Off balance
The unintended consequences of prioritizing one risk in target date fund design
FOR INSTITUTIONAL USE ONLY | NOT FOR PUBLIC DISTRIBUTION
MULTI-ASSET SOLUTIONS FROM J.P. MORGAN
J.P. Morgan Global Investment Management Solutions oversees more than $162 billion in multi-asset solutions worldwide.1 The Solutions team leverages its specialized asset allocation expertise, together with the vast resources of J.P. Morgan Asset Management and its partners and affiliates, to provide customized solutions across asset classes for institutions, third-party intermediaries and individuals. The team blends its experience in capital markets investing, strategic and tactical asset allocation, portfolio construction and risk management with one of the industry’s broadest product offerings to develop and implement optimal portfolio solutions for a wide range of client needs.
A B O U T
T A B L E O F C O N T E N T S
2
F O R E W O R D4
T H E M U LT I FA C E T E D R I S K S O F D C I N V E S T I N G6
TA R G E T D AT E F U N D S : S O LV I N G F O R PA R T I C I PA N T E X P E R I E N C E D R I S K S7
C A S E S T U D I E S : N A R R O W E D V S . D Y N A M I C R I S K M A N A G E M E N T10
R I S K A N A LYS I S 1 : L O N G E V I T Y R I S K12
R I S K A N A LY S I S 2 : M A R K E T A N D E V E N T R I S K15
R I S K A N A LY S I S 3 : I N F L AT I O N R I S K17
R I S K A N A LY S I S 4 : I N T E R E S T R AT E R I S K19
A S T R O N G E R R I S K B A L A N C E21
C O N C L U S I O N22
M E T H O D O L O G Y2 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN 2 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN
WHAT ARE THE BIGGEST RISKS TO PARTICIPANTS’ RETIREMENT
SECURITY? This is one of the most challenging questions plan sponsors and their
advisors must address if they hope to position the largest number of participants for retirement funding success.
Our most recent research focuses on analyzing the risks inherent in the defined contribution (DC) model. In an effort to help understand and effectively manage each of these risks in plan and investment design, we undertook this research to provide a more comprehensive view of the challenges that may potentially deteriorate participant investing experiences. We were especially interested in evaluating the various risk management approaches utilized by different target date funds, given the broad—and rapidly growing—adoption of these strategies in 401(k)s and other self-funded, employer-sponsored retirement plans. Today, these professionally managed multi-asset-class portfolios capture approximately 38% of 401(k) contributions, a figure projected to climb to 88% by 2019.2 We continue to believe that target date funds are the most prudent investment choice for the vast majority of participants.
However, we believe it is equally important to understand how differences in glide path design may enhance or detract from expected retirement outcomes. This is particularly true in how the strategy handles risk management in its portfolio allocation and construction choices. Given the broad number of factors that go into securing retirement funding success, assessing a glide path’s risks entails more than evaluating standard deviations and downside volatility alone. Instead, our analysis examines how different glide paths allocate risk capital and quantifies how these decisions may affect risk/reward trade-offs that could significantly shape participant outcomes. Our research has found:
• DC risk is dynamic and multifaceted. Participants face an array of DC risks, some of which they can control with a high level of certainty, such as accumulation risk, participant-user risk and withdrawal risk. Other risks are driven more by what participants may experience, where the only degree of control they might have is through their saving and asset allocation choices. These include market and event risk, longevity risk, inflation risk and interest rate risk. The magnitude of each risk can also change over time and in response to different market climates, underscoring the importance of taking a broad risk perspective in target date fund design.
• Target date funds that emphasize one particular risk over others can introduce unintended participant experiences. Optimizing a portfolio with multiple asset classes is a delicate balance. Constructing a portfolio that focuses primarily on mitigating one risk may over-expose participants to other potential pitfalls. Our research found several areas of concern with target date funds that prioritized a specific risk in their fund design.
F O R E W O R D
J.P. MORGAN ASSET MANAGEMENT 3 J.P. MORGAN ASSET MANAGEMENT 3
• Dynamic risk management offers the potential for steadier performance results through a broader range of investment climates. Some target date funds claim to manage longevity risk better, while others claim to manage market risk or inflation risk better. Still other target date managers focus on the risk of fee erosion in isolation of other potential additive outcome considerations. The truth is that optimizing participant experiences requires all of these risks—and others—to be closely reviewed and managed through a dynamic risk management approach that is better equipped to more effectively weather all of the potential rigors of retirement investing. The key is to consistently perform relatively well through the widest range of investment climates. This should help deliver the most successful outcomes over the long-term.
J.P. Morgan SmartRetirement strategies were specifically created to take a more realistic, all-encompassing approach to managing the multifaceted nature of DC risk. We developed our glide path based on extensive experience managing multi-asset-class portfolios for some of the world’s largest, most respected institutions, including numerous public and private retirement plans.
We further refined our portfolio design using detailed insights into real-world participant behaviors. The findings of our current research highlight a single
conclusion: Dynamically managing risk across all stages of the glide path can enhance protection against the one risk that truly matters— whether participants will be able to afford to retire.
For more information on evaluating how risk can shape potential retirement outcomes, or about target date fund research, please contact your J.P. Morgan Asset Management representative.
Sincerely,
Lynn Avitabile
Managing Director
Katherine Santiago, CFA
Executive Director
Christie Wootton
Associate
Daniel Oldroyd, CFA, CAIA
4 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN 4 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN
The multifaceted risks of DC investing
The DC industry has experienced a great deal of innovation over the past 10 years as plan sponsors, their advisors, regulators, investment managers and other service providers have continually looked for new and effective ways to help position participants for self-funded retirement success. Many of the resulting solutions have revolved around helping participants either avoid or better manage the potential pitfalls that could lower the odds that they will be able to retire with an adequate level of retirement assets.
The challenge of putting participants—many of whom may be new to investing—on a safe retirement savings path is a complicated one, given the multifaceted nature of risk in a DC investment program. As illustrated in
EXHIBITS 1 and 2 (next page), risks fall into two general categories: participant-controlled risks and participant-experienced risks.
Participant-controlled risks cover areas that hinge on participant behavior. These include accumulation risk, participant-user risk and withdrawal risk. These types of risks are usually the largest determinants of whether participants will secure safe retirement funding, since even the most innovative DC programs still require participants to save enough and invest appropriately. While plan sponsors cannot completely control participant decisions around how much to contribute, how to invest those assets and when to make
EXHIBIT 1: SOME RISKS ARE BEST ADDRESSED THROUGH PLAN DESIGN
Participant-controlled risks PARTICIPANT-USER RISK WITHDRAWAL RISK ACCUMULATION RISK
Possibility that the participant misuses investment options (e.g., too conservative or aggressive, under-diversified)
Risk of needing to withdraw funds prior to retirement
Failure to save enough to retire
J.P. MORGAN ASSET MANAGEMENT 5 withdrawals, smart plan design can help facilitate constructive
behaviors through strategies such as automatic enrollment, contribution matching, automatic contribution escalation and plan re-enrollment.
