Gillian: Welcome to Asset TV. I’m Gillian Kemmerer. As Defined Benefit plans fall out of favor, new challenges and opportunities have arisen in the retirement landscape. How do plan sponsors keep retirees invested and what are the best practices for plan design? In today’s masterclass we present a variety of demographic and behavioral factors shaping the industry and dive deeper into Target Date solutions. Welcome to the Defined Contribution Masterclass. Thanks so much for joining us, guys, we’re thrilled to have you. So, Nick, I’m going to start with you, I think it makes sense as we’re talking about the retirement landscape to maybe give a little bit of a macro overview. The capital markets environment has changed significantly over the past 10 or 20 years. How has your plan design evolved to keep pace? Nick Nefouse: Yeah, it’s a great question. So capital markets are always changing. So the idea that there is some sort of an equilibrium ever, doesn’t really happen. And it’s changed due to preference changes, asset class availability as well as capital market changes. And we wrote a paper earlier in the year talking about capital market changes. Specifically what we were looking at was how returns have changed in a balanced portfolio over the last 30 years. So we think about the last 30 years, the number is about 6% you can get in a portfolio of a 60/40 stock to bond mix. As we look forward, these aren’t BlackRock numbers specifically. We did an analysis across the industry, capital markets across the industry and the number’s going to be closer to 3% as we look forward looking. So does that mean that everybody’s going to get a 3% return? Probably not, it probably means you’re going to be somewhere less than 6, somewhere more than 3, but we think investors have to take this into consideration when they’re thinking about savings rates as well as retirement dates. Gillian: You mentioned asset class availability, are there any new assets classes you have introduced in your Target Date series? Nick Nefouse: Not recently they haven’t. I think we’re kind of at the event horizon of asset classes going into Target Date Funds. There’s not a lot out there left which is liquid enough to go into a Target Date series than you’d want any portfolio for 40 or 60 years over the entire time horizon. These portfolios have gotten exceptionally efficient across the industry, which has been great for the individual investor in that the cost has really come down. Gillian: Okay, great. Chris, tell us a little bit about how the changing capital markets have altered the way you approach your plan design. Chris Nikolich: So I would agree with Nick and state that what we’ve realized and what investors have realized over the last 20 years isn’t at all what they’re going to experience over the next 5 or 10 or beyond. They have been spoiled for two decades with declining interest rates and low inflation. That’s helped to boost equity returns as well. But a simple stock bond portfolio in a Target Date Fund, that won’t cut it for a participant. Bond yields are simply just too low today for bonds to effectively offset equity risk. You need diversifying allocations. You need exposure to global bonds, all be it hedging away the currency risk to widen your economic exposure, diversify your interest rate risk, but at the same time not take on more currency risk. You need to, in the current environment that we’re in, think about inflation. We’ve been in a low inflation environment but given the protectionist philosophies here in the US and abroad, we’ll likely see higher inflation. And participants need more exposure to inflation sensitive assets, especially near retirement as well. Gillian: So the role of fixed income, as you alluded to has really changed in the way that you construct your Target Date portfolio? Chris Nikolich: Absolutely. You had this structurally beneficial return over the last couple of decades and bonds will be challenged to deliver any sort of real return over the next 5-10 years. If that’s all you’re implementing in your Target Date Fund to offset equity risk, you’re leaving yourself and your participants short. Gillian: Got it. Now, John, capital markets are changing, is your investment philosophy changing with them? John Doyle: No, I’m not sure that the investment philosophy is changing. And I think you’re right, the capital markets have certainly shown a lot of change over the years. But I also think that they’ve proven that they’re not really predictable. And so I think we take a little bit of a different approach in the way we build the portfolio, because we really look at the objectives of an individual participant at that point along their timeline. And we try to build a portfolio that matches the objective that they would have. So somebody’s objective when they’re 60 or 65 is very different than somebody’s objective when they’re 25 or 30. So the portfolio is built less from an asset class basis of looking at capital markets and asset classes and more on what would the portfolio look like? What are you trying to achieve when you’re at this point along your timeline and what objectives you might have? So that’s the fundamental basis in terms of how we built the portfolio. From there then we look at and acknowledge that it’s not predictable, understand how to manage risk both by using fixed income as a risk mitigator, but also adjusting the equity and the other asset classes on the equity side so that we’re really mitigating risk and managing to risk equities and income oriented equities as well as using fixed income as that mitigator. Gillian: So you start with the participant and then use the macro environment at the time to set? John Doyle: Well, we use the participant’s objective and we really try to look at it from a long term basis. So we know it’s not predictable. We can certainly look at the past and past results and say, “Okay, we’ve been through this before, this type of thing before, how would that then translate to the current market environment?” And so that’s the approach that we take in terms of building that portfolio. So we start with somebody as they’re in, you know, in their 50s and 60s and look then objectively, what would they look like 15 years later? What would they look like 15 years earlier? And build the portfolio with that long term view. I think, you know, the one thing that we have changed about 3/3½ years ago, we added inflation protection, we added more of a TIPS fund. Because while we didn’t think to that point that inflation was an issue, we wanted to make sure as we saw kind of the environment change a little bit and inflation maybe pick up a little, that we were able to address any short term shocks. Obviously inflation long term would be addressed through the equity portfolios in the broader portfolio. But you really have to protect against those short term shocks as well. Gillian: Okay. So we’ve seen some changes in the structure of capital markets, whether it influences your investment philosophy or not, of course is a personal decision. We’ve also seen changes in the retirement landscape. So number one, we’re seeing baby boomers start to come up to their retirement date and perhaps working through it. We’re also seeing a colossal shift from Defined Benefit to Defined Contribution. So, Chris, starting with you, what are some of the new challenges and opportunities you see that participants are raising, particularly the baby boomers? Chris Nikolich: Well, think of that legacy, three-legged stool, Defined Benefit, Social Security and DC. Most people don’t have Defined Benefits; will have to wait longer for Social Security benefits that are less. It’s all about DC. And unfortunately most Target Date Funds have been