critical to have diversified portfolios such as Target Retirement Date Funds. I mean in terms of our long run expected returns, we have the same expected returns for US equity around 6%, sort of before and after the election. Clearly the expected returns for fixed income have moderated with the rise in rates. We had about 2.2% for long run expected returns. And those returns now are slightly higher. So the equity risk premium has come in slightly. That being said, equities are still attractive for the long term.
Gillian: And it’s interesting, speaking of outsized reactions, I think the equity market futures dipped even further than the night of 9/11, which just shows you how outsized and unexpected the market reaction was.
Nick Nefouse: Yeah, I think it’s important to note, similar to what John said that this is what Target Date Funds are for, they’re built for diversification. The futures market came all the way back, even though I’ve seen a rally. So I think that that’s what’s most important, is that people stay the course. We haven’t seen any major changes. I know at BlackRock we have been running Target Date Funds for almost 25 years. So we actually have seen a Clinton presidency in our Target Date Funds. But with Trump coming in I don’t think there’s a major change you need to make, especially until you see any sort of policy changes in place.
Gillian: And we’ll talk about some of those later, Christie?
Christie Wootton: We would reiterate that about staying the course and focusing on the long term with respect to Target Date Funds. We just released our 2017 long term capital markets assumptions for JP Morgan last week. And really what we’re seeing overall is that return expectations are coming down across the board. Volatility’s not coming down across the board. And again this is our 10-15 year view. So we think now in the short term as well as in the long term environment it’s more important than ever to have broad diversification, to have a lot of asset class exposure within your Target Date Funds. And really be able to leverage things like high yield, emerging markets debt, emerging markets equity in addition to traditional US stocks and bonds.
Gillian: Got it, and Derek, I know you’re not managing tactically, but how have you thought about the most recent turn of events?
Derek Beane: Yeah. And I think from the standpoint of why we don’t do tactical, I think this is kind of an example as to why that makes sense. So I think when you think about what’s gone on in the market, it’s been very jittery. There’s been a lot of volatility. And we do have broad long term capital market assumptions that are the basis of our asset allocation from a strategic standpoint as well as our glide path decision. But from that standpoint, the way we’ve thought about developing a strategic approach was based on risk and not return. So risk is a much more stable metric over time, returns tend to be highly environment dependent and can vary over time. So we choose to identify portfolios of varying levels of risk as opposed to trying to project future returns for those given asset classes.
Gillian: Great. Thank you. And so let’s reorient a little bit toward the longer dated discussion, obviously Target Date Funds are created for longer date discussion. So we had four Fed speakers in four days right after the election all have committed to staying the course for a December rate hike, the market’s been primed for it. When we think about inflation, interest rates and these longer term expectations, John, again starting with you, how are you looking at the long term returns for capital markets?
John Cuniff: When we look on the fixed income side, we have, have had in our 10 year looking forward, expected returns for fixed income built in, that we expect the 10 year to gradually move to around 4% or so over the long run. And clearly it moved more quickly here in the last week or so. It’s important we have diversification within our lifecycle funds. We have investments beyond Barclays Aggregate and treasuries. We have investments in US high yield, which has been a benefit to us this year in diversification, also emerging market bonds and also international bonds. So diversification is key beyond the treasuries market.
Gillian: Nick. Great point and we want to drill down a little bit more into diversification later.
Nick Nefouse: Yeah. So I think one of the points I’d make and I think this is shared by JP Morgan is returns are coming down. We’re going to see lower returns in the future than we’ve seen in the past. And we have to adjust for that. We can adjust that by doing a few things. We can adjust the way we spend our money for individual investors. You’ve increased your savings, right. Or you can actually do something different in the portfolio. So you really have to look at what amount of equities do you have in your portfolio? What other asset classes do you want to put into the portfolio? But in all the return forecasts that we have seen, they’re all lower. Now, we can debate whether it’s much lower or a little bit lower, but they’re all lower, which means individuals; particularly millennials are going to have to save more and then invest smarter to offset those returns.
Gillian: We have seen good saturation among millennials for Target Date Funds as well.
Nick Nefouse: Yeah. It makes sense to, because it’s … look, lifetime asset allocation is very complex. This is a different set of risks that will happen and it changes at every point of your life. So for a millennial to start off, to start with an investment, a small investment and to grow that, the best place for them to be without any other real education in finance is in the Target Date Funds, that’s what all of our funds are built to do.
Gillian: Great, perfect. Christie, long term thoughts.
Christie Wootton: We would agree with that, very similar views with BlackRock. We think return expectations are coming down. It’s a result of growth slowing a little bit. But either way, the point of the Target Date Fund is to get people invested for the long term, especially with millennials. As traditional 60/40 portfolios, what we used to say is if you had a 60/40 portfolio made of traditional stocks and bonds a few years ago, you could reasonably expect that to deliver an 8% return. Last year with our capital markets assumptions update we said, “This is actually closer to 6, 6 is the new 8.” This year it’s 5½ is the new 6. And if you account for inflation, you’re really looking at a 3% real return. So to get participants to the level that they need in terms of income replacement in retirement it’s going to come down to savings, increasing their savings rates, keeping them invested for the entire 40 years leading up to retirement, because the game really for traditional stocks and bonds in our view is over.
Gillian: Got it, inflation are huge, key point when thinking about retirees.
Nick Nefouse: So we just released a paper last week, two weeks ago maybe and it has 2.9%. And we didn’t use BlackRock’s estimates; we took a broad swath of the industry and used that for capital market assumptions. And we looked at a traditional 60/40 portfolio ish, and you’d have got a 2.9% return gross of fees. So I think what’s critical as well is that people stay invested, is the volatility there, which you mentioned earlier, volatility is not going to change. So you’re going to stay relatively highly volatile markets with lower returns. What that’s going to do, what our fear is, is behaviorally, people are going to want to not stay invested. And we have to build these products so people stay invested, because the worst mistake they can make is they sold out before, you know, before the election and now they’re coming back in to the equity markets at a higher point, when you do that enough times over 45 years you’ve got a bad outcome.