In contrast, participant-experienced risks are caused by factors that are largely out of the participants’ control. These include longevity risk, market risk, event risk, inflation risk and interest rate risk. These types of risks are usually best addressed through participants’ asset allocation choices and a plan’s target date fund. Over the course of any individual participant’s working years, all of these risks may be experienced to some degree. While it is true that not all will encounter a 2008 market drawdown, hyperinflation or rapidly rising interest rates, an effective asset allocation framework must be structured to weather each of these scenarios reasonably well given the often surprising nature of investing.
No one really knows what the future holds, either in terms of how long any individual might live or what the performance of markets will be, especially short term. What is clear, however, is that participants are retiring all the time and are highly likely to be exposed to one of these risks right as they most need
their assets. This highlights the necessity to extract the most prudent risk-adjusted performance potential from a glide path over the long-term, but equally important is the consistency of returns to help stabilize outcome security over shorter time horizons. Moreover, this emphasis on short-term risk becomes increasingly vital as retirement draws closer and participants prepare to access their investments.
THE MULTIFACETED RISKS OF DC INVESTING
Source: J.P. Morgan Asset Management. For illustrative purposes only.
EXHIBIT 2: PARTICIPANT-EXPERIENCED RISKS ARE BEST ADDRESSED THROUGH PLAN INVESTMENT LINEUP
Participant-experienced risks INFLATION RISK LONGEVITY RISK INTEREST RATE RISK EVENT RISK MARKET RISK
Risk of drawdown as one approaches retirement
Risk of severe loss due to a single extreme market event
Risk that fixed income securities will lose value if rates rise Risk that value of principal will
be eroded by inflation Risk of outliving savings
The evolving nature
of risk
Participant-controlled and participant-experienced risks can change over time, as can regulatory requirements and expectations for capital markets. Consequently, a target date fund’s glide path requires ongoing monitoring to assess if it may also need to evolve in response to these changes.
6 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN 6 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN
Solving for participant-experienced risks
T A R G E T D A T E F U N D S
One of the most significant achievements in managing participant-experienced risks continues to be the introduction of target date funds. These professionally managed multi-asset-class portfolios vastly simplify the retirement investment process for a large—and growing—number of participants, many of whom have been defaulted into these strategies.
For plan sponsors, however, selecting the most effective target date fund has become increasingly complex. There are more than 50 target date mutual fund series available in the market place,3 and the managers of each can employ significant differences in asset allocation, portfolio construction and equity exposure at the point of retirement, all of which can have implications for a strategy’s risk/reward characteristics and expected potential retirement outcomes. Plan sponsors must carefully evaluate the potential ramifications of these differences on participants’ retirement investing experiences.
Fiduciary responsibilities around target date fund selection extend beyond comparing relatively short-term one-, three- and even five-year performance numbers. Saving for retirement can entail a lifetime of investing, and plan sponsors must consider how a specific target date fund design might respond to the many types of market cycle fluctuations that can occur across a 40-plus-year time horizon. For example, participants investing during strong, extended bull markets will have a much different experience than those investing during volatile or severe bear markets, but the reality is that participants may experience both on their paths to retirement. Participants retiring in periods of shorter-term market cycles may see their retirement balances significantly impacted. Remember, different glide paths can perform dramatically different year by year as investing conditions change.
Further clouding this issue is the growing trend of some target date fund managers to differentiate their offerings by emphasizing a specific risk over others. For example, some prioritize longevity risk, while others stress market and event risk. All target date funds offer important diversification benefits, but skewing a glide path to focus more heavily on a particular risk may elevate risks in other key areas, which, in turn, can introduce unintended consequences that may result in greater uncertainty around retirement outcomes as market cycles change. Our research shows that this idea of balance is crucial in managing the diverse range of participant-experienced risks. We believe plan sponsors should carefully evaluate how a target date fund manager approaches this risk balance within the context of what the plan seeks to achieve.
In our opinion, the most prudent goal of a target date fund is to deliver safe levels of retirement income to as many participants as possible as they enter retirement. Market, event, longevity, inflation and interest rate risk management are all important inputs for this goal, but they should be managed collectively through a dynamic risk management approach. This will help determine the target date fund design that performs consistently well against all of these areas collectively, rather than performing best in any one scenario at the risk of falling short in others. Our findings, presented in the sections that follow, illustrate that applying this more expansive view of risk management could help secure stronger outcomes across a broader range of market cycles. 3 Morningstar Direct; data as of December 31, 2014.
J.P. MORGAN ASSET MANAGEMENT 7 J.P. MORGAN ASSET MANAGEMENT 7 In our past target date fund design research, we evaluated the effectiveness of different types of glide path strategies by employing the framework of J.P. Morgan Asset Management’s Target Date CompassSM. This framework maps actual funds in the marketplace into one of four quadrants based on asset class
diversification and equity exposure at the point of retirement. We applied similar evaluation parameters for our risk evaluation, but this time focused on how various popular glide paths approach managing
participant-experienced risks and how this may affect outcome potentials, both positively and negatively. It is important to note that participant risks can change over time and across age cohorts, a fact that should be reflected in a more robust glide path design. For example, market and event risk is less of a threat in the early years but grows increasingly important as retirement approaches and participants have less time to regain any portfolio losses. The later years closer to retirement are also when the amount of assets in the retirement account should be at their highest. Interest rate risk and inflation risk increase as fixed income allocations rise in the later stages of the glide path and into retirement.
Additionally, longevity risk is a factor as participants near retirement. Conversely, accumulation risk remains high in both the early and middle years. One of the most powerful things participants can do to ensure retirement funding success and to maximize the benefits of investment compounding is to start contributing as much as possible early on and to continue to do so steadily throughout their working years.
Participant-user risk continues to remain high during the early and middle years, as asset allocations that are too conservative in the early years can mean participants are missing the substantial larger gain potential of higher risk/reward asset classes. Asset allocations that are too risky in the later stages, however, may fail to lock in these gains and may expose participants to downside losses just when they may need to begin making withdrawals.
The magnitude of these risks can evolve as market cycles change. Interest rate risk, for example, has remained a relatively low practical investment concern for the past few decades but has recently started to weigh more heavily on general market expectations.
Narrowed vs. dynamic risk management
C A S E S T U D I E S
8 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN With this in mind, we began to categorize different target date
fund designs based on how their glide paths address various risks. Through our evaluation we found that some of the most popular target date fund managers tend to over emphasize one risk in their glide path design, with varying implications for exposure to others. We identified four general groups that had adapted their glide path design to focus more narrowly on a particular risk, as well as a fifth segment that applied a more dynamic, balanced approach to managing the full range of participant risks.