built to deliver performance in an environment like the last 20 years. They don’t have the best practices that you see elsewhere in investment management. They tend to be active or passive. They don’t tend to have a blend of both. They tend to have traditional stocks and bonds and not diversifying asset classes. In many cases they’re a single manager instead of multimanager and they have a set it and forget it mentality. You don’t see that in endowments or foundations, pension plans, even on DC core menus. But we’re still waiting for Target Date Funds to advance to the best practices you see elsewhere. Gillian: Okay. So you’re saying that perhaps some plan designs are pigeonholing themselves when they could actually be diversifying? Chris Nikolich: I think so. I think there’s a lot of strategies and methods of management that have been utilized elsewhere in multi asset class portfolios. And it just simply hasn’t made it to the broad depth of Target Date Funds. Gillian: Okay. Nick, as you get an increasing number of baby boomers coming to you, do you find that they’re asking new questions? Are there new challenges or opportunities you’re facing? Nick Nefouse: I think the big challenge that we face is educating people about how to spend from Target Date Funds. Target Date Funds were built as accumulation vehicles. For 30 years we’ve used them as accumulation vehicles. It’s not clear that people are going to stay in plans. The data still doesn’t support that they’re going to stay in their Defined Contribution plans. Most of them will roll out within 3 years. However, we have to build our strategies assuming people will use them as spending vehicles. So that to me is the big challenge. It’s how do you help somebody understand what to do with this amount of money when they are at their retirement date and then explain to them how to make that money last over what’s going to be a longer time period than most of them expect. Gillian: Yeah, that’s right. One of the biggest demographic shifts is that people are just living longer, outliving their assets in some cases. Nick Nefouse: Yeah. And I think as an industry we spend a lot of time on product. We spend a lot of time on asset classes. When I think that the bigger problems are how do we help people increase savings and how do we help people spend their money that they’ve saved effectively. Gillian: Okay. And we’re going to dive a little deeper into that when we talk about plan design. John, how do you look at this kind of changing retirement landscape? John Doyle: So I think Chris brought up an interesting point because you’re looking at kind of the slowdown or the elimination of the Defined Benefit plan for a lot of participants. And this is really, as we move into the, you know, the next 5-10 years, we’re starting to see people who have had Defined Contribution plans their entire career. So we’ve got the first wave of folks that are actually starting to look at their accumulation in their nest egg and trying to figure out what their next step is. So you know, in a lot of these cases, they’ve built a fairly big nest egg, unfortunately they’re not really sure now how to translate that into an income stream. I do think though that to compare it to a traditional DB plan or a traditional endowment foundation in terms of how that money is invested, creates a little bit of an issue because the individual is the one taking on this risk. In the traditional Defined Benefit plan, if you’re underfunded, eventually the company can put more money in. If you’re underfunded as an individual, there are only certain IRS limits that you can put in. So I think you have to take that different type of risk into account as you build the portfolio, as you understand how that portfolio is going to act, both in the current markets but also how that’s going to influence the participant’s behavior. And so I think that really is a different nuance than you might see in a traditional portfolio with portfolio management that’s bringing in managers and taking them out at various points. So I think that’s certainly a challenge. Translating that into an income stream, I think is one of the biggest things that we really haven’t addressed as an industry yet. I think the plan sponsors are starting to look at it, certainly participants are starting to look at it. But a lot of the mistakes that advisors make and people make when they look at a Target Date solution is that point about people leave the plan, as soon as they retire, they’re gone. And in most cases, that’s true, whether it’s 80%, 90%, and so I think a lot of them are using that as an excuse to just not worry about the retiree, saying, “Fine, we’re going to take the glide path, we’re going to stop managing it at 65, and let the participant fend for themselves.” And I think that two parts of that are wrong. One is even if 80% leave, 20% are still there. They’re still in the plan. Why are you managing the fund for the 80% that left, manage it for the 20% that are still there, which, by the way means I think we still need to do a better job of addressing that income generation need within the Target Date structure, even as they are today. Gillian: Interesting points. Do the two of you agree that it’s something that the industry as a whole hasn’t addressed? Chris Nikolich: I would agree. I guess we have addressed it to some degree and this is with the large multibillion dollar space as well as our own default fund. We have integrated a guaranteed lifetime withdrawal benefit into an age based personalized asset allocation. It looks a lot like a Target Date Fund, but it’s personalized, Gillian, for your retirement age and the amount of income that you want. And it’s backed by multiple insurers. Now, the marketplace isn’t quite there yet. So I think that’s what we’re all aspiring to do and in the interim I would agree with John, that we need to not default people into strategies and let them delegate their investment responsibility, and then at 65, suddenly expect them to become investment experts. There’s also data that shows that the average stock bond allocation within a 401(k) plan is 60/40, the average stock bond allocation within an IRA is almost exactly the same, it’s 61% in stocks and 39% in bonds. So just for the simple fact that someone’s rolling out, that shouldn’t itself dictate and drive the asset allocation. Gillian: Okay. Nick, when I think about plan design or when I think about retirement in general, there seem to be two inputs, one is the amount that the retiree is saving, the other is the plan design that’s being applied to those savings. Is one more important than the other? Nick Nefouse: They’re equally important, so we’ve looked at this in so many different ways. And, look, to go back to the previous question, as an industry we haven’t spent enough time teaching people how to decumulate. You can’t throw a rock without hitting another asset allocation strategy in accumulation. We just as an industry don’t have the … we don’t have the intellectual property out there in the market talking with people about decumulation. I think that goes into plan design as well as savings rates. Savings rates are going to be equally as important as investment returns over this time horizon, if you want to increase your returns, one of the easiest ways is to increase your savings. We spend a lot of time talking about products and nuances of products, when I think we need to spend a lot of time educating people on saving a lot and saving early, particularly in a lower return environment. And there are a lot of tools you have, particularly for millennials, even some of the earlier Gen Xers that can save more to offset any sort of lower market returns. Gillian: Okay. So getting