Session 22, Evolution of Target-Date Funds Moderator: Erik Troutman, FSA, MAAA

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Session 22, Evolution of Target-Date Funds

Moderator:

Erik Troutman, FSA, MAAA

Presenters:

Matthew Brancato, CFA, CPA

Jerome Clark, CFA, MBA

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Incorporating Lifetime Income Solutions into

Custom Target Date Funds

Investment Symposium

March 27, 2015

Society of Actuaries

2015

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0 10 20 30 40 50 1948 1956 1964 1972 1980 1988 1996 2004 2012 P e r c e nt of P opula tion

Total, 65 and older Men, 65 and older Women, 65 and older

0 10 20 30 40 50 60 70 80 90 100 1900 1950 1980 2000 2025 (est'd) 2050 (est'd) Male Female A g e i n Y ear s

CHANGING FACE OF U.S. RETIREMENT

35% 56% 65% 75% 20% 40% 60% 80%

Defined Contribution Formula as Primary Retirement Vehicle Prevalence—Types of Retirement Plans

10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

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MOVING FORWARD WITH PLAN DESIGN

Examination of risks & regulatory standards

Plan Funding Risk Investment Risk Longevity Risk Inflation Risk

Traditional DB Employer Employer Employer Employee

Traditional DC Employee Employee Employee Employee

New DC Designs Employee Third Party Third Party Employee

Old New

Source: AllianceBernstein with creative credit to Nationwide

Standard of Care

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Which term best describes most defined contribution plan designs

a) A Secure Retirement Benefit

b) An Investment Portfolio

c)

A Savings Account

FUNDAMENTAL CONCEPTS

Questions for employers & fiduciaries

Which description best fits members of most defined contribution plans

a) Valued Employees & Esteemed Retirees

b) Risk Tolerant & Savvy Investors

c)

Disciplined & Frugal Savers

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5

UTC PLAN INVESTMENT LINEUP

Mutual Funds 10,000+ Funds Available 4,000+ no load/transaction fee

250+ Mutual Fund Families

2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005

Fixed Income Diversifiers Emerging Non-U.S. Equity U.S. Equity - Small U.S. Equity

Target Retirement Funds

Mix & Monitor℠ Core Passive Options Lifetime Income Strategy

U.S. Equity Small Cap Non-U.S. Equity Stable Value Fund Gov./Corp. Bonds Emerging Equity U.S. Equity Large Cap Common Stock & ESOP UTC Ownership

Mutual Fund Window

Risk Parity Fund Real Asset

Fund

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LIFECYCLE SAVING & INVESTING

Theory & practice

Principle 1: Focus not on the financial plan itself but rather on the consumption profile that it implies

Principle 2: View financial assets as vehicles for moving consumption from one location in the life cycle to another

Principle 3: A dollar is more valuable to an investor in situations where consumption is low than in situations where consumption is high

Theory Practice

Lifetime budget constraint Manage realistic expectations,

“Total Wealth” concept Forecast income on statements

Importance of constructing Securing income guarantees

“contingent claims” Negotiate reasonable fees for value

Prices of securities matter! Budget risk relative to point in cycle Risky assets in the life-cycle model

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PUTTING THEORY INTO PRACTICE

Lifetime Income Strategy

A 21st _{Century Pension Design} Secure retirement QDIA offered

through a defined contribution plan Professionally managed investments Retirement income guaranteed by

insurance contracts

Combines a guaranteed floor income benefit with upside potential,

liquidity, optional joint life and beneficiary features

Offers security & certainty in

retirement like traditional pensions while preserving the freedom & flexibility participants want today

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RETIREMENT INCOME ALTERNATIVES

Control Certainty Complete Control Guaranteed Lifetime Income Complete Control No Guaranteed Lifetime Income Traditional Fixed Annuity Systematic Withdrawal

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RETIREMENT INCOME ALTERNATIVES

Systematic Withdrawals

Buy & Hold Treasury Bonds Lifetime Income In Plan Withdrawal Benefit Variable Annuity (Out of Plan GLWB)1 Traditional Fixed Annuity Lifetime Benefit Guarantor Income Protection Indicative Income Fixed Cost Fees