• Funds prioritizing longevity risk tend to maintain greater allocations to equities and other higher risk/reward asset classes in the years leading up to and through retirement, based on the belief that participants must maintain greater exposure to these potentially higher return investments to lower their risk of outliving retirement assets. The downside to this approach is that higher equity exposure increases portfolio vulnerability in other areas, such as market and event risk.
• Funds prioritizing market and event risk tend to maintain greater allocations to fixed income and other lower-risk asset classes throughout the glide path in order to protect against negative market events before retirement. The downside is that these funds are then more susceptible to accumulation risk, interest rate risk and longevity risk.
• Funds prioritizing inflation risk tend to maintain greater allocations to inflation-sensitive asset classes in an effort to fortify purchasing power and protect against high inflation and low-growth markets. This increases interest rate risk and longevity risk.
• Funds with concentrated, fee-sensitive glide paths use passively managed strategies to gain specific asset class exposure in portfolio construction rather than actively managed strategies, based on the belief that this offers a more efficient way to invest long-term. However, this means that portfolio managers are often more constrained in asset class choices, since some types of investments are difficult or costly to manage passively. We have included this analysis in the study because the resulting less diversified glide path allocation can increase market and event risk, longevity risk and inflation risk.
• Funds that manage risks dynamically, which includes J.P. Morgan SmartRetirement, pursue a more balanced approach, adjusting over time as various risks rise and fall in magnitude across the glide path. These strategies tend to provide broader asset class diversification, with greater exposure to extended and alternative assets. They also maintain tighter risk controls, particularly in the years leading up to retirement, through a sharp reduction in equity exposure.
EXHIBIT 3 (next page) summarizes how these various approaches to risk translate into glide path designs, highlighting key differences in asset class allocations based on representative funds in each category. Our evaluations of how each might be expected to perform in various investment climates against different, individual risk metrics, as well as the overall effectiveness of each, are presented in the sections that follow.
CASE STUDIES: NARROWED VS. DYNAMIC RISK MANAGEMENT
The potentially
destructive interaction
of risk
Our Ready! Fire! Aim? research highlights that a significant driver of DC success is how the size and timing of cash inflows and outflows interact with the size and timing of portfolio returns. We began analyzing real-world participant usage of 401(k) plans in 2005 and have now gathered a decade of behavioral findings through vastly different market cycles. This research consistently shows that saving and withdrawal patterns are much more varied and volatile than most typical DC models incorporate. This volatility in participant-controlled cash flows, particularly in terms of accumulation and withdrawal risks, can amplify the volatility a participant experiences. Plan sponsors can help mitigate this potentially negative magnifying effect by introducing strategies that reduce volatility in both participant-controlled and participant-experienced risks.
J.P. MORGAN ASSET MANAGEMENT 9
CASE STUDIES: NARROWED VS. DYNAMIC RISK MANAGEMENT
0 20 40 60 80 100 % of portfolio allocation 25 30 35 40 45 50 Age55 60 65 70 75 80 INFLATION RISK MARKET AND EVENT RISK LONGEVITY RISK 25 30 35 40 45 50 Age55 60 65 70 75 80 0 20 40 60 80 100 % of portfolio allocation LONGEVITY RISK INFLATION RISK MARKET AND EVENT RISK 0 20 40 60 80 100 % of portfolio allocation 25 30 35 40 45 50 55 60 65 70 75 80 Age INFLATION RISK LONGEVITY RISK MARKET AND EVENT RISK 25 30 35 40 45 50 Age55 60 65 70 75 80 0 20 40 60 80 100 % of portfolio allocation
U.S. EQUITY FEES
EXHIBIT 3A: FUND THAT PRIORITIZES LONGEVITY RISK 3B: FUND THAT PRIORITIZES MARKET AND EVENT RISK
Comparing glide paths and their focus on risk
EXHIBIT 3C: FUND THAT PRIORITIZES INFLATION RISK 3D: FUND THAT PRIORITIZES LOW FEES
U.S. Large Cap U.S. Small/Mid Cap EAFE Emerging Markets Equity Global Natural Resources
REITs Commodities Direct Real Estate Emerging Markets Debt High Yield
Core Fixed Income International Fixed Income TIPS Cash Alternatives
EXHIBIT 3E: FUND THAT MANAGES RISK DYNAMICALLY: JPMORGAN SMARTRETIREMENT
0 10 20 30 40 50 60 70 80 90 100 25 30 35 40 45 50 55 60 65 70 75 80 % of portfolio allocation Age At and in retirement: Portfolio seeks to preserve participant balances and purchasing power reaching most conservative asset allocations and adding inflation-sensitive asset classes Early years:
High allocation to diversified risk assets allows for higher growth potential
Middle years:
As participant cash flow volatility increases, portfolios de-risk quickly, adding allocations to diversified fixed income asset classes to combat rate risk MARKET AND EVENT RISK MARKET AND EVENT RISK MARKET AND EVENT RISK INTEREST RATE RISK INFLATION RISK LONGEVITY RISK INTEREST RATE RISK LONGEVITY RISK
10 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN 10 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN
R I S K A N A LY S I S 1
Longevity risk
Longevity risk refers to the very real concern that retirees might outlive their assets. Declining mortality rates and rapidly rising health care costs are creating even more pressure in this area. Average American life expectancies continue to expand, and many participants can anticipate spending 25 years or more in retirement. Adequately maintaining living standards over these lengthening time horizons requires higher retirement funding levels. There are two ways participants can address this:
• First, they can increase the amount they save for retirement to levels that ensure they do not run out of money once they start to make withdrawals.
• Second, they can increase exposure to higher risk/reward assets in the hopes of securing greater investment gains that grow assets more aggressively. Although, investing more aggressively strictly to compensate for a savings shortfall is never a good idea given the considerable risks of possibly losing value in the few assets that may be contributed.
Still, most participants are not saving enough for retirement and will need to maintain a larger allocation to higher risk/reward assets to help manage longevity risk. The question is, of course, how much risk is appropriate? Target date funds that prioritize longevity risk in their glide path designs usually maintain significantly greater allocations to equities and other higher risk/reward assets in the years leading up to and through retirement.
Unfortunately, this can also lead to greater market and event risk when participants may be least able to afford any portfolio losses. To help quantify this potential trade-off, we analyzed how each of the five glide path designs might perform once participants began to pull assets out of their accounts post-retirement.4 Simulating a range of market environments and a constant annual 6.5% withdrawal rate, we projected median outcomes of when account assets should be depleted. While higher than what might be expected, this 6.5% rate reflects the withdrawal amount necessary to provide 40% of pre-retirement salary to keep pace with inflation. As shown in EXHIBIT 4 (next page), the fund that prioritized longevity risk had an account balance that lasted the longest, until participant age 97.5, but this was not materially better than the other glide path designs. The fund that prioritized market and event risk predictably ran out of funds earliest, at participant age 93, given its substantially lower exposure to higher risk/reward assets. But the range tightened considerably for the other designs:
• The fund with a concentrated, fee-sensitive glide path lasted until participant age 95. • The fund that prioritized inflation risk lasted until participant age 96.