Gillian: Yeah, it’s a great point, a lot of it is insulating from the talking heads that might be driving them to make decisions that they shouldn’t be making, when they should be orienting for long term. Derek.
Derek Beane: Yeah. And I think to that point, there is a lot of noise out there. And I think that scares investors, especially those that aren’t used to doing this on their own. So when left to their own devices, I think a lot of individual investors would get scared of the volatility. We’ve seen it time and time again, study after study shows that investors get in and out at the wrong time. So I think from the perspective of Target Date Funds, having the ability to stay invested, allow people to default into those investments and ride that glide path down so that they become more conservative when the point is right for them to be, and not have to worry about should I buy, should I sell, what should I be buying, what should I be selling. Have an easy one stop shop broad diversification that will adjust over time for that plan participant profile.
Gillian: Let’s drill down a little bit into fixed income; it’s been such an interesting area. I think if we had had this discussion a few weeks ago we would have said, “Okay, 10 year treasuries hovering below 2%.” The last I looked today they were at about 2.2. So when you think about how we’re allocating to fixed income, we actually received a lot of viewer questions to this point. So I want to bring in a perspective from Ross Kemp, he’s the managing partner from Kemp Consulting and he had this to ask of all of you.
Ross Kemp: Hi, this is Ross Kemp, managing partner at Kemp Consulting Solutions in Northern New Jersey. And my question relates to Target Date Funds and specifically asset allocation changes. As we’ve been going through a 30 year bull market in fixed income and interest rates, at least at this point in time for the 10 year, are down near historic lows. How aggressive should a plan sponsor be in reducing fixed income exposure in this environment? Or do you maintain certain exposures based solely on retirement age?
Gillian: John, we talked a fair bit about this before the panel, talk to us a little bit about how you are diversifying in fixed income.
John Cuniff: Well, fixed income has a role in portfolios over the long term. And what it provides is … and when we saw that election night, the Dow Futures were down like 750 points. That reality could have played itself out. And for investors going into retirement and in retirement, they’re very sensitive to what’s the worst thing that can happen in any one year period. And they’re setting their lifestyle in retirement. So fixed income has a role, even if rates are lower, and those returns may be more muted. You can’t go all in equities. You can diversify within fixed income and broaden out beyond treasuries and look at, as we talked about earlier, high yield emerging market debt. But fixed income always has a role in a portfolio; you can’t go all equity for example.
Gillian: Would you say a reduced role or a similar size?
John Cuniff: You need to take more advantage of diversification within fixed income. And then there are some other assets. Our firm has recently launched direct retail investment in our 40 Act Fund. And we received an SEC exemption to do that, and we’re building that. So we’ll have investments in equities, fixed income and also direct commercial real estate, which provides sort of a hybrid return in income. So the key there is diversification. But you can’t move away from fixed income and all into equities.
Nick Nefouse: Yeah, it’s a good point too. So when we look at the actual factors of what’s driving returns, if you look at equity factor, what you basically have is economic risk within there. The reason why fixed income works is you’re getting this big duration factor, which is not correlated at all with equities. So even at low rates you do need this ballast on the other side to really protect people in down markets. Now, what we’re doing at BlackRock is we’re predominantly investing in the Aggregate Bond Index, where we struggle, we struggle with international bonds. And we struggle with high yield because we just don’t see the diversification benefits, particularly in the international bonds where you have 50% of those indexes trading negative. So if you look at those yields starting to back up, even after the Trump victory where people are pricing in more inflation, you’re going to get hit with a longer duration bond internationally. High yield as an asset class is a greater asset class; correlation to equities is just too high, particularly in down markets. So we look at fixed income is the real insurance policy within the Target Date Fund, is we want to be able to make sure that you offer that diversification down markets. And we’ve seen repeatedly within the BlackRock product suite is in rough markets, in volatile markets we see significantly strong performance because we haven’t moved away from the duration.
Gillian: Got it. Christie.
Christie Wootton: I would echo some of your comments on the international fixed income space. Those are a lot of the reasons we don’t allocate to international fixed income in JP Morgan Target Date strategies. But we do see value in high yield. We do see value in emerging markets debt and in traditional core fixed income. We think all of those things have low correlations to equity, do dip in volatility and even though high yield and emerging markets debt are viewed as risk assets. They’re still less volatile than the traditional equity market. So what we’re trying to do at JP Morgan, especially as you near retirement, for those participants 5-10 years before retirement and in retirement, is think how can we at the same time market risk. The risk that someone’s going to have a large portion of equity risk on the table and a bear market situation happens right in advance of retirement without overexposing those participants to rising interest rates. And we think diversification in fixed income is the way to do that because it allows us to take equity risk off the table in those crucial years before retirement. But it allows us to have allocations to high yield in emerging markets debt and not be overly reliant on US core fixed income and overly reliant on interest rates in the US for performance.
Gillian: All great points. And emerging market debt has been a standout recently. So it will be interesting to see how that continues. I would imagine some of it has to do with reimagining the BRICs and looking at other markets, or at least splitting those up because there’s pockets of opportunity within them. Derek.