people early and keeping them invested? Nick Nefouse: Absolutely. I think that what Target Date Funds have done is they’ve done an incredible job and you can look at the behavioral research on this. They’ve done an incredible job getting people to invest and keeping them invested over time to earn those capital market returns. We just need more people in there investing. We need more access to 401(k) or 401(k) type plans further down the market. Gillian: Okay. John, how do you think about savings rate versus plan design? John Doyle: So I think, you know, and I’ve heard many times that you can’t invest your way out of poor savings habits. And I think that if you ask which is more important, it’s more of a sequence, because I think that you can use plan design to encourage or force more savings. So you know, in my opinion, savings rate is the most important, but plan design can really help impact that. And so a plan sponsor that’s really working towards being paternalistic and helping their employees achieve retirement readiness and achieve retirement can really leverage plan design and understand the direction that they’re going to go in to encourage a savings rate that will continue to improve. I’m not saying that the investment, investment results aren’t important, they’re very important. But if you’re not in the plan, and you’re not saving the right amount, you’d never have an opportunity to take advantage of the investment options that are in that plan. And I think that’s really important. Gillian: Yeah, good point. Chris, same question to you, when you think about savings rate versus plan design is there one that you put more emphasis on the other? Does it change over time? Chris Nikolich: I think savings rates will drive the success ultimately more so than investment design. But I agree that you can use the design of the plan, not to try and communicate to participants, unfortunately that doesn’t work. But leverage the auto features, we figured out, you know, nearly a decade ago how to get people invested with auto-enrollment. Fewer plans are using auto-escalation than auto-enrollment. If you default someone at 3%, they tend to stay there. You need to auto-escalate them up probably to 10% plus. You also need to revisit those decisions. Don’t just do it once when someone joins and if they opt out you don’t try and auto-enroll them again. Don’t just auto-escalate the defaulted participants. Go back every year and make people opt out, because they seldom do and they’ll thank you 20 or 30 years later that, you know, they didn’t manage any of their own assets, but you put them in a well defined default or well designed default. And you move them from a 3% to let’s say a 10% savings rate, that’s going to go a long way in terms of their success. So it’s the plan design really driving the behavior of the participants when they don’t have the wherewithal to do it on their own. Nick Nefouse: And I would argue, Chris, that is the communication. It’s not the actual verbal communication, it’s the non-verbal cues that the company is giving to what they’re going to default, how much they’re going to default, what the auto-escalation is going to look like. That’s going to give the biggest indicator of savings. We can look at the studies and every one that we look at says that most people in the plans will save up to the match, so if you increase your match, you're going to increase savings rates. So instead of going and spending lots of money on communications, which maybe good, you can simply increase your match, or change the way you drive your match. Chris Nikolich: I would agree, but still as an industry there are a number of plan sponsors that simply, they've gone down the route of auto-enrollment and they just haven't gone down the role of auto-escalation, they haven't said, “I'll match 50% of 10% instead of 100% of 5”, as you're suggesting. And those are easy fixes, and they're just, they haven't been done yet, which is frustrating for all of us. John Doyle: I think if you have auto-enrollment, and you have it at too low a rate, and I don't know if that's 3% or 6%, and you don't add auto-escalation, I really think you're in breach of your duties, because I think you're ... and you look at participants. A lot of them are going to assume that you enrolled me at 3%, that must be the right number, and they're not going to add to it. And so a lot of the argument against auto-enrollment is it's bringing the general savings rate down. And that's understandable to a certain extent, because you're getting more people in the system starting at a lower rate. But you still have to do something to get them up to the target rate, and whether that target rate is 10% or 12%, and by leaving them hanging, I really think that as a plan sponsor, you're doing them a disservice. Gillian: Let’s stay actually on participant behavior for a second, because this is interesting. And you know we have the one sense of auto-enrolling, auto-escalating, but the financial media of which I am admittedly a part of, is now widely available. You can turn on Bloomberg, you can go online and you can see, okay, there's a bear market coming, there is this fear looming in bonds, liquidity questions. Anyone can access that information. How do you start to encourage people to stay invested in bear markets? Nick Nefouse: Look, I think partly this; I think we've been going into a bear market since 2009. I don't think there's a day that I wake up that we're not about to go into a bear market, about to have interest rate rises. I've been in the industry for about 15 years. and every year it's the same prediction, interest rates are going up, and Japan's coming back. So when you think of it that way, I think a lot of it is, is not listening to the news as much, it's not watching as much and it's staying in a professionally managed product, which is reasonably priced and diversified. And I think that's what we've seen. I've made the joke to you in the past, Gillian, where Warren Buffett often says, “There hasn't been a great invention in the banking industry since ATM's.” And I'd argue the last one was really the Target Date Fund. It keeps people invested, it helps them invest, and it's letting somebody else do it for you. Gillian: Yeah, I think those are all great points. What do you guys think, do you think that there's anything that you can do as a plan sponsor to encourage people to stay in when the headlines are saying get out? Chris Nikolich: You know, most participants don't de-risk, in their after tax money they tend to chase performance. But how do they get their investment information? It tends to be on their quarterly statement, they open it up, they don't look at the returns as we all might. They look at the dollar value. And well, that's down, but it's maybe not as bad as I thought it would be. Well, you've been contributing every other week, your sponsor or your employer’s been matching part of that, and that reduces some of the volatility. So I think this notion of people, mass flight from equities in a negative environment, it just simply doesn't happen in DC plans. Most people are on, to some degree auto pilot, and that's a good thing, which means they're not buying high and selling low. Gillian: Okay, great, and John? John Doyle: Stop reading the financial media. No, I'm sorry. Gillian: Except, but continue watching Asset TV. John Doyle: Absolutely, you can continue watching Asset TV. I think Nick actually nailed it. And one of the issues that I have is that we've been talking about this bear market for years. I mean we've been talking about a rising interest rate environment for years. We've seen a little bit of it. The bear market hasn't materialized yet. Yes, of course, at some