Liquidity & Control Upside Potential

1 _{GLWB – Guaranteed Lifetime Withdrawal Benefit}

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Participant & plan sponsor perspectives

Source: AllianceBernstein

Participants

Lifetime Income (Longevity Protection) Growth Potential (Income Ratchets) Full Liquidity & Control of Assets Simplicity & Portability

Institutional Pricing & Transparency Diversified Insurer Coverage

QDIA (Integrated within Target-Date Portfolio)

Plan

Sponsor/Fiduciary

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Secure Income Portfolio - 60% equity/40% bonds, higher fee, secure income via insured withdrawal benefits Phase-In Period 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% A llo c a tio n %

Target Date Portfolio - Custom target date allocation, low fee, no secure income

Complete solution over lifecycle

As a young saver, invest in a target-date portfolio As a pre-retiree, build secure lifetime income As a retiree, withdraw lifetime income

Age

LIFETIME INCOME STRATEGY

Investment & allocation

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40 50 60 70 80 90 100

Uninsured Balance

1. $100k balance remains invested in target date portfolio and starts building secure income

2. Portfolio grows to $200k by the time participant elects to commence 5% guaranteed withdrawals 3. Participant entitled to withdraw $10k per year in retirement (5% of $200k benefit base)

4. If assets are ever depleted, insurer pays $10k annual income (guaranteed for life)

Point of Election

Accumulation Withdrawal Insurer Payout

Insured Benefit Base

Secure Income 1 2 3 4 Age 100 200 Balance ($000)

LIFETIME INCOME ILLUSTRATION

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Ongoing price discovery Insurer competition Capacity & constraints

Potential indications of solvency risk Adaptable to changing conditions

Integrate new insurers / enhanced benefits Conform to new regulatory requirements Minimize participant disruption

Diversification of issuer risk Insurance Safety Net

MULTIPLE LEAD INSURER DESIGN

Advantages to sponsor

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Approved Insurers Allocation Formula Quarterly Blended Withdrawal Rate 25% Quarterly Poll 5.2% 5.0% 5.0% 25% 50%

Insurer 1 Insurer 2 Insurer 3 Insurance Aggregator

5.1% Diversification, competition & capacity

Record Keeper (Hewitt)

Multi-insurer aggregator platform

Withdrawal rate process

Aggregator polls insurers quarterly

Allocate via rate & diversification formula Fixed fee cannot increase

Purchased benefit cannot decrease

Aggregator interfaces with record keeper & insurers A flexible & extendable operational structure

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Responsibilities

Alliance Bernstein (AB)

Custody and Daily Valuation State Street

Alliance Bernstein (AB), AonHewitt

Manager*/Insurer Selection UTC

Income Benefit Guarantees _{Lincoln, Nationwide & Prudential}

Investment Strategy / Asset Allocation / Glide Path

Operations / Rebalancing

LIFETIME INCOME STRATEGY

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Low utilization rate

Benefit becomes outmoded / Insurers discontinue benefit Insurer insolvency

Aggregator termination / replacement

Early adopter Regulatory

Growth, liquidity and control Flexibility in design

Multi-insurer, insurance safety net Transferable platform

Design control

Broad support and interest

LIFETIME INCOME DESIGN

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BECAUSE YOU CAN Managing service providers at the enterprise reduces cost & improves outcomes

IT’S RIGHT Addressing social impact enhances employment & commercial brands

IT CREATES FLEXIBILITY IN

MANAGING WORKFORCE Retirement ready workforce increases flexibility & reduces severance costs

IT ENHANCES EMPLOYEE

ENGAGEMENT & LOYALTY Actively supporting employees differentiates employment & improves engagement

IT WILL ENHANCE

BARGAINING POWER Retaining assets in the pension plan reduces costs for members & the enterprise

IT WILL ATTRACT HIGHER

QUALITY SERVICERS Elevating plan status internally & externally makes it a more desirable prospect

IT LEVERAGES EXISTING

INFRASTRUCTURE Aligning plan objectives & retirement income creates consistent, whole-life approach

The business case for improving design

WHY INVEST IN RETIREMENT PLANS

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Background &

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Quarterly fund fact sheets

Consistent formatting with other options

Statements include account balance and guaranteed income

On demand, participant-specific benefit estimates

PARTICIPANT COMMUNICATIONS

Lifecycle-based

Simple, concise

Young / Mid-Life Savers: Accumulation

Saving, diversification & long-term investing

Pre-Retirees: Building Protection

Near-Retirement Participants: Ready to Retire?