Derek Beane: Yeah. And I think back to the question that was asked, with rates now at, let’s call it 2%. We got the same question when rates went from 5 to 4, rates can only go up. Then they went from 4 to 3, then 3 to 2, and here we are. So it’s a constant question. And I think bringing it up a level to what is the role of fixed income and how do you think about that holistically within your Target Date landscape is critical. So the way we think about it is, you have the duration component. So, along the glide path as fixed income becomes a greater percentage of your overall allocation, we’re actively lowering the duration so that you’re not as exposed from that duration risk standpoint. Moreover, as you get closer to that retirement date we’re increasing the diversification and the types of funds within that fixed income sleeve. So we have a very broad fixed income line-up, we have eight different funds that are the underlying portfolios for that fixed income sleeve, so very diversified across interest rates, credit qualities, maturities, term structure etc. And really what we’re trying to do is not have an overreliance on just US treasury rates and their path. So if rates go up, how will that impact the performance of that fixed income sleeve? And we’ve seen it, you know, it was modeled out when we constructed the portfolio and we’ve seen it real time. You know, when treasury rates go up, our portfolio and allocation to those mixed asset classes, those eight funds, you know, compared to just the treasury return, tends to be about flat, whereas if you’re just looking at the treasury rates, those can be negative anywhere from 4 to 10% based on the market environment that we’re in. So maintaining that diversification so that you’re not overly reliant on any one factor is critical for us.
John Cuniff: Yeah, I could just add to that, I mean just to bring it back to the events of the past couple of weeks. The markets have priced in president elect Trump being able to accomplish corporate tax reform and infrastructure spending and some financial reform we’re reading from analysts. But every day is a new news day here leading up, and it’s not January yet. And these things haven’t been accomplished. So clearly the markets could pull back. I mean you know, as mentioned, long term interest rates could back up again. They could end up south of 2 before they climb again.
Gillian: Yeah, absolutely, great point.
Nick Nefouse: We’re still in an environment where rates are going to be lower for longer. You’re not going to see rates come up dramatically from where we are. At least we don’t think you will, there’s just too much of a demand from the demographics. There’s too much a demand from foreign buying, we you still have negative interest rate policies. And we haven’t seen the policies change, to your point. We haven’t seen anything. We haven’t seen any of the proposals come back. So I think you’re going to be in a time where you’re going to see higher levels of volatility in fixed income markets, no matter what you do.
Gillian: Yeah, all great points. And diversification really has been the name of the game for all of you here in fixed income. So I want to switch the conversation a little bit over to equities, I suspect we’ll have some similar things to say. But, John, let’s start it with you again, when we talk about equities, where are you seeing pockets of opportunity? And is there anything you’re avoiding?
John Cuniff: Well, within equities we have diversified funds within US and international, including developed and emerging markets. And we have growth and value in large cap, mid cap, small cap. And in addition we have different approaches to investing at our firm. So that provides a degree of diversification. We have teams of fundamental managers that look at stocks on a bottom up basis. And then we also have the quantitative teams that look more top down, more macro driven, looking at different factors in the market. So blending that together is critical over the long term.
Gillian: Christie, talk to us a little bit about how you’re thinking about equities in your portfolios right now.
Christie Wootton: Sure. Right now from a short term perspective, going into the election we moved to moderately pro risk in our portfolios. We were saying that the current environment we characterize in three ways. We’d say it’s low growth but non-recessionary environment, government bonds are overvalued, and we would call it a do no harm Fed. We don’t believe the Federal Reserve is going to raise rates quicker than the market can handle. And that environment we think is favorable to equities versus fixed income. So at the beginning of September we moved to moderately overweight stocks versus bonds. Most of that’s in the US. We’ve added recently a little bit to US small cap equity. We do think the US is going to be the favored region. But we have had allocation to emerging markets equity this year, which has been beneficial. What I would say is right now actually, today through Thursday of this week a lot of our senior investors are getting together for a quarterly strategy summit, which is really where we identify the big themes for our tactical asset allocation views over the next quarter. And there’s a lot that they have to discuss with implications from the election, do we think that any of president elect Trump’s policies with respect to immigration or fiscal or monetary policy, infrastructure spending will change our views? From the long term perspective, as we continue to look at our glide path in the context of our updated capital markets assumptions, we still believe in broadly diversified equities, from the 10-15 year forecasts we still think emerging markets equities have a strong role to play in portfolios, especially as there’s an aging population, potentially lower productivity growth in some of the developed markets.
Gillian: Great. Derek.
Derek Beane: Yeah. I tend to think about the positioning from the standpoint of how we have structured our glide path. And for younger investors who have extremely long term time horizons, we’re willing to take on more of an aggressive stance. And that’s kind of our strategic policy. Again we’re not making market bets on which market we think will or won’t do better. We have 22 underlying equity funds that are well diversified across geographies, market caps, styles, investment disciplines, so a diversified alpha source. We really strive to take, you know, essentially a maximum growth viewpoint for those young investors. And as we go down the glide path, really reduce that, bring it back in. So for our younger investors we are willing to take more exposure to maybe mid caps and small caps and non-US because of the risk premia associated with those. Over time those investors should be rewarded for that additional risk that they’re taking. Conversely, when you think about it at the short end of the glide path or as you’re nearing retirement date, we’re changing that construct. So we take less of an overweight position in mid caps, small caps, move more of the equities towards US because of that volatility profile being or move more of the equities towards higher cap as opposed to lower cap. So from the strategic allocation perspective, that’s how we think about it. That said those 22 underlying manager are also looking at the areas of opportunities within their landscape, finding the best opportunities based on market dynamics that they’re seeing at the moment.
Gillian: So on the risk spectrum, going from small mid cap and international to more weighted toward domestic and large cap?
Derek Beane: To a degree, weight might be a little strong, but on a relative basis if you look at where we start and where we end, there is definitely that tilt from a more volatile to less volatile time period because that’s where we think volatility makes sense for the younger investors. And where we think a lower volatility profile makes sense for those that are nearing retirement.