point it will. But if you try to time it and if you stay out because you're waiting for it to happen, history will show that you'll miss opportunities, and you won't actually know when to get in. So I think what plan sponsors need to do, what we need to do as an industry is to continue to encourage long term investing, get in. I mean this goes back 20 years, dollar cost average in, share cost average out, there's still fundamental principles that work for a participant. And if we can get them, I hate to say, if we can get them away from the day to day news, that the short term thinking, the immediate gratification, and really get them to think about the 20 or 30 years that they have to retirement, or even if they're in their 60s. The 20 or 30 years that they're going to have after retirement, look at that long term. Don't worry necessarily about the next few days or next few weeks, and understand that you can adjust your portfolio to immunize it a little bit from some of those risks. Gillian: Another element that's very related to participant behavior is the luxury and also cursive choice. So, Chris, when you think about it, is simplifying the actual line-up helpful, in keeping people or getting them invested in the first place? Chris Nikolich: I think reducing the number of choices versus simplifying, to use your word, that the line-up is the way you want to go. Studies have shown that people get overburdened with too many choices, and they tend to make a failed choice. I'm just going to throw up my hands and put all my money and cash on stable value, because I simply don't know what to do. So you can reduce the number of choices. But why not make them better? Do most participants have the wherewithal to think about an inflation sensitive strategy, or number of strategies? How much should I put in TIPS? How much should I put in real estate? How much should I put in commodities? Build a diversified real asset exposure and have that as one of your options. Better yet, you could have a White Label Fund and have a mix of active and passive. You can have a mix of a multiple number of managers under the hood. And it's seamless for the sponsor to manage. It's not disruptive to the participant where you make a change, so it has the appearance of simple, but it's very complicated under the hood. Gillian: Okay. And Nick, choices of luxury and cursive, how do you think about it? Nick Nefouse: Yeah, again you referenced the studies, Chris. The studies have shown, I think the number is something like for every 10 choices you have on a plan, you get participation dropping by about 2%. So the evidence is out there. I think that simple solutions that are outcome oriented maybe, or that are going to solve a problem for an investor, as well as a Target Date option, I think is the way to go. Unfortunately it's one of the things that I don't think we like to admit, but choice is not good, and giving individuals, who don't really understand investing, lots of choice, leads to bad decisions. And that we've learned in the last 10 years since the Pension Protection Act was passed. The more we've been able to default people into Target Date Funds, the fewer options we've given them on plans, the better outcomes we've seen. Gillian: So as Chris says, labeling it simply, but you're taking care of the complicated stuff on the other side, okay. John, how do you think about it? John Doyle: Yeah, when I think about a line-up I think almost in terms of tiers. So you have the first tier of the line-up would be the QDIA. so the packaged solution, kind of build it for me, and that way the participant can just go in there, default in, however they go there. The second tier would be the core line-up, so you would have any number of options where an individual who didn't want to go with the QDIA or the prepackaged, could build their own core line-up. I think they're the challenges. We always thought 20/25 years ago that the more choice, the better, that if you gave them more choice, they would argue less, they would complain less, and they would be able to build a portfolio. We've proven that communication doesn't make them investment experts. So taking a step back from that, how do you give them a core line-up that makes sense without giving them, you know, so much choice that they reach paralysis? And Nick’s point about the more choice you have, the lower participation rate, is one of the key indicators of the problems there. So I remember seeing line-ups where the core line-up was 50 options or more, and we started to see that come down in the late 90s and early 2000s. Where now I think the trend is going to be to have a fairly limited line-up, maybe 10 or fewer options that are broader. So don't ask the participant to understand the difference between value and growth. Have a growth fund that makes sense for a participant that knows a little bit, but not a lot about investing. Do the same thing with fixed income, maybe you have a balance fund, stable value, something along those lines. But it's a reasonably constructed tier that is manageable and understandable, both to the participant and to the plan sponsor who has to monitor it, and who has to go through those funds and do their due diligence on a regular basis. And then the third tier could be something like a retirement income tier, where we're talking about trying to solve that problem for those folks that are approaching or moving into retirement or in retirement. And maybe that's a separate tier that addresses those needs as well. Gillian: Okay. So speaking of choices, I want to dive a little bit deeper into each of yours and what you provide. And we've talked a little bit about your Target Date solution. So let’s go a little deeper into them. Let’s start with the question that everyone asks you when you talk about your Target Date Funds, to versus through. Chris, starting with you, what have you chosen for your plan? Chris Nikolich: I'd say that's an oversimplification, while we have a through methodology, the question to be asked is it's really about the appropriate level of growth assets versus diversification along the glide path. We have a through mentality for a couple of reasons. One, as I mentioned earlier, people that are defaulted in don't become investment experts at 65. Two, I want to balance the risk. I want to balance the short term market risk with the longer term, longevity risk. And with a through exposure you can do that. The question then becomes if I have a through exposure that tends to have more growth exposure than the typical to exposure, how do I manage that short term risk? And I do that in a number of different ways. I carve out a portion of the equity exposure and specifically allocate it to defensively oriented equities, in corporate equity and bond diversifiers, strategies that especially in today's environment will diversify the equity and fixed income returns and risk more so than you'd see in those asset classes alone. And something that I mentioned earlier that the implementation, one manager as much as I or anyone else up here would like to be, we can't be best in class in everything. And implement that in a multimanager approach, and if I can diversify the manager selection and the alpha, that's another way that even with a higher exposure to growth assets, I can help limit short time risk. The final way is not having a set it and forget it mentality. And in certain environments, especially when risk has risen substantially, that's the period when we want to temporarily reduce the equity exposure and smooth the ride for participants. Gillian: Okay. John, how do you think about it? John Doyle: I think the to versus through argument is maybe based on a misperception in the marketplace. I