• J.P. Morgan SmartRetirement lasted until participant age 97, only 6 months short of the fund that prioritized longevity risk.
J.P. MORGAN ASSET MANAGEMENT 11
RISK ANALYSIS 1: LONGEVITY RISK
This is because J.P. Morgan SmartRetirement maintained comparably higher risk/reward exposure at the point of retirement (only 14.2% less than the fund that prioritized longevity risk), but is much more diversified across asset classes, including an 18% smaller exposure to equities. This broader diversification helps to better manage overall expected volatility, should equity markets in particular become difficult.
Moreover, these age differences became even more negligible for participants who fell into the bottom 95th percentile of outcomes. This is an important group to evaluate for plan sponsors concerned with providing retirement security for as many participants as possible, not just for those fortunate enough to enjoy strong markets or optimal saving behaviors. Considering the notable market drawdown exposure of the fund that prioritized longevity risk (presented in the next section: Market and event risk), this seems like a small potential reward at a sizable risk cost. Our Ready! Fire! Aim?
research also shows that more than 90% of participants withdraw assets at or soon after retirement. Based on this behavior, it is clear that the vast majority of participants are using their 401(k) plans to get to, not through, retirement. With this in mind, why skew market and event risk unnecessarily higher with the argument of managing post-retirement longevity risk? Instead, focus on a glide path design that better balances longevity risk with market and event risk in an effort to deliver more consistent performance through the widest range of market climates, not just when equities are rising. This should help secure higher balances for a broader range of participants at the point of retirement, most of whom will withdraw their assets then anyway. In our opinion, adding less than 6 months in potential retirement income does not seem worth taking the substantial added market and event risk throughout the glide path.
$1,600,000 $1,400,000
Median account balance
$0 $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 SmartRetirement Longevity Concentrated
Market and event Inflation
95th percentile account balance
$0 $200,00 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 SmartRetirement Longevity Concentrated
Market and event Inflation
How long will retirement assets last ...
EXHIBIT 4A: ... FOR THE AVERAGE PARTICIPANT? 4B: ... FOR THOSE WITH THE SMALLEST ACCOUNT BALANCES AT —MEDIAN OUTCOMES RETIREMENT?—95TH PERCENTILE
Risk scorecard
Source: J.P. Morgan Asset Management; data as of September 30, 2014. For illustrative purposes only.
Over emphasizing longevity risk by
significantly increasing equity exposure in the years leading up to and through retirement ...
Reduces risk of asset depletion
but ...
Increases
market risk event riskIncreases inflation riskIncreases The modest, potential 6-month increase in retirement income from the fund that prioritized longevity risk does not seem worth the significantly higher exposure to both market and event risk, compared with J.P. Morgan SmartRetirement’s more effective balance of market and event risk and longevity risk.
12 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN 12 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN
Market and event risk
R I S K A N A LY S I S 2
Market risk and event risk generally refer to declines in both equity markets and other higher risk assets that can negatively affect returns. These risks entail both frequency and magnitude of potential losses,
encompassing general day-to-day volatility, as well as severe events that might drive markets sharply lower, such as the burst of the tech bubble in 2000 or the more recent credit crisis. Plan sponsors need only recall how different target date funds fared in 2008 and early 2009 to remember the impact portfolio design can have on this type of downside exposure. The average peak-to-trough performance across target date 2015 vintages during that period ranged from -26.58% to -51.14% for some of the riskiest target date designs.5 Target date fund glide paths typically begin with a majority of holdings in higher risk/reward assets that become increasingly conservative as participants move toward their final target allocation. The timing and steepness of this trajectory can vary significantly, however. The fund that prioritizes market and event risk begins this glide path descent very early and ends at a much lower level of higher risk/reward assets, with 56% of its portfolio in conservative holdings at the point of retirement, almost all represented by core fixed income. Compare that with the 49.2%, 36.5% and 41.8% of conservative holdings at the point of retirement for the funds that prioritize inflation risk and longevity risk, as well as those with concentrated, fee-sensitive glide path, respectively, as well as the 48% for the dynamic, risk-focused J.P. Morgan SmartRetirement. J.P. Morgan SmartRetirement is generally more diversified across cash, core fixed income, Treasury Inflation-Protected Securities (TIPS) and credit, although specific allocations can be markedly different across and even within different vintages.
To evaluate how effectively each design protects against market and event risk, we examined how susceptible each was to potential portfolio losses in the years leading up to retirement. This is a critical period with heightened sensitivity to both market and event risk, since participants are getting ready to tap into their portfolios to solve their income needs in retirement and do not have significant time to recoup any potential losses. As shown in EXHIBIT 5 (next page) we first ran simulations projecting the frequency of any loss based on historical asset class returns. We then reviewed the expected probability of loss using J.P. Morgan’s 2015 Long-Term Capital Market Return Assumptions.
J.P. MORGAN ASSET MANAGEMENT 13 Next, we focused on the worst-case magnitude of past losses,
as well as the probability of varying degrees of a three-year decline in portfolio value based on our forward-looking market projections (EXHIBIT 6).
The fund that prioritized market and event risk offered strong defensive characteristics across all of these simulations, as did the fund that prioritized inflation risk. This would be expected given the larger fixed-income allocations of each of these portfolios. The funds that prioritized longevity risk and those
with concentrated, fee-sensitive glide paths were the most vulnerable to declines, both in frequency and magnitude, again as expected, based on their heavier reliance on outsized equity exposure and fewer diversifying asset classes, respectively. J.P. Morgan SmartRetirement placed firmly in the middle, notably it’s because the strategy maintained a relatively larger allocation to higher risk/reward assets in an effort to enhance risk-adjusted performance, even as retirement approached. Its much broader asset class diversification, however, allowed the
1 year to retirement 3 years to retirement 5 years to retirement
Frequency of occurance 0% 2% 4% 6% 8% 10% 12%
14% SmartRetirement Longevity Concentrated Market and event Inflation
1 year to retirement 3 years to retirement 5 years to retirement
Annualized return
SmartRetirement Longevity Concentrated Market and event Inflation -30% -25% -20% -15% -10% -5% 0% 5% Frequency of occurance
SmartRetirement Longevity Concentrated Market and event Inflation
1 year to retirement 3 years to retirement 5 years to retirement 0% 5% 10% 15% 20% 25% Size of loss Frequency of occurence 0% 2% 4% 6% 8% >5% >10% >15%
SmartRetirement Longevity Concentrated Market and event Inflation
How likely is it the portfolio will suffer losses as participants approach retirement?
EXHIBIT 5A: HISTORICAL FREQUENCY OF LOSS 5B: EXPECTED PROBABILITY OF LOSS
How large might these losses be?