Gillian: Perfect. And, Nick, last thoughts on this.
Nick Nefouse: Yeah, Derek, it’s a great point that, we look at it the same way. So when we think about, you want to have the maximum exposure you can to equities when you’re young. You’ve got huge amounts of human capital in front of you and you’ve got a very long time horizon. So we maximize our equity exposure when you’re young. And then we drawdown as you age. Most of the products that we’re going to be talking about are index at BlackRock. We have broadly based global portfolios, emerging markets small cap, mid cap, and of course large cap. The only difference that I think from what you had said, Derek, that we have is we will actually increase our small cap and mid cap exposure as you age, because of the correlation to fixed income. So we actually see the benefits of small cap size premia essentially is lower correlated to duration than large cap. So we’ll slightly increase that. But I think we’re saying the same thing where when you’re young you want to have lots of risk, when you’re older you want to be getting de-risked, and we don’t play with the allocations very much. We just want to give you exposure to that equity risk premia.
Gillian: So let’s talk about the length of the glide path a bit here. We’ve been setting the scene largely, but I want to talk about the changing demographics, obviously we have people living longer, the longer into retirement the more cash that they need at the end of it. How are you seeing savings rates keep up and how are you starting to adjust the DNA of your glide path in order to accommodate these changing demographics? So, Christie, I’ll start with you.
Christie Wootton: Sure. One of the inputs that we use when we build our glide path is actually participant behavior research, looking at those very statistics. How much are people making? How much are they saving? Why don’t they increase in savings rates? Looking at any loan and withdrawal behavior that people are doing within the context of their 401(k) plan, we’ve actually at the last run of our data which was published last December, we have kind of some bittersweet news about savings rates in the country. And the good news is that on average more participants are saving in their 401(k) plans, or their DC plans, so that’s great, more people are saving money. The bad news is that the average savings rates are actually coming down. We think a lot of that is because of auto enrollment, people are auto enrolling at about 3% and staying at that 3% savings threshold where maybe some participants on their own would have elected 5 or 6%. I think auto escalation has a big role to play there in getting people to savings rates that they need. But historically we haven’t seen people on average reach a 10% savings threshold in advance of retirement, which we’d really like to see. So that’s something that the industry can work on. In terms of people staying in the plan and people living longer, we have seen the average retirement age in this country still stay at about 62.
Retirement is fluid, so people are retiring really anywhere between 59 and 65, a lot of people retiring unplanned, either due to a health problem of their own or a health problem of a relative. So we’re still seeing people retire pretty early on. And the majority of participants we find are taking their money in full from these plans three years after they’ve retired. That’s a statistic we’re continuing to look at, especially in light of the DOL fiduciary rule and seeing any impacts that might have, are people staying in plan longer? But we’ve built our glide path on real participant behavior assumptions which are they’re not always behaving perfectly. They’re not saving enough and they are taking their money right after they have retired.
Gillian: And certainly you don’t want the retirement age to be determined by how much they have in their savings. You want it very much to be their own decision based on personal factors, so yeah, an excellent point. John.
John Cuniff: Yeah. I could just add to that, each series may have a different behavior. And I’ve managed the TIAA funds now for 10 years. And even our 2010, we have a 2010 retirement of retirees and a 2015, they still have some net in, and some net out. They sort of balance each other out. So some people are taking money out and some people are still contributing. And it’s interesting, they may plan to retire or they have maybe making a household decision. But we’re seeing the investors stay in our Target Retirement Date Funds through retirement. We have a through retirement glide path. And so we look at our behavior just as JP Morgan does. I think it’s also critical to consider longevity. And we do a lot of work, we have a whole insurance arm and our team has worked with our actuaries and looked at mortality. And if you look today the average 65 year old, the average American expected to live about 20 years after date of retirement. If you look at Social Security administration work, that young individuals today, when they reach the age of 65 with expected improvements in healthcare, they’re expected to live about three years longer, more like 23 years after date of retirement. And those are improvements of longevity growth for women and marginally more for men that are more catching up. So these funds need to be designed for the increasing longevity of Americans.
Gillian: Absolutely. Nick, how are you thinking about longevity risk?
Nick Nefouse: Yeah, it’s a great question. So one of the points that you made earlier is that it’s ERBI research, Employee Retirement Benefits Institute research, which shows within three years the money has gone out of the plan. So we can actually see the same thing that you see. The way that we think about this is we think about, we have to look at the entire glide path to really understand what we’re doing. So maximize risk when you’re young, you want to minimize risk on the day that you stop working, that’s what’s absolutely critical. When you look at that last phase, the way that we model this is we’re trying to model two things. We’re trying to figure out how to maximize the life expectancy of your assets while minimizing the income volatility year over year, that’s what we think most people want. I’m guessing most of us do this, we’re looking at the actuarial tables, we’re building back into how long we think. We think, if you kind of put a number on this, about 30 ish years, 35 years is how long you’re going to have to make these assets work. So longevity risk is a very big risk that we have to manage to. And I think that what’s critical when you understand the glide path, it’s not to versus through or it’s not where you take risk, at what point. It’s can you actually work in retirement? So there’s a bunch of research we’ve been doing now looking at how do you actually decumulate from a Target Date vehicle? What it’s shown is that you need to be able to decumulate for about 30 years and be able to minimize that volatility.
Gillian: Great, and Derek.
Derek Beane: Yeah. There is a few points there. I think as we think about, it kind of comes to that to verse through discussion. From our standpoint when we develop the funds we weren’t thinking we want to be a to manager. It was really from our standpoint what made sense for that end client when they reach their retirement date, what we want to do is get them to a comfortable resting spot. I think the to verse through discussion has become somewhat a relevant or maybe more attention is paid to it than it should be and investors might want to be looking at other things as opposed to whether I’m just a to or a through manager, given the facts that most people do indeed pull their assets from the plan within three years of retiring.