hear all the time that a to strategy is more conservative than a through strategy, that's kind of the first thing that I hear a lot of plan sponsors and advisors throw out. And I think then if you actually look at the numbers you find that there are many to strategies that actually aren't less volatile or aren't more conservative than some of the through strategies. So I think the first thing we need to do is throw out that misperception. So then the decision that a plan sponsor has to make is exactly why would I want to look at a to versus through. At American Funds we have a through strategy. And the reason we have a through strategy is that we believe that you should have the right portfolio for your timeline, regardless of the point that you are on that timeline. So whether you're 65 or 75 or 50, the asset allocation, the portfolio that you have built should meet your needs and objectives at that time along the timeline that you've laid out. So I agree with Chris, we can't expect anybody to become an expert just because they turn 65. But I also don't think that you can look at somebody who's 65 and assume that they should have the same allocation for the next 5, 10 or 15 years if they choose to stay in the fund. And the fund isn't necessarily built so that everybody stays 30 years past retirement. The fund is built so that you have the proper allocation the day you come in and the day you leave. And that’s going to depend on your timeline, with Target Dates that’s based on age. And I think that understanding then how you manage risk to that age, so whether you’re into retirement or past age 65 or not, are the adjustments that you make underneath in the underlying portfolios? Gillian: Okay. So even though we have debunked a few misperceptions about the definition, with have two through managers, Nick you are too, is that correct? Nick Nefouse: Yeah. And I think the other thing more polarizing than active passive in this industry is to versus through. I think both of them have been horribly butchered over time. Just to look at this academically, the whole reason why you have a Target Date Fund is to offset human capital, that’s why Target Date Funds exist. Your human capital is how much money you earn over a lifetime. We are a to provider, we are classified as a to provider. We look at ourselves as a through provider with a flat landing point. We absolutely manage this money on the view of what is somebody going to do in retirement? What are they going to do in their transition period? So how do you accumulate over time? So the idea that we somehow stop managing or we don’t need to change is just not accurate. The way that we think about this though is that when you’ve exhausted your human capital, there’s no longer a need for a glide path. So think of a foundation, if you think of an endowment, they don’t have glide paths because they don’t have human capital. When your human capital equals zero is when you want to have your lowest level of equities over your lifetime. The academic literature supports this. This was done in the 1960s and the early 70s, glide paths were developed in the 60s and 70s by a guy named Merton. And what you consistently see is that when your human capital equals zero you don’t really need a glide path. Now, it’s not to say that you don’t want to continue de-risking, somebody might. What our concern is, is that, glide paths never actually de-risk, we simply trade different risks at different points of your life. So when you talk to managers who run Target Date Funds you hear things like sequencing risk, inflation risk, longevity risk, you hear these different risks. You just trade those risks at different points of your life. And what a glide path is built to do is to balance those risks during all points of your life. And, John, this is kind of what you have said, where you’re trying to understand at what point in time, what portfolio was most efficient. And it’s taking all of these risks together into the mix and trying to figure out what is the … we describe at BlackRock, as an optimized portfolio for each point. So the reason why we land at 40% is we feel that that is the best balance of risks at that point when you are no longer working because you’ve lost this ability to earn money, which is your human capital. Gillian: So would you say that you’re more aggressive in the earlier stages of your glide paths than [inaudible]? Nick Nefouse: Yeah, absolutely. And glide paths are just risk exercises, that’s all they are, oversimplifying. I mean in the way that we want to do this at BlackRock is we tend to take lots of risk when you’re young. The difference to us between 90 and 99% growth assets is de minimis. So we take lots of growth assets when you’re young, we de-risk as your human capital peaks in your mid to late 40s. And then we want to land at about 40% in equities, 40% is what gives us the balance to hit the longevity risk that we want to hit. We’ll be able to pay down for about … it doesn’t work out this way, but about 30 or 35 years out of the fund to decumulate. Gillian: Okay, great. And please, go on. Chris Nikolich: Well, I was just going to add, I would agree, it’s all about a trade-off of risks, and the way we think about it is that the risks for a 65 year old versus an 80 year old, their time horizon, they’re different. And where maybe 40% is a good average of where we are to have a little bit more growth exposure. We’re at 54% at retirement, but it behaves more like a 40% equity risk given the equity diversifiers, given the defensive equity, the low volatility strategies. And we end up at a landing point closer to 30% where as someone moves to their 80s, they’re not compensated for having more exposure to growth. I really just want to preserve their ability to spend and do so in real terms. So based on the different needs, the different time horizon, that’s why we have a different allocation at 65 versus 80. Nick Nefouse: Yeah. And I think without herding out too much on this, the guy that wrote this was a guy named Samuelson, and what he actually argued is you would want an upward sloping glide path. So you would hit your low equity point at the point in retirement. And your glide paths would begin to slope upwards thereafter because your life expectancy is decreasing, so your longevity risk is shortening. Similarly, your costs for healthcare are increasing as well. Now, we don’t have upward sloping glide paths in the industry. But I would assure you, theoretically at least, an 80 year old can take more risk than a 65 year old, given a shorter life expectancy and the need for more money to spend for health insurance. Chris Nikolich: They’ll lose less of their spending given an equity shock, a 20% shock for someone at retirement might cost them 9 years, for an 80 year old it’s more like 4 or 5 years. A number of the studies I’ve read about the upward sloping glide paths, and there’s been a number of them as well, they tend to focus on that notion that you referenced of a risk tolerance. And they tend to focus less on the wealth accumulation and that detrimental effect that you could have in that 2 or 3 standard deviation market, if you’re unfortunate enough to live through that, on average it looks great. And then if you’re the person that ends up being 80 in 2008, well, sorry. Nick Nefouse: Yeah. Look, you know, we can go back and forth on this. When we go through the research we look at what’s happening. I think that there’s two risks here, and this is the point that I made about balancing risks. There is the risk of you running out of your money, and there is the risk of sequencing risk, there’s the risk of volatility of income. So it’s not that there’s a right answer, a mathematical right