EXHIBIT 6A: WORST HISTORICAL RETURN PRECEDING RETIREMENT 6B: PROBABILITY OF A NEGATIVE 3-YEAR RETURN PRECEDING RETIREMENT
Source: J.P. Morgan Asset Management; data as of September 30, 2014. For illustrative purposes only.
Funds that prioritized longevity risk and with concentrated, fee-sensitive glide paths were three and four times more likely, respectively, to experience negative three-year returns immediately prior to retirement than was the fund that over emphasized market and event risk.
There is a wide 16.3% to 24.0% probability range for potential loss in the year prior to retirement, with funds that prioritized longevity risk and with concentrated, fee-sensitive glide pathsbeing most susceptible to declines. Source: J.P. Morgan Asset Management; data as of September 30, 2014. For illustrative purposes only.
14 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN
RISK ANALYSIS 2: MARKET AND EVENT RISK
Risk scorecard
Over emphasizing market and event risk by sharply elevating core fixed-income allocations ...
Reduces frequency and magnitude of portfolio loss
but ...
Increases
accumulation risk interest rate riskIncreases longevity riskIncreases design to reduce reliance on equity performance significantly in
the years leading up to retirement, offering attractive downside protection but without overly constraining upside potential. This reiterates the importance of balancing risk in glide path design. Our Ready! Fire! Aim? research shows that target date funds that tightly control volatility can play a powerful role in positioning a greater number of participants for retirement funding success, but only if the design does not excessively restrict long-term return potential. More aggressive equity allocations may result in greater losses when participants are most sensitive to balance declines, but playing it too safe can leave them falling short in potential long-term retirement outcomes.
Hence, over emphasizing market and event risk in design results in far greater accumulation risk, as participants must save more to overcome the lost return potential of less
exposure to higher risk/reward assets when markets are normalized. In addition, managing market and event risk exposure by sharply increasing conservative fixed-income allocations intensely elevates interest rate risk, as well as longevity risk if the emphasis is purely on core fixed income. History has also shown that all but the highest quality bonds tend to decline during periods of extreme market stress, making it unrealistic to base a long-term glide path around this possibility; the lost return opportunity costs are simply too great. That is why we believe the defensive attributes of broader diversification offer more prudent protection against market and event risk when it comes to pursuing optimized, long-term retirement outcomes.
Are low-fee target date funds less risky?
Some plan sponsors focus on passive, or “indexed,” target date funds because they think these typically lower-cost strategies are somehow less risky. The only components that can be indexed in a target date fund, however, are the underlying strategies used in portfolio construction. There is no such thing as an indexed glide path. All glide paths have been actively built by the manager, and each comes with unique risk/reward characteristics.
Indeed, these low cost strategies may actually increase participant risk. In an effort to keep cost low, managers
with a bias towards fee sensitivity may rely strictly on easily indexed asset classes to drive returns. The unintended consequence of this is their glide paths are usually less diversified. This has historically reduced long-term outcome potential and increased volatility exposure in areas such as market and event risk, and longevity risk. Low cost also usually means buy-and-hold, which eliminates any ability to implement tactical asset allocation shifts that may add return potential by taking advantage of opportunistic short-term market dislocations.
J.P. MORGAN ASSET MANAGEMENT 15 J.P. MORGAN ASSET MANAGEMENT 15
R I S K A N A LY S I S 3
Inflation risk
Managing a fund with an eye toward inflation involves protecting the purchasing power of retirement assets. Most target date funds have been successful in safeguarding against the erosive effects of inflation over the long-term by helping participants keep ahead of generally rising prices. The fund that prioritizes inflation risk places even greater weight on this goal, with its glide path emphasizing assets that have a direct relationship with inflation, such as TIPS, real estate and commodities. Of note is its particularly large allocation to TIPS— more than 30% of its conservative holdings—in the years leading up to retirement, when participants typically become more sensitive to higher inflation.
To help assess the effectiveness of this approach, we first evaluated the frequency with which each glide path design delivered historical returns above inflation in the years preceding retirement. While there were moderate differences in success across shorter time frames, all produced positive real returns 100% of the time over 10-year periods, although the fund with a concentrated fee-sensitive glide path lagged somewhat (EXHIBIT 7, next page).
We then reviewed how each design might be expected to perform specifically during inflationary environments. We simulated periods when inflation was rising and also when it was high and falling, both of which can be restrictive to investment performance.
As shown in EXHIBIT 8 (next page), the fund that prioritized inflation risk delivered positive real returns slightly more frequently, with the fund that prioritized market and event risk and J.P. Morgan
SmartRetirement following close behind. Interestingly, this modest outperformance was the result of securing stronger real returns when inflation was rising. When inflation was high and falling, J.P. Morgan SmartRetirement actually outperformed the fund that prioritized inflation risk, as did the fund that prioritized market and event risk.
This is because the fund that prioritized inflation risk relies heavily on TIPS. TIPS tend to perform best when inflation is rising, but can lag when it is falling; these securities also tend to be more volatile than other traditional fixed-income assets. The net result was that the fund that prioritized inflation risk was highly effective at handling inflationary shocks, but less so across the entire cycle. Therefore, to address inflation risk and maintain purchasing power, we believe it is important to hold a diversified basket of inflation-sensitive securities such as commodities, natural resources and real estate, in addition to TIPs. This broader approach may perform better in multiple inflationary environments, not just when inflation is rising.
16 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN
RISK ANALYSIS 3: INFLATION RISK
Risk scorecard
The fund with a concentrated fee-sensitive glide path fell behind inflation more frequently than the other funds in the years leading up to retirement.
Longevity Concentrated SmartRetirement Market and event Inflation 75% 80% 85% 90% 95% 100%
10 year 5 year 3 year 1 year
Frequency of real returns
Years preceeding retirement 50% 55% 60% 65% 70% 75% 80% 85% 90%
Frequency of real returns
Inflation environment
SmartRetirement Longevity Concentrated Market and event Inflation
All inflation Rising inflation High and falling
Has the portfolio outpaced inflation?
EXHIBIT 7: HISTORICAL RETURNS ABOVE INFLATION
How will the portfolio perform in inflationary periods?
EXHIBIT 8: FREQUENCY OF REAL RETURNS
Source: J.P. Morgan Asset Management; data as of September 30, 2014.
For illustrative purposes only. Source: J.P. Morgan Asset Management; data as of September 30, 2014. For illustrative purposes only.
Over emphasizing inflation risk by mainly increasing TIPS exposure ...
Reduces risk when inflation is rising
but ...
Less effective when
inflation is high and falling interest rate riskIncreases longevity riskIncreases The fund that prioritized inflation risk actually under-performed other strategies when inflation was high and falling.