Nick Nefouse: If you don’t mind, I’d take that a step further. So the way that we look at it is it’s irrelevant. If you set the problem up as we need to decumulate over a long time period and minimize the amount of volatility of income. If you set your glide path too low at retirement you’re going to end up with a shorter longevity of assets, lower income volatility but a significantly shorter longevity of assets. If you go too high you then end up with more volatility of income and longer life expectancy of assets. If you change anything you end up with sequencing risk. So the question really is how do you manage all of these risks together and be able to find something that people are comfortable with? So I agree with you, it’s not just to versus through. You have to take a step back and look at this whole glide path and understand what’s the point? What was the actual objective of the glide path?
Derek Beane: Right. I think that answer to a degree is getting people to successfully retire, right. And there’s a lot of different ways to think about that. One of the things of our approach is we’re not really doing the representative participant model, which tends to be more focused on average. What we’re trying to do is focus on each and every individual investor. So those investors that are five years from retirement, those that are retiring a year from today, how would they be impacted by a significant drawdown in the markets right as they’re about to retire? You think about it, the average bear market is about negative 30%, it happens every five years or so. So the chance of that happening as you approach that retirement date is not insignificant. So you really have to factor that in. And again, thinking about longevity risk and again maybe the argument for more equity at that retirement date, I think again it comes back to the thought that on average people would be better served by having more equity in their portfolio because over 30 years equities should probably do better than fixed income. But again, we’re not trying to focus just on that average. We’re trying to think about every single individual who’s maybe just retired. What if they have too much equity, the market falls and then they’re either forced to go back to work or reduce their standard of living within retirement. So there’s a lot of different ways to think about it. I think, you know, the central theme though is how do you get investors to retire successfully? How do you grow their wealth and protect it?
Christie Wootton: And I would just add that even though we do see the majority of participants take their money out of the plan right after retirement, we do think that the static glide path in retirement is still appropriate if you want to leave your money in the plan. Because what we’re trying to do is again reduce market risk for people at and in retirement, right near retirement where you’re five years away and that’s the biggest your balance will ever be. You don’t want to lose 40% of that balance right in advance of retirement, not overly expose people to the risk of rising rates. But also consider the impact of inflation, by adding in inflation sensitive assets at that point so you can be CPI and you can buy as much in retirement as you planned on buying, and not take equity completely off the table in retirement. So that you can have longevity, you still leave equity risk on the table for people who do want to stay in the plan a long time. So I would echo that, it’s a combination of what people are doing, but also what risks you’re trying to mitigate for them and how you can get people the income replacement that they need.
Gillian: Did you have something to add, Nick?
Nick Nefouse: No, I agree. There’s just no silver bullet, you’re trading off risks here. It’s, do you want to pick up longevity risk or trade off volatility risks? These are all risks? I think what we’re saying is you’re trying to solve for a myriad of risks in the most optimal solution for the widest amount of people within your plan.
Gillian: I know that to versus through feels like a kind of a reduced discussion and we’re seeing there’s so many other things you’d like to focus on. And it would be interesting for each of you just to take a second to talk about what you choose and why you’ve chosen it. And I think weighing those pros and cons doesn’t make one right or the other, it’s just an interesting way to get a diversity of opinion. So if you wouldn’t mind just each taking an opportunity to explain kind of why you’ve chosen which or the other and what it is that you’re hoping to get out of it, so if, Derek, you start.
Derek Beane: The two verse the through?
Gillian: Yes.
Derek Beane: Yeah. And again I go back to, you know, we incepted these portfolios over 10 years ago. And again we weren’t trying to think, do we want to be in the to bucket or the through bucket. I think that was an easy way as more and more providers started to manage these type of products, to categorize them. And there’s a lot of different things that you can look at to categorize in certain buckets. But really I think you said it well, there is no silver bullet, there is no such thing as an optimal glide path. It all comes down to how you balance the competing objectives of growing your wealth and then protecting that principal that you’ve built up over time as you approach the retirement date. So from our standpoint again, we want to maximize that growth potential early. We actually keep a flat glide path at 95% risky assets, all the way until 25 years. And then we start to roll down in a slightly more progressive fashion than the peer group average. So we start to bridge that gap because the peer group starts to roll down faster than us. And then we end up actually at a more conservative spot at that target date. Again we’re trying to focus on the things that we’re able to control. There’s a lot of assumptions that go into trying to figure out which type of glide path, where do I want my ending point to be? A lot of those are out of our control. So we’d rather err on the side of caution and have a more conservative landing spot for those investors who will many times likely withdraw their assets once they reach that retirement. So really focus on the downside for those people as they approach retirement, again, trying to minimize any type of volatility that they might have as they are really in that retirement red zone so to speak.
Gillian: Okay, and John, to versus through.
John Cuniff: We have a through retirement glide path. And we formed it through a human capital, financial capital framework. So individuals, what they’re earning and their future Social Security payments will decline even after retirement. And in addition, their risk aversion, and what’s the worst thing that can happen in 12 months, the sensitivity to that will evolve throughout retirement. And individuals are living longer and if you look at … if you glide too quickly and come to a too low equity allocation too early in your life and you still have 20-30 years ahead of you, that’s a tremendous risk from replacing income in retirement.
Gillian: Got it. And, Christie, how do you think about it?