Saving, diversification, long-term investing & planning for certainty of income at retirement

Maximizing guaranteed retirement income

Retirees: Collecting Retirement Income

Income preservation / purchasing power

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Defines employer objectives for offering retirement benefits

Outlines basic principles used in the design & delivery of benefits Describes how benefits offered are expected to meet objectives

Identifies internal/external constituents who have authority, influence and accountability for design, implementation & oversight

Examples of RPS objectives

Support employee access to secure retirement income

Simplify choice architecture while offering a broad range of risk/return

Emphasize default design with automatic enrollment & automatic escalation Establish & maintain a framework to enhance plan features & options with

manageable participant disruption

Address needs of all plan participants regardless of their “investor” type Offer low-cost investment options, negotiate institutional fees

Maintain access to non-core investments through self-directed window

The Retirement Policy Statement (“RPS”)

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0 10 20 30 40 50 60 70 80 90 100 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100

GLIDE PATH COMPARISON

E q u it y A llo c a tio n % Age

Target Retirement Funds / Lifetime Income Strategy

Lifetime Income Strategy

Target Retirement Funds

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INSURER SELECTION & OVERSIGHT

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TOTAL WEALTH & LIFETIME INCOME

Sources, timing & contingent claims

Longevity Risk

Inflation Risk

Mortality Risk

Employment Risk

Human Capital Financial Capital Source: Morningstar Retirement

Accumulation Phased? Consumption

¥

€

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The Retirement Plan Audit

MORE TOOLS FOR PLAN DESIGN

Ask the following questions

Is it designed to emphasize secure retirement income as a default outcome? Does it address the needs of the broad range of members in the plan?

Can it function effectively with little or no employee direction?

Is it flexible enough to respond if members face unexpected circumstances while they are working or in retirement?

Then take the following actions

Frame thinking in terms of retirement income and lifestyle Help people identify with their older selves

Make default options relevant to the individual Use auto-enrollment and auto-escalation

Provide Future Enrollment and Future Escalation options for those opting out Design defaults with built-in income conversion features

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Final Average Earnings (FAE) DB pension for decades

2002 Cash Balance Plan for new hires

2006 Savings Plan introduces Target Date Funds

2008 Auto-enrollment for new hires

2009 FAE pension sunset* announced

2010 Savings Plan in lieu of pension for new hires

2010 Savings Plan accepts Cash Balance Plan rollovers

2011 Savings Plan investment redesign

2012 Introduction of Lifetime Income Strategy

RETIREMENT BENEFITS

10 Years of accelerating change at UTC

* Future accrual for active FAE participants converts to cash balance design after 12/31/2014

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Retiree/Member Perspective Initial income generation

Protection from risk

Longevity risk Inflation risk

Insurer credit risk

Downside market risk

Annuity conversion rate risk Terms and conditions risk Maximize returns

Access to capital

Employer Perspective Initial income generation

Transferability to another provider In-plan or out of plan

Fiduciary/regulatory concerns Insurer credit risk

Fees

Potential conflicts Other

At least 2 perspectives & 2 checklists

TOOLS FOR PLAN DESIGN

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ACCESSIBLE RESOURCES

Downloads from the Web

The Future of Life-Cycle Saving and Investing, Second Edition

Zvi Bodie, Dennis McLeavey, CFA, and Laurence B. Siegel Research Foundation Publications, (Feb 2008): 1–183

http://www.cfapubs.org/doi/pdf/10.2470/rf.v2008.n1

The Future of Life-Cycle Saving and Investing: The Retirement Phase

Zvi Bodie, Laurence B. Siegel, and Rodney N. Sullivan, CFA Research Foundation Publications, (Oct 2009): 1-76

http://www.cfapubs.org/doi/pdf/10.2470/rf.v2009.n4

Making Investment Choices as Simple as Possible, but Not Simpler

Zvi Bodie and Jonathan Treussard Financial Analysts Journal, May/June 2007, Vol. 63, No. 3:42-47

http://www.cfapubs.org/doi/pdf/10.2469/faj.v63.n3.4689

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Design principles:

Easier to understand, even lower cost, flexible

New fund lineup messaging:

“Let a professional manage it for you”

Target Retirement Funds

“Do-it-yourself…”

Core Options & UTC Ownership

“Do it yourself with more choice”

Mutual Fund Brokerage Window

Behaviorally informed approach

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ACCESSIBLE RESOURCES

More downloads and other material

DOL EBSA Final Rules on Qualified Default Investment Alternatives, 2007

http://www.dol.gov/ebsa/regs/fedreg/final/07-5147.pdf

DOL EBSA Proposed Rules on Annuity Selection in DC Plans, 2007

http://www.dol.gov/ebsa/regs/fedreg/proposed/2007017743.pdf

DOL EBSA Final Rules on Annuity Selection in DC Plans, 2008

https://webapps.dol.gov/FederalRegister/PdfDisplay.aspx?DocId=21588

Social Science Research Network for Social Science Research Delivered Daily

http://www.ssrn.com

CFA Publications for the Latest In Investment Management Research

http://www.cfapubs.org

AonHewitt Retirement Research & Statistics Web Site

http://www.aon.com/human-capital-consulting/thought-leadership/retirement/default.jsp

Mature Markets Institute for MetLife Research on Aging, Longevity & the Generations

https://www.metlife.com/mmi/index.html

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BEHAVIORAL PSYCHOLOGY & RETIREMENT

Focus on what retirement is for Help the imagined “Time Travel” De-emphasize quarterly returns Annuitization should be a default Emphasize expected income Make Default Relevant to the Individual Harness people’s Inertia Active decision-making Money illusion Fairness

Products need to be defined in terms of income and not accumulated wealth

Imagining the future helps making a correct decision

Sensitivity to losses increases significantly after retirement

After the age of 60, cognitive capabilities may decrease rather rapidly and

significantly

It is easier to plan if income is subdivided in accounts; necessary and discretionary Collective default options can

hurt individual needs

Behavioral Default is to do Nothing

Allowing people to select amongst comparable options is helpful Perceived fairness is relevant to retirement products Inflation is difficult to internalize

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PROGRAM IMPLEMENTATION

What happens “under the hood”

 Lifetime Income Strategy Fund displayed as single option for investment elections and transfers

 Quarterly statements include single Lifetime Income Strategy Fund market value & income

 Web requests and accounting activity list single Lifetime Income Strategy Fund

 Some performance pages will display data for sub-funds

 Unique personal rates of return are calculated for participants at plan account-level

 Lifetime Income Strategy program implemented through a single shell fund and multiple sub-funds on recordkeeping platform

 Investment Manager provides investment direction to record keeper for each participant – specific to date of birth and activity.

 Record keeper and Investment Manager exchange balances and activity nightly

 Aggregator supports daily record keeping functions for Lifetime Income Strategy

 Coordinates competitive bidding and allocation process for quarterly withdrawal rates

 Calculates “Income Base” and guaranteed withdrawal amount (“Income Benefit”) per participant

 Coordinates insurer payments through Trustee if market value is depleted

 Track benefits and elections

 Maintain allocated group annuity contracts and insurance company separate accounts

 Pay benefits if market value of account is depleted

Participant

Lifetime Income Strategy Retirement Option

Equity Fund Secure Income Fund Investment Manager Aggregator Platform Insurer 1 Insurer 2 Insurer 3 Bond Fund

Structure delivers custom-built, individual Income Benefits Unique to each participant by date of birth & individual activity

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WHY TARGET DATE FUNDS

HAVE REVOLUTIONIZED THE

DC MARKET

Jerome A. Clark, CFA

Portfolio Manager, T. Rowe Price Retirement Products March 2015