J.P. MORGAN ASSET MANAGEMENT 17 J.P. MORGAN ASSET MANAGEMENT 17
R I S K A N A LY S I S 4
Interest rate risk
Interest rate risk refers to a portfolio’s sensitivity to rising interest rates. Given the fixed-income exposure inherent across all glide paths, interest rate risk progressively grows as participants move closer toward retirement. After years of extremely low interest rates, many expect higher rates ahead as the Federal Reserve (Fed) unwinds its quantitative easing efforts. Similar to the risks discussed earlier, the key to managing this threat appears to be through broader diversification.
To help quantify interest rate sensitivity, we examined how the five designs performed during the past nine Fed interest rate increases. Predictably, the funds that prioritized market and event risk and inflation risk fell the most in value due to their larger fixed-income holdings, while the fund that prioritized longevity risk was the only one to rise in value as a result of its lower fixed-income exposure. In the middle was the fund with a concentrated fee-sensitive glide path, as well as J.P. Morgan SmartRetirement, both of which limited losses relative to other glide paths by as much as 200 bps (EXHIBIT 9, next page).
Next, we simulated how much each design might lose in value for every 1% rise in interest rates. Again, the funds that prioritized market and event risk and inflation risk would be expected to decline the most. J.P. Morgan SmartRetirement, the funds that prioritized longevity risk and the funds with a concentrated, fee-sensitive glide path were less vulnerable. All three funds delivered comparable results, falling only about half as much as the more sensitive designs.
Keep in mind, however, that the funds that prioritized longevity risk and those with a concentrated fee-sensitive glide path both accomplished this mainly because of their larger allocations to equities and other higher risk/reward assets, which, in turn, increased their market and event risk exposure. In comparison, the J.P. Morgan SmartRetirement better managed both market and event risk and interest rate risk through broader diversification within higher risk/reward assets, as well as within fixed-income holdings that include asset classes less susceptible to climbing interest rates, such as emerging market debt and high yield bonds.
18 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN
RISK ANALYSIS 4: INTEREST RATE RISK
Risk scorecard
Funds that prioritized market and event risk and inflation risk might lose more than double compared with other designs when interest rates rise.
Annualized real return Annualized real return
-5% -4% -3% -2% -1% 0% 1%
SmartRetirement Longevity Concentrated Market and event Inflation
-5% -4% -3% -2% -1% 0% 1%
Historical return over past 9 rate hikes Isolated loss with 100bps rise in interest rates
What happens to performance if interest rates rise?
EXHIBIT 9A: GLIDE PATH PERFORMANCE DURING EXHIBIT 9B: PERCENTAGE LOST WITH 1% RISE IN RATES RISING RATE ENVIRONMENTS
Larger allocation to more concentrated domestic equities and other risk/reward assets can ...
Lower interest rate sensitivity
but ...
Increase
market risk event riskIncrease inflation riskIncrease Source: J.P. Morgan Asset Management; data as of September 30, 2014. For illustrative purposes only.
J.P. MORGAN ASSET MANAGEMENT 19 J.P. MORGAN ASSET MANAGEMENT 19 A dynamic risk management approach appears to deliver more consistent, expected returns across changing market cycles by navigating all of these risks reasonably well, rather than excelling in one area to the detriment of another.
A stronger risk balance
The key takeaway from this research is the intricate nature of risk management in target date fund design. Over emphasizing one risk may better address that particular risk, but it often elevates exposure to other risk areas when a more diverse set of circumstances is considered. This narrow risk focus may result in less optimal retirement outcomes over the many types of economic cycles that can occur over a lifetime of investing. The fact is that any type of target date fund is usually more effective for participants, when compared to the results most retail investors achieve when left on their own to allocate their assets. Still, our findings once again highlight that differences in glide path design can greatly affect the quality of outcomes that
participants experience. As such, plan sponsors must consider the ramifications of the various approaches to target date fund design if they hope to help as many participants as possible reach adequate retirement saving levels.
We created a risk ranking (EXHIBIT 10) to help summarize the relative ranking of each glide path’s effectiveness based on simulations replicating each individual risk scenario. Viewed collectively, these results show that the overall asset allocation of the glide path can have more of an impact on participant outcomes than the underlying holdings making up the portfolio.
EXHIBIT 10: RISK RANKINGS BASED ON MARKET SIMULATIONS
Source: J.P. Morgan Asset Management. For illustrative purposes only.
SmartRetirement Market & event
Inflation Concentrated Longevity Market and event risk Inflation SmartRetirement Concentrated Longevity
Market & event
Longevity risk
Market & event
Inflation SmartRetirement Concentrated Longevity Inflation risk
Market & event
Inflation SmartRetirement Concentrated Longevity Interest rate risk
20 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN
A STRONGER RISK BALANCE
Source: J.P. Morgan Asset Management; data as of September 30, 2014. For illustrative purposes only. Performance is an aggregate of all vintages in the series. For additional information on the research findings and performance methodology refer to “Off Balance—The unintended consequences of prioritizing one risk in target date design.”
For illustrative purposes only.
8% 9% 10% 11% 12% 13% 14%
Annualized returns
Annualized volatility Market and event
SmartRetirement Inflation Longevity Concentrated 5% 6% 7% 8% Annualized returns Annualized volatility 5% 6% 7% 8%
Market and event SmartRetirement
Concentrated
Longevity Inflation
8% 9% 10% 11% 12% 13% 14%
Historical and forward-looking expected risk/reward characteristics
11A: FORWARD-LOOKING GLIDE PATH PERFORMANCE 11B: 10-YEAR HISTORICAL GLIDE PATH PERFORMANCE
Evaluating target date fund risk management
J.P. Morgan’s Selecting Target Date Funds: The RFP Process can help plan sponsors evaluate the wide range of available target date fund designs. This sample request-for-proposal structure includes questions
developed through independent legal research to help plan sponsors meet ERISA’s prudent process requirement for target date fund selection. J.P. Morgan SmartRetirement performed consistently well across
each risk aspect by applying a dynamic approach to risk management, rather than prioritizing any one area that may skew negative results in another. The benefits of this balanced risk focus are more consistent, expected investment results through all market cycles. This is in stark contrast to the other four designs, which tended to offer attractive defensive characteristics in specific risk scenarios but performed dramatically worse in others. The extent of this variability is reflected in each design’s position on the risk ranking.
Given its stronger, comprehensive risk management
approach, J.P. Morgan SmartRetirement appears to offer the most optimal risk/reward balance. EXHIBIT 11 shows the strategy’s historical and forward-looking expected 10-year returns. In both cases, J.P. Morgan SmartRetirement delivered expected returns above or comparable to other target date strategies, but with less volatility. Using this design helps to keep participants’ assets working as hard as possible, but with substantially less overall risk across a fuller range of
J.P. MORGAN ASSET MANAGEMENT 21 J.P. MORGAN ASSET MANAGEMENT 21
Conclusion
Calibrating for risk in target date fund design is a complex process. It requires a comprehensive view of the types of risks that might derail participants from achieving adequate levels of retirement funding, as well as an understanding of the consequences—both intended and unintended—of trying to solve for these risks in a certain way.