Christie Wootton: Sure. I think what’s important about our strategies is that we’ve been running Target Dates for 11 years. But our group, the multi asset solutions team, started about 45 years ago managing Defined Benefit and pension assets. So we come from a heritage of what is the problem that we’re trying to solve and how do we maximize the probability that we achieve that goal? So within the smart retirement portfolios, our goal is getting the majority of participants in a plan, the income replacement that they need to sustain their standard of living in retirement, which is going to be about 40% coming from the Target Date Fund. When we look at the ending … our ending landing point, our glide path, we really … we’ve got on that for two reasons. One is the participant behavior research and it’s that we’re seeing people leave the plan right after retirement. But the other is thinking about the risks that we’re trying to mitigate so that we can get people the income replacement that they need. So we think the static glide path at retirement allows us to mitigate market risk by taking down equities, interest rate risk by having diversified fixed income, inflation risk, by adding inflation sensitive asset classes at that point, and longevity risk by not taking equity off the table at and in retirement.
Gillian: So you’ve took your Defined Benefit point of view and brought it over to Defined Contribution as the landscape shifted?
Christie Wootton: Exactly.
Gillian: And, Nick, what about you, how do you think about it?
Nick Nefouse: So we think about it in terms of an outcome. Our equity landing point is an outcome of the problem. And the problem is how do you spend down when you’ve got a pot of money? So what we’re trying to manage is the longevity of assets with the income volatility. So what we come to is we come to a 40% landing point. But we see that as a 40% landing point through retirement. And the idea that we stop managing the money at that point is just not right. The whole point we’re trying to do is maximize the probability of successfully living a stable retirement.
Gillian: Okay. There’s another debate that really dominates this field and it’s active versus passive management. And something I want each and every one of you to weigh in on. So starting with you Derek, active versus passive, weigh us the pros and cons and this also kind of plays into our fees discussion. So I’d like to incorporate that too.
Derek Beane: Sure. Well, from our perspective, MFS is an actively managed shop, so it’s probably no surprise that we are a believer in active management I think. From the perspective of where we’ve come from, where we are right now. I think it has been a pretty easy cheap beta led rally, whether you’re looking at equity or fixed income, if you’re exposed to the S&P and Agg you’ve probably done pretty well, diversification hasn’t really helped. But I think where we are right now and kind of where we’re going from here is really active management is probably more important now than it really has ever been especially within the Target Date landscape, and for two reasons I’d point to. The first would be returns, right now we’re in an environment where, we talked about at the beginning, rates are 2% or in Europe I think 40% of the sovereign debt’s in negative territory. So it’s not easy to have outperformance or any type of positive return in this environment, maybe five years ago when yields were 5% and you could provide a 100 basis points of excess performance, you maybe got a pat on the back and a job well done from your clients. But now when rates are essentially zero, it’s a very low growth, low return environment. Adding that 100 basis points right now is that much more important. So I think from that return side of the equation, active really makes sense right now. From the risk side of this ledger, I’d say that’s the other main reason why we think active makes sense right now.
When you’re buying a passively managed fund, let’s say the markets are down 30%, you will by definition be down 30% plus any fees that you’re incurring from investing in that fund. So, active management does have the ability to position the portfolios so that they’re not in the most overpriced equities or the most indebted firms or nations when you’re looking at the Fixed Income Indices. And we’ve done studies on this. We have some whitepapers on it that point to skilled active managers and skilled active managers can outperform over a full market cycle and especially, I think where they really shine is the down markets. Skilled active managers outperform by about 700 basis points in down markets. And certainly if we look at kind of where we are in equities and fixed income landscape right now, maybe both being rich, you know, you want to have … we’re not saying you absolutely have to be a 100% active, but if you have passive investments you want to make sure that you’re including some active in there to really help mitigate that downside. So those are the two things. I’ll stop there; we can certainly get into fees as the conversation goes on.
Gillian: Sure. Let’s start there, yeah.
Christie Wootton: We, at JP Morgan we run both fully active and passive blend portfolios. And we think there’s room for both active and passive management in portfolios. What we feel strongly about though is that the glide path is an active decision. There is no such thing as a passive glide path. Somebody is actively deciding how much risk to take at what point in the glide path. And we think that strategic allocation is going to determine between 80-90% of performance or participant outcomes. And we don’t think that you should build a glide path only using asset classes that are cheap or easy to index. We think there is room for passive management in some asset classes that are more efficient to index like the US equity market, developed international equities. But we’re not willing to sacrifice asset class or glide path diversification for the sake of fees. So even in our passive blend portfolios where we are indexing US equity, developed international equity and TIPS, we’re still going active where we think we need to be, and that’s in high yield. That’s in emerging markets equity and debt, that’s in real estate. We also think that the ability to be tactical is important, especially in this environment, having a manager who can navigate some of the ups and downs and not just be wedded to the long term strategic allocation can add value for participants, especially going forward.
Gillian: Sure. And, John, you talked a little bit about tactical allocations as well, so.
John Cuniff: Yeah. We have both an active series and an index Target Retirement Date series. And often a client will ask for one or the other. So it’s often a client view. The active series provides more diversification from a beta perspective, high yield emerging market bonds now, direct real estate, in addition some flexibility for tactical asset allocation. An index series provides more transparencies and lower fees. But as mentioned, that’s an active decision, that glide path, so the glide path is the same and that’s the key engine behind it. And that’s an active decision, so it’s important for investors when they compare an index series that they’re not all the same, that underneath here you need to look at the overall glide path and the asset allocation.
Gillian: So to some extent, passive is a big misnomer here, you may be working with a passive structure but in fact that glide path is always decided, actively decided.
John Cuniff: Yes.
Gillian: Nick.