or wrong answer [inaudible] the upward sloping glide path is just to say that when you get to the academics, it’s very different. The question is what risk do you want to take, at what point? Are you more concerned with income volatility or are you more concerned with running out of money? And then that’s where you’re going to get to the different points on an equity landing point, post retirement. John Doyle: So I think both Nick and Chris raise some interesting points. And it may be one of the things, and I’m hopefully not getting ahead of us here. That during the accumulation phase it’s easy and fairly accurate to say most people are average because they have the same objectives. Once you hit retirement, whether you hit it at 65 or you hit it at 70, depending on what your plans are, I think most participants actually get a little bit more engaged and identify what their objectives are. So we’re talking, I’m talking about a through strategy with a glide path that continues to go down, that probably works very well for a certain percentage of individuals. But at that point you’re really looking at a … the way we look at it, it’s a portfolio that will eventually wind down and it’s designed to generate income and wind down to, you know, close to a low number by the time you hit 90 years old. There are many participants who may hit age 65 and move into retirement that want to make sure they leave a legacy or want to make sure that they only live off of income or drawdown principle faster for other reasons. So we can talk all we want about, you know, what happens after retirement and the different models that may work. The real answer is all of them will work depending on the objectives of the participants. So I think the question for the plan sponsor is, what do my participants look like and what do I expect, is going to be closest to the average participant, understanding that this is not the right answer for everybody, because it’s not. Gillian: Let’s stay on the decumulation phase for a second, because so often we focus on accumulation, but we don’t talk about what happens at that point, whether you’re to or through. Nick, how do you think about the best practices for encouraging plan participant behavior when they’re at the point of decumulation? Nick Nefouse: Yeah. I think that, and this goes back to one of the earlier comments we talked, but I don’t think we have talked a lot about this. I think there’s a lot talking about the accumulation phase. But it’s still a pretty tough go of it. Part of that reason is that we rely a lot on plan sponsors. And it’s not that plan sponsors are doing anything wrong specifically, but not a lot of people have stayed with the plan sponsors, even the very big plans that we cover, very few of them have a large amount of retirees that stay with the plan, most of them roll out. So where most of the Target Date Funds and the DC space stops is when people start to leave the plan. And I think that what we’re seeing now is two things happening. One, the DOL rule, whether it happens or not, the DOL put a lot of onus back on the plan sponsors saying, “What are you going to do if people stay in the plan?” That was the really big driver that we saw with the change. The other big driver though is the demographic shift. There’s more people that are in their late 50s or in their early 60s in a plan and they are starting to ask the questions. What do I do now? So those people are getting older, they’re becoming more interested in this. And I don’t think we’ve done enough to help them and show them what they can do. Gillian: Okay. Chris, would you agree, do you find that at the decumulation phase, education has stopped significantly? Chris Nikolich: Education tends not to work throughout someone’s life path. So at the end of the day, there’s more that we need to do as an industry beyond education. And I think that that gets to some of where the industry may go. There’s two ends of the spectrum today. There’s a Target Date Fund where we assume everything and ask nothing. There is a managed account where we assume nothing and ask everything. The problem is people don’t engage. And so what might we see over the next 5 or 10 years is the evolution, not throwing out the Target Date Fund per se, but having that be the chassis of something that’s customized. Do I need to customize the asset allocation for the 25 year old? No, they need a lot of growth exposure. But at aged 65, do they have Defined Benefits or not? Do they have a lot of company stock? Have they been fortunate enough to live through an environment where they’ve had really good returns and what are their goals? That’s where the element of personalization could come into play. And maybe you still retain that retirement vintage or that 2015 vintage. But you have a completion fund around it. And that could be a more elegant solution than what we have as Target Date Funds today. So I see that’s where the industry is going. Nick Nefouse: Yeah, Chris, I completely agree with you. I completely agree with you. And I think that we’ve all agreed that Target Date Funds have done an incredible job accumulating assets, but we’re just … there’s still this kind of murky space where managed accounts aren’t really the right answer, but are Target Funds the best answer? And it’s probably maybe somewhere in the middle of something customized. There’s really four factors that we look at when you’re at that point. It’s, what is your account balance, which will vary wildly across plans. Is there outside income coming in? Do you have a spouse’s income that’s going to continue to work or a legacy DB plan? Capital market assumptions going forward and then life expectancy. And you can kind of get … when you go to a plan and their big enough, those four numbers, you can kind of make some estimates around those four numbers. But they vary wildly between different plans and different industries. And I think that, I think you’re right. I think that you’re going to start to see more customization on the back end of Target Date Funds. John Doyle: So I think one of the challenges is whose job is it? Because you know, it kind of goes back to, we’re talking about Target Date Funds, and we’re talking about in plan and communication and education to participants as they approach retirement. I think one of the first things we need to do is address communication to plan sponsors and help plan sponsors understand: (a) whether it’s their role, because many believe it is and many believe it isn’t. And then (b) if it is their role, how can they address it? Because I’ve sat down with a number of plan sponsors where the benefits in HR department, want to make sure that they’re involved with their participants as they retire, have no problem with them staying in the plan and would like to provide them with tools. On the other side of the table, still with this plan sponsor but now their legal counsel is sitting there saying, “We’d actually rather they leave because we see an increased liability.” So the question is, do you need to address that liability? Is there truly a liability there or is it something that you can continue to help address without upsetting legal counsel and taking that direction. So once you’re over that hump then the question is how do I look at it? Because the minute I bring up retirement income the plan sponsors start to shy away and say, “Well, we don’t want insurance products in there because that’s going to create too much of a long term exposure. Or we don’t want guaranteed products that may or may not involve insurance, but that aren’t portable or that they’re expensive or that need to be sold and won’t be bought.” And I think if we can get the plan sponsor to understand that there