Our findings illustrate how the risks a target date fund manager chooses to focus on may affect participant outcomes, particularly in the sensitive years leading up to retirement. With the growing prevalence of different managers claiming to manage against a specific risk more effectively in their glide path, plan sponsors need to weigh, when reviewing both long- and short-term outcome potential, if a particular approach might be additive under a certain set of circumstances but possibly detractive in other areas. Accumulation risk, participant-user risk, withdrawal risk, market and event risk, longevity risk, inflation risk and interest rate risk—all of these critical inputs must inform glide path design if the goal is to deliver as many participants as possible safely to retirement. The key is to capture long-term performance consistency by pursuing an effective and balanced glide path that addresses the changing and often unexpected nature of DC risks.
J.P. Morgan SmartRetirement’s dynamic risk management approach focuses on each of these DC risks when they matter most. Our glide path is designed to help keep participants on a tighter track to achieving retirement funding success by reducing the threat of being thrown off balance by any market surprises.
22 OFF BALANCE: THE UNINTENDED CONSEQUENCES OF PRIORITIZING ONE RISK IN TARGET DATE FUND DESIGN Analysis in this paper uses a combination of backward-looking
historical index returns and forward-looking risk and return assumptions to calculate the various metrics of each risk discussed.
Data sources
Both historical- and forward-looking returns are based on index level returns only and make no assumptions about the potential for active alpha achieved above those returns. Historical index returns are based on the index series listed below for the period of January 1, 1975 through September 30, 2014. For data prior to index availability, index returns were chosen for the most likely asset allocation substitution, indicated below. Forward-looking risk and return assumptions are based on J.P. Morgan Asset
Management 2015 Long-Term Capital Market Assumptions.
Index sources
US Large Cap Equity–S&P 500 Total Return Index; US Small Cap Equity–Russell 2000 Total Return Index; International Equity–MSCI EAFE Index; Emerging Market Equity–MSCI EM Free Index (replaced with MSCI EAFE for data prior to 1985); US Fixed Income–Barclay Capital US Aggregate Index (replaced with Barclay Aggregate for data prior to 1984); International Fixed Income– Citigroup WGBI ex-US All Maturities Index Currency Hedged USD; High Yield Corporate–Barclay Capital US Corporate High Yield Bond Index (replaced with Barclay Aggregate for data prior to 1983); Emerging Market Debt–JP Morgan EMBI Global Index (replaced with Barclay Capital US Corporate High Yield Bond Index prior to 1991 and Barclay Aggregate for data prior to 1983); Inflation Linked Bonds–Barclay Capital US TIPS Index (J.P. Morgan Asset Management simulated returns prior to 1997; simulated returns are based on estimated real yields equivalent to U.S. Treasury nominal yields minus the previous period’s inflation and rolling 3-year volatility); Commodity–Bloomberg Commodity Index Total Return; Direct Real Estate–NCREIF Index Total Return (replaced with NAREIT Index prior to 1978); Cash–US 3-month T-bill total return; Inflation–US CPI-U Index (year-on-year return).
Market risk and event risk
In order to capture both the likelihood and magnitude of negative market returns, we have separated this risk into market risk and event risk. All periods are based on the cumulative returns ending at the point of retirement and assume a monthly rebalancing of the portfolio and annual asset allocation moving along the glide path.
Market risk is a calculation of the likelihood of a negative return, of any size, based on historical frequency or forward-looking
probability. The historical frequency of negative returns is calculated as the number of negative rolling 1-year, 3-year and 5-year returns since 1975, ending at the point of retirement divided by the total number of rolling 1-year, 3-year and 5-year periods since 1975. The forward-looking probability is the probability of a negative 1-year, 3-year or 5-year return ending at the point of retirement based on a Monte Carlo simulation using J.P. Morgan Asset Management 2015 Long-Term Capital Market Assumptions, where 10,000 different market return series based on a lognormal distribution of returns were applied to all portfolios.6
Event risk measures the size and probability of a significant market loss. For historical analysis, we identified the largest historical drawdown over a rolling 1-year, 3-year and 5-year period since 1975 (for all cases this resulted in the period ending February 2009). The forward-looking analysis calculates the probability of a loss greater than -5%, -10% or -15% based on the same 10,000 Monte Carlo simulations as described previously.
Longevity risk
Longevity risk is measured as the age at which the portfolio depletes to zero after market returns are combined with annual withdrawals equalling 6.5% of initial portfolio, growing with inflation.
Withdrawal rate: Instead of assuming a flat 4% or 5% withdrawal rate in retirement, we looked at the implied rate of withdrawal based on the income replacement likely needed in retirement.7
Based on analysis by Aon/GSu,8 a typical investor reaching
retirement with a salary of around $80,0009 will need
approximately 40% of his/her salary annually, which when combined with the income received from Social Security will provide a suitable replacement income to maintain his/her current standard of living. Assuming a simple annual contribution rate of 10% and modest salary growth rate during accumulation, the investor will reach retirement with an expected level of assets between $500,000 and $550,000 (for the majority of glide path designs used in this study). This will imply an initial withdrawal rate of around 6.5% of the portfolio, which we assume to grow annually with inflation.
Target Date Fund Risks Methodology
6 J.P. Morgan, “Ready! Fire! Aim?,” 2007. 7 J.P. Morgan, “Breaking the 4% Rule.”
8 Aon Consulting’s 2008 Replacement ratio study. 9 J.P. Morgan, “Ready! Fire! Aim?,” 2007.
J.P. MORGAN ASSET MANAGEMENT 23
TARGET DATE FUND RISKS METHODOLOGY
Forward looking: Outcomes are determined by a Monte Carlo simulation with 10,000 different periods of 100 years with different market return series. Each simulation assumes an annual
contribution rate prior to retirement of 10% and an annual salary starting at $50,000, which grows at around 1.5% above inflation to reach $80,000 at retirement (in today’s dollars). At the point of retire-ment, the contributions stop and an annual 6.5% withdrawal rate is applied to the retirement portfolio, which grows annually with inflation. We determine the median, 75th and 95th percentile of ages achieved prior to the portfolio reaching a terminal value of $0.
Historical: There are currently a limited number of historical data period that can be used for this analysis, which would cause the results to potentially be misleading when compared to a broader forward-looking sample; therefore, it has not been included in this paper at this time.
Inflation risk
Given the non-linear relationship between inflation and asset returns,10 inflation risk calculations focus solely on historical return
patterns since 1975 to keep the analysis intuitive. Calculations are based on the historical frequency of returns over different periods (rolling 10-years, 5-years, 3-years and 1-year) exceeding the rate of inflation over those same periods. All periods are based on the cumulative returns ending at the point of retirement and assume monthly rebalancing of the portfolio and annual asset allocation moving along the glide path.