Nick Nefouse: Yeah. So same thing, there is no such thing as a passive investor. You’ve got to make the decision of do I want S&P or do I want Russell, which is an active decision. The glide path is clearly an active decision. And then we have the fully passive. If you look at where flows are going, flows are going clearly to passive, because I think there’s a huge drive into fees. We’re agnostic between what the clients are looking for. I think what we try to do is talk about human capital versus financial capital, or the understanding of the glide path. And then from there let the investor choose whether or not they want to go into a passive, a fully active or somewhere in the middle.
Gillian: John, as you’re managing multiple products as well, would you say that fees are at a race to the bottom right now? How do you talk to people about it?
John Cuniff: Well, fees are very competitive. Our active series has fees in the lowest quartile, our index series has fees in the lowest decile. So our firm is very competitive with fees. But with an active series you have the opportunity for active manager greater diversification, and the benefits of having multiple other asset classes.
Gillian: Let’s talk a little bit about portfolio construction here and how you’re blending the underlying funds in your portfolio. So whether you’re looking at externally managed, internally, talk us through how you think about this from, you know, a high level point of view, Derek.
Derek Beane: Yeah. So everything that we do is internally sourced within MFS. So thankfully we do have a lot of breadth from a product standpoint, that we’re not having to find outside managers to fill those diversification buckets that we need. So we do have good long term track records within our underlying suite of products. So from that perspective we are definitely closed architecture, another bucket, you know, that you can categorize funds in. Really for us though is that risk component that we want to make sure why we’re using MFS solutions only for those underlying funds. When you’re utilizing a third party, sub advisor or fund you’re relying on their definition of risk and how that potentially marries into your decision on risk and what you view as risky, they might not. You could have different definitions. So risk is something that’s embedded in everything that we do, from the underlying security selection to the, you know, we have daily, weekly, monthly informal reviews on a semi-annual basis with the underlying portfolio managers to make sure that the risks they’re taking are intended, understood, not excessive. Our firm’s portfolio manager for the Target Date series, Joe Flaherty, also serves as Chief Investment Risk Officer for our firm. So having him have the ability, the transparency to see the underlying holdings, to potentially influence positioning and behavior of those underlying managers to ensure that they’re meeting their own strategy’s objectives helps us ensure that diversification is ultimately met within our fund.
So if we have a large cap growth manager and starts to drift into mid cap or starts to drift to value, we’re able to essentially stop that before it happens, because if they did start to drift, you lose that diversification benefit. So really making sure that we can control that risk aspect is a huge thing. And then Jo as Portfolio Manager of our Target Date series is also reviewed by that same investment and management committee to ensure that the risks we’re taking within our Target Date series are also appropriate. So there’s really multiple levels and multiple lens’ that we view risk through and that’s really why we’ve decided to go with a, you know, a closed architecture as opposed to hiring other sub advisors.
Gillian: Perfect. And, Christie, how do you think about it?
Christie Wootton: Sure. All of the active underlying managers in our portfolios are proprietary to JP Morgan, to the extent that we use passive managers in our blend portfolios; those are third party passive funds. We do think within our active funds that we have a broad platform at JP Morgan. And we talk a lot about the importance of diversification of the beta, diversification of the asset classes in your glide path. We also think diversification of alpha is important. So we have access to fundamental managers, quantitative managers, behavioral managers, managers who are adding value in different ways. And as we look to choose underlying managers, particularly in the active space, it’s what is your investment philosophy and strategy and how do you generate excess return? Because ultimately what we’re trying to do is pick managers who add value in different ways and at different times to maximize diversification in the portfolios.
Gillian: Okay, manager selection is key here, Nick.
Nick Nefouse: The simplest way to think about what we do, we start off with a two factor portfolio, you have stocks and bonds. And then we’re going to add something to the portfolio based on whether it increases return, it diversifies the portfolio or it reduces risk. And that’s how you build up to the asset classes, the underlying asset classes that we have. And then at every point, at every vintage we re-optimize, and this is how you end up with more small cap when you’re older than when you’re younger, because the correlations between small cap and fixed income are lower than large cap and fixed income. So the key for us is, is it going to add a benefit to the portfolio? Does it reduce risk? Does it increase return? And then we’ll add the asset to it.
Gillian: Got it, John, how do you think about it?
John Cuniff: We do full due diligence on our underlying equity managers and across fixed income. And we have full x-ray work where we look through the individual holdings as if our lifecycle funds were a diversified portfolio of individual stocks and bonds. So we look at overlap, we look at active risk; we look at independence of alpha that the managers are generating from a different approach to investing. And we do our own due diligence. And some funds, they may be appropriate for other investors, but they may not be appropriate at the margin for a lifecycle fund. So we also have an asset allocation committee and we report that and work with the leaders. So we have input overall into what’s appropriate and what’s the right fund for the shareholders of the lifecycle.
Gillian: Perfect. Now there’s one change coming down the horizon that I want to touch on before we end. I’m talking a little bit about investor behavior and that is DOL fiduciary ruling, firms have spent a lot of money in compliance but the fate of that ruling is actually coming into question, Anthony Scaramucci is on the transition team for Donald Trump, very vocally denounced the DOL fiduciary ruling. I want to get a sense from you just high level; obviously we have no idea what’s going to happen, not even at inauguration day at the time of filming. How are you thinking and positioning moving into this uncertainty, so, Nick, starting with you.
Nick Nefouse: I think the first point you made is that we don’t know. But I think the underlying trends we’re seeing, that the fiduciary rule is enhancing are trends that have been long dated. So if you think about since 2008, more people are moving to … there’s a bigger demand for an IRA type person with a fiduciary responsibility. You’re seeing a chase for lower fees. So I think those types of things that the DOL was going to enhance, I don’t see those going away. So we’re acting as if at this point.
Gillian: Okay, John.
John Cuniff: We’re prepared, but again I mean the … all the news and Washington is changing, so we’re monitoring that as well.