are a lot of different options and those are certainly some of them. But at least start to dip your toe in the water and address the needs of the early retirees now as the baby boomers start to move into retirement and provide solutions that don’t scare them as much as I think they’re expecting, I think we’ll make a lot of progress there. But I think a lot of the communication and education at this point needs to be at the plan sponsor level because once we solve that problem, I do think participants will jump at the opportunity to get help, whether it’s a customized managed account as they move into retirement or some sort of other solution. So we’ll see what happens. Chris Nikolich: And I think the key is evolving the default fund. You could have, and plans have a number of options today. There are plans that have annuity purchase windows and they get maybe 1% take up. So it just doesn’t happen, and whether it’s a more robust Target Date Fund that’s a packaged product, whether it’s customized, whether it can include lifetime income, whether it evolves to be something that’s more personalized. I think the focus as the default is where you’re going to get the biggest bang for your buck, because that’s where most of the money will be for people that are staying in the plan. John Doyle: So one of the challenges with retirement income and default, and especially if there’s any sort of annuitization that’s built into a default, that I’ve seen and heard when I’ve talked to plan sponsors and other experts. You look at the average participant, their average salary as they move into retirement and the amount that they might expect from Social Security. A large percentage of their replacement income will come from Social Security, their lower income, that’s where they’re driving it. That’s really the … and you can by the way, argue Social Security may or may not be there, but that’s … for our purposes, let’s assume it will be there. That means that a large percentage of their retirement income is already annuitized, because Social Security is an annuity. So the question is, if you’re actually defaulting somebody into an annuity or some sort of guaranteed product, are they now at this point over-annuitized? And I think that the idea of guaranteed income and annuity within a Target Date solution of some sort is exactly what we need. I’m not suggesting that that’s not a good idea. I am concerned about it being the default where you have a majority of people who already have a lot of their retirement income tied up in an annuity type solution. Chris Nikolich: And that’s where it becomes a plan specific conversation. If you have a low compensated workforce and they’re getting upwards of 50% income replacement from Social Security, I would agree with you. If they’re higher earners and their income replacement is maybe mid teens from Social Security, they don’t have Defined Benefits whereas the generation before them did; those are the participants that could benefit most. And that tends to be a plan specific decision versus one, I would agree with you that you could just make a blanket statement about. Gillian: And with higher income comes higher lifestyle expectations usually in tandem? Chris Nikolich: Yes. Gillian: Okay, and Nick? Nick Nefouse: No, I mean I agree with everything that was said. I think that, you know, I think one of the hard parts we have when we look at plans is once you get above about 10,000 people you start to get this average that comes out. And what you find is there’s a very big spread across the average. So you have your lower paid workers, you have your higher paid workers and then few plans will have multiple 401(k) plans serving a single workforce. But you come up with a problem of some people are really well taken care of and other people may not be. But we’re kind of in the law of averages here hoping to do a very good job for the average worker. Gillian: It provides a nice segway, so you know, of course so often we think about benchmarks when we think of investment success. But your successes may be defined slightly differently. So, Nick, how do you think about the way you set objectives and whether or not you benchmark your success against anything with your Target Date solutions? Nick Nefouse: Yeah. So there’s not a great benchmark for Target Date Funds I think, I made the joke earlier about active versus passive. Target Date Funds, even passive Target Date Funds are active strategies. We’re making decisions, we’re making active decisions along a lifetime about what asset classes to own, how much risk to take. So that being said, there’s not a great way to benchmark these strategies because of … there’s not an index to track next to them. There’s really nothing to look at. There’s some industry numbers we would look at. And I mean I think these are the original and the ultimate outcome oriented strategy. What I would argue is you really want to look at what levels of risk you’re taking, you want to look at your population within your plan to understand does the glide path fit your plan? Does the objective of the fund fit your plan? And I think that’s when it becomes more about is what is the objective? And does that objective line up with the plan as opposed to there’s an index out there and you’ve beaten the index by 2% or you haven’t beaten the index by 2%. Gillian: John, how do you think about benchmarking and success? John Doyle: So I’m going to take a slightly different approach and not … I agree with what Nick said about the challenge of benchmarking the Target Date. As far as looking at the plan and the objectives of the plan and a plan sponsor as they’re putting one together. If you can narrow it down and get them to recognize or at least acknowledge that the goal of having a plan is to get their employees ready to move into retirement, which believe it or not is sometimes a stretch. But if they acknowledge that they want them to be retirement ready then the question is, how do you set your objectives and measurements to see if they are ready for retirement? Because you only own your participant for an average of 5 years, and I think that’s part of the challenge with all of the discussion around retirement readiness, is you just rarely have enough data. So I think what you have to look at is, okay, if my employee is going to be retirement ready, and let’s assume that they’ve had decent behaviors before they join the firm and will have good behavior afterwards. Then what are the three things that I need to address? Obviously, and we talked about this earlier, get them in the plan, get them saving the right amount and then get them invested appropriately. So it’s easy to benchmark participation, you’ve set a goal and you measure it. It’s easy to benchmark savings rates, same thing, if you want the average to be 12%, then that’s your goal and you communicate and you put all sorts of other things in place. The real challenge now is benchmarking how are the investments doing? And the traditional method is let’s look at the line-up, we’ll look at the Target Date and benchmark that the way Nick talked about it. We’ll look at the core line-up and we’ll measure each one against their benchmark. And we’ll pat ourselves on the back and say we’re doing a great job. But if you look at how participants are actually using the core line-up, you end up with a much different picture because you look at the Target Date Fund, those that are in their … are obviously, you know, you’ve done your due diligence, you’ve done the analysis and you’ve made a decision that you think is best for the plan. Then you look at the 50% or more that are investing on their own and look at their personalized rate of return. So don’t look at the investments