In addition to looking over all rolling periods, we also isolated periods of rising inflation versus falling inflation and high versus low inflationary environments over rolling 1-year periods to better identify the reaction a portfolio may have to changes in inflation. Rising inflation environments are defined as a period when the current inflation is higher than the rate of inflation 3 months prior. A high inflation environ-ment is defined as inflation above 4% year-on-year.
Interest rate risk
Forward looking: Duration is a standard measure of interest rate sensitivity. To translate that common measure into actual downside risk, we took the current duration of the Target Date 2015 portfolios based on the weighted average of the current underlying index level durations (assuming zero duration for non-fixed income assets).11 The portfolio’s duration can provide the
potential percentage loss for the portfolio given a 100 bps rise in interest rates (potential loss = -duration/100 bps) and assuming no return for the remaining assets in the portfolio.
Historical: Because there are non-static correlations between assets over time, a diversified portfolio will not necessarily behave in line with the simple duration measure. Therefore, we also identified the historical returns during period of interest rate rises. We identified the past nine interest rate hiking cycles in the U.S. determined by the federal funds rate (all periods of interest rate hikes since 1975 defined as starting at the first rate move and ending at the terminal high rate) and calculated the annualized portfolio returns based on index returns. We then calculated the portfolio’s average real returns over these nine periods by subtracting the cash return in order to adjust the total returns for the expected level of interest income to be received given the current level of interest rates versus the significantly high levels they have been historically.
Risk ranking
Risk rankings for each risk is determined by comparing the average outcome of each glide path versus each other. For each risk, we took an average of the different data points we have discussed (a list of the final data points included are below). We then calculated the standard deviation of those results to measure the distance between the points and obtain an equivalent measure for each risk that indicates not only the best and worst glide paths but also how far apart each glide path was from each other. The overall ranking is an average of these standard deviations.
Market risk: Average of market risk and event risk: Average of the historical frequency of loss and forward-looking probability of loss for rolling 3-year returns, worst 3-year return and expected probability of loss more than -10%.
Longevity risk: Average of the age at portfolio depletion for median outcomes and 75th percentile outcomes.
Inflation risk: Average of the probability of real return over one year for “All Periods” and the “High and Rising Period.”
Interest rate risk: Average of negative duration (higher duration is worst) and historical percentage loss.
Overall ranking is average of these four rankings.
10 J.P. Morgan, “Keeping It Real.”
The projections utilized throughout are based on J.P. Morgan Asset Management Capital Market assumptions are provided for illustration/discussion purposes only and are subject to significant limitations. “Expected” or “alpha” return estimates are subject to uncertainty and error. For example, changes in the historical data from which it is estimated will result in different implications for asset class returns. Expected returns for each asset class conditional on an economic scenario; actual returns in the event the scenario comes to pass could be higher or lower, as they have been in the past, so an investor should not expect to achieve returns similar to the outputs shown herein. References to future returns for either asset allocation strategies or asset classes are not promises of actual returns a client portfolio may achieve. Because of the inherent limitations of all models, potential investors should not rely exclusively on the model when making a decision. The model cannot account for the impact that economic, market and other factors may have on the implementation and ongoing management of an actual investment portfolio. Unlike actual portfolio outcomes, the model outcomes do not reflect actual trading, liquidity constraints, fees, expenses, taxes and other factors that could impact the future returns. The model assumptions are passive only— they do not consider the impact of active management. A manager’s ability to achieve similar outcomes is subject to risk factors over which the manager may have no or limited control.
RISKS ASSOCIATED WITH INVESTING IN THE FUNDS. Certain underlying J.P. Morgan Funds may invest in foreign/emerging market securities, small capitalization securities and/
or high-yield fixed income instruments. There may be unique risks associated with investing in these types of securities. International investing involves increased risk and volatility due to possibilities of currency exchange rate volatility, political, social or economic instability, foreign taxation and differences in auditing and other financial standards. The Fund may invest a portion of its securities in small-cap stocks. Small-capitalization funds typically carry more risk than stock funds investing in well-established “blue-chip” companies since smaller companies generally have a higher risk of failure. Historically, smaller companies’ stock has experienced a greater degree of market volatility than the average stock. Securities rated below investment grade are called “high-yield bonds,” “non-investment grade bonds,” “below investment-grade bonds” or “junk bonds.” They generally are rated in the fifth or lower rating categories of Standard & Poor’s and Moody’s Investors Service. Although these securities tend to provide higher yields than higher rated securities, there is a greater risk that the Fund’s share price will decline. Real estate funds may be subject to a higher degree of market risk because of a concentration in a specific industry, sector or geographical sector. Real estate funds may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by the borrower. The underlying funds may use derivatives, which are instruments that have a value based on another instrument, exchange rate or index. In addition, the Fund may invest directly in derivatives. Derivatives may be riskier than other types of investments because they may be more sensitive to changes in economic and market conditions than other types of investments and could result in losses that significantly exceed the Fund’s or the underlying funds’ original investments. Many derivatives will give rise to a form of leverage. As a result, the Fund or an underlying fund may be more volatile than if the Fund or the underlying fund had not been leveraged because the leverage tends to exaggerate the effect of any increase or decrease in the value of the Fund’s or the underlying funds’ portfolio securities. Derivatives are also subject to the risk that changes in the value of a derivative may not correlate perfectly with the underlying asset, rate or index. The use of derivatives for hedging or risk management purposes or to increase income or gain may not be successful, resulting in losses, and the cost of such strategies may reduce the Fund’s or the underlying funds’ returns. Derivatives also expose the Fund or the underlying funds to the credit risk of the derivative counterparty. There may be additional fees or expenses associated with investing in a Fund of Funds strategy.
TARGET DATE FUNDS. Target date funds are funds with the target date being the approximate date when investors plan to start withdrawing their money. Generally, the asset
allocation of each fund will change on an annual basis with the asset allocation becoming more conservative as the fund nears the target retirement date. The principal value of the fund(s) is not guaranteed at any time, including at the target date.
We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
Contact JPMorgan Distribution Services at 1-800-338-4345 for a fund prospectus. You can also visit us at www.jpmorganfunds.com. Investors should carefully consider the investment objectives and risks as well as charges and expenses of the mutual fund before investing. The prospectus contains this and other information about the mutual fund. Read the prospectus carefully before investing.
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. JPMorgan Funds are distributed by JPMorgan Distribution Services, Inc., which is an affiliate of JPMorgan Chase & Co. Affiliates of JPMorgan Chase & Co. receive fees for providing various services to the funds. Products and services are offered by JPMorgan Distribution Services, Inc., is a member of FINRA/SIPC.
J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, JPMorgan Chase Bank N.A., J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. Copyright © 2015 JPMorgan Chase & Co.
March 2015 RI-WP-RISK
RETIREMENT INSIGHTS
FOR INSTITUTIONAL USE ONLY | NOT FOR PUBLIC DISTRIBUTION
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