Gillian: Got it. Christie, how are you thinking about?
Christie Wootton: We’re acting as if the DOL fiduciary rule is going to happen at the previously scheduled time. And from a glide path perspective really the implication to us would be are more people going to stay in the plan longer? So from a research perspective it’s how do we help people drawdown assets, if they are no longer taking their money three years after retirement and leaving.
Gillian: Okay. And, Derek, lastly.
Derek Beane: Yeah. And I’d echo a lot of those same thoughts that it’s a kind of a wait and see approach. We’re definitely looking into it as much as we can. But from the perspective of the way we designed the funds to begin with, it almost doesn’t matter from that standpoint. We did design these for people to, you know, utilize throughout their retirement, we did a lot of work around longevity risk. So if people are staying in the plan longer, you know, we’ve appropriately aligned our portfolios to allow for that, whether they’re leaving or not is kind of irrelevant to us. We do think that it does strike that balance between appropriate growth and principal preservation. So it’s a wait and see at this point.
Gillian: Well, I’d like to bring this conversation as we start to come to a close, to have a look at participant behavior, we’ve alluded to it a little bit earlier. But we had a viewer that submitted a question, her name is Jamie Greenleaf, Principal at Cafaro Greenleaf. She wants to think a little bit about how participants are behaving in post 2008 and how Target Date Fund managers are dealing with the fact that participants know a lot more about finance and might be reacting in the short term to market volatility.
Jamie Greenleaf: Target Date Funds are an ideal choice for many participants because it’s a set it and forget it. Although during market volatility many participants are very reactive. What lessons have you or other managers in the Target Date space learned from 2008?
Gillian: John, what lessons have you learned from 2008?
John Cuniff: Yeah. Well, I managed our funds through 2008 and it was very exciting, each day I came in to see what was happening overseas. So I mean, you know, some things that we’ve added and the firm overall has added is much more education. And what we were advertising and having for websites. And the industry as a whole has significantly brought that up. So that’s critical. It’s critical for investors to know that they’re taking equity risk near retirement. That was the complaint in 2008 was people in the 2010 Fund, well, I didn’t know that part of that was in equities and equities fell like 45% from the S&P 500. Some of the work that we do in our team is among the risk measures that we look at, we look at and in retirement what’s the worst thing that can happen in 12 months? So we’ve added that short term perspective. So any changes that we make to our strategic allocation, we always reference where we were and then where we will be with adding a diversifying asset. And what we want to do is not make it worse in a short period of time, or potentially lessen that.
Gillian: Okay, great, thank you. Derek.
Derek Beane: Yeah. I think one of the main lessons taken out of that time period was that I think a lot of investors were surprised, they thought that they’re in something safe and you could have been in an income oriented solution that was down as much as equity markets. So really I would echo kind of an education of plan participants. And I think there is a growing level of sophistication that we’ve seen there. The way we really structure our portfolios was significant work around stress testing for those type environments. Again going back to the risk side of the equation, really trying to focus on how those portfolios for people that are just about to retire or just retired would react in those type of markets, so stress testing, initial analysis. I think one of the lessons from this too is that people have struggled with how to evaluate Target Date Funds. Should I look at them over 45 years? Do I look at them over very short term timeframes? And I think the answer is both because these really are meant to be solutions that people are holding for 40 years etc. But at the same time, if I’m an investor in a 2020 Fund, my time horizon might not be four years. So really looking at how managers have performed in down markets in specific stress environments I think will tell you a lot about how they might do in future environments. And really looking at funds over, you know, a rolling three year, a rolling five year timeframe or a trailing basis isn’t necessarily indicative of market or a market cycle. So really trying to look at a peak to peak or a trough to trough to see how managers have stacked throughout various cycles as well as components within those individual cycles as well.
Gillian: Got it.
Christie Wootton: I would reiterate that as being a really important point. As the 2008 number has rolled off of the five year and the seven year performance numbers, we really want to remind plan sponsors and consultants and advisors to look at the longer term. We wrote a paper last year called Off Balance where we tried to quantify the impact of a lot of those risks that we were talking about earlier, to get an understanding of the trade-offs inherent in deciding on which Target Date Fund you’re going to use. Because there is a trade-off in any decision, and what we were trying to do is give people an understanding of if rates rise, what might you lose in your portfolio? What would this glide path have done in 2008? If inflation rises, what might your portfolio look like? To help give people an understanding of how to benchmark their Target Date Fund and understand when their Target Date Fund will outperform and underperform. So the educational aspects, the communications aspect and also just bringing more resources to our clients to help them understand how to evaluate and how to look at these Target Date Funds over a long term period.
Gillian: And, Nick, what’s changed for you since 2008?
Nick Nefouse: Yeah. There’s not much for me to add. The one thing I would say, I don’t think it’s just 2008, if you look at the volatility we have seen since then, you’ve seen a US debt downgrade, Greek debt crisis, taper tantrum, whatever happened last August. I mean you see this repeatedly and we don’t think it’s going to stop. We think you’re going to see actually more of this type of volatility, especially in a lower return environment. So it’s understanding the downside protection that your fund has. You know, it’s really about education. I think we’ve all come a long way with the amount of education. We’re trying to help people understand what to look for within Target Date Funds, because what’s critical for all of us, whoever you’re investing in is you have to stay in these funds to make them work, that’s what’s critical.
Gillian: So more robust performance analysis and better conversations with clients to make sure they understand what they’re getting into is what I’m taking away from this largely. I want to give you each 30 seconds for quick final thoughts, if you’d like to focus them on, and what makes your firm unique or what’s kind of special about your Target Date offering, that would be great, otherwise just takeaways. What do you want advisors and investors t