underneath, look at the personalized rate of return of each individual. So one of the things that I think if you’re trying to measure the success from an investment point of view, is you should compare the individuals who are managing money on their own to their appropriate Target Date Fund or QDIA, as the benchmark. And it doesn’t mean that many are investing more conservatively because they have legitimate reasons to, or more aggressively. But if you’re using it as a benchmark and trying to define, am I being successful in pushing my employees towards retirement. It gives you a different type of benchmark on the investment front than you may normally have had if you were just looking at each individual investment. Gillian: Okay. A really interesting way to frame that, now, Chris, this might seem like a basic question given some of what we have talked about and given the level of active decisions that are taken in Target Date structures. But do you believe that a passive investment plan will shield a plan sponsor from potential lawsuits? Chris Nikolich: No, in a word. We have seen lawsuits already for those that have invested with passive funds. Maybe they haven’t had the right share class or the most appropriate from a cost perspective. As we were talking about earlier, as we think about default funds, there’s no such thing as a passive Target Date Fund. There are some that are passively implemented. But it’s a very active choice in terms of the selection of the underlying components and how that allocation changes over time. Those are very active decisions. And in some cases with a purely passive approach, you may be limiting yourself. You may be limiting yourself to the amount of diversifying assets you have, whether it be inflation protected assets or assets like risk parity or long short or market neutral. These are asset classes you don’t typically see in Target Date Funds. But if you think about that simple 60/40 stock bond plain vanilla portfolio, that returned 9+% a year over the last 5 years. And going forward that’s going to be more like 4%. You need to look beyond traditional asset classes and in some cases you’re limiting yourself with a passive implementation. So it should be about the outcomes versus just I’m trying to shield myself as a plan sponsor from lawsuits. Because who knows if we see in the next couple of years continued choppy markets where passive, where less well diversified strategies don’t do as well. Well, there’ll be lawsuits. Well, how could you not have seen this coming? How could you not have seen an environment where we were going to see inflation or interest rates rising? And you had ample opportunity to do something different and you chose not to. Gillian: John, how do you think about the liability? John Doyle: So I think this is another misperception. There’s a perception with plan sponsors that everything is about low fees and the lowest fee, if you go with the lowest fee you’re protected. And if you go with a passive approach to investing you won’t get sued. And the DOL has never said that. Passive investing is not a safe harbor. And even if you decide to go passive, you still need to do the same amount of due diligence on that fund that you would do on any other fund. So you need to understand if it’s a passive Target Date or a passive standalone asset class, what are the indexes that are being used? How are the indexes built? How do you address changes? I mean, you know, we talked about the Target Date Fund, if you look at just passive Target Date Funds, there’s about a 30% spread in equity at retirement from one to another. And that’s fairly sizeable. So an active decision needs to be made by the plan sponsor if they’re going in that direction. I do think at least for the time being because of all the focus on fees and litigation and lawsuits, that it’s certainly possible that going passive delays a potential lawsuit. But it certainly doesn’t insulate you from a lawsuit. I think that as Chris said, there will be things down the road that may bring into question how you made that decision. The protection you have from being sued is the process you use in making the decision; it’s not about the final decision. And I think that if you don’t have that process in place, if you simply think that you’re going to, you know, take the easy path and go passive because you feel you’re protected, you have really no protection at all. And in fact if the decision is based on the fact that you want to avoid getting sued, you’re probably again in breach of your fiduciary duty, because your fiduciary duty is to make a decision on behalf of the participant, not make a decision on behalf of the safety of the plan committee. Gillian: Nick, final thoughts on this? Nick Nefouse: I couldn’t, I don’t have much to add. Going passive is not going to prevent you from getting sued. It’s about the process. It’s about the process you take. It’s about the suitability of the investment for your investors. Passive could help you with that at some point. It seems the industry is going passive. So that’s what people want to do. We run both active, passive, mixed, custom, we do about everything across the board. And being passive, we run about $140 billion passively. It’s not going to prevent people from getting sued. What’s going to prevent people from getting sued is doing the proper due diligence, putting through the proper process, doing the research. Gillian: We’re coming to the end of our discussion here today. So I just want to give you each an opportunity to offer some closing remarks on what you think anyone that’s watching this program should really take away about the evolution of Defined Contribution and Target Date Funds. So, John, I’ll start with you. John Doyle: Yeah. So I think a couple of the takeaways, understand from a plan sponsor point of view and when you’re working with a plan sponsor, what their goals are. Help them identify their goals if necessary. And then put plans in place. Understand that probably the most important decision that they’re going to make is the Target Date decision, the QDIA decision. And so put that evaluation process in place. And one of the things and the reasons that Target Dates have been so successful is because they look simple to participants. They don’t feel like they have to make a big decision. So try to keep at least the view of the participant into that Target Date Fund as a fairly simplistic one. And if they do that and build the plan around their objectives, they should end up being very successful. Gillian: Great. Chris. Chris Nikolich: You know, we believe that best practices in investment management should be incorporated in Target Date Funds as well. It’s again a mix of active and passive, it’s multi manager, it’s using diversified asset classes. And we for over a decade at AB have been working with the billion and the multibillion dollar plans to construct and implement customer Target Date Funds that can deliver all of this to them. The good news is that you could now from us and others access that in a package, whether it’s in a CIT or a mutual fund, so you don’t have to be a multibillion dollar plan sponsor in your default fund to take advantage of best practice in investment management. Gillian: Great. And, Nick, final thoughts. Nick Nefouse: Yeah. If we can focus more on the individual, I think success for an individual is about savings rate, the QDIA and time. Gillian: Excellent. Well, that was a great note to end on. Thank you all so much for joining us here today for our masterclass. And thank you for tuning in. From our studios in New York, I’m Gillian Kemmerer. This was the Defined Contribution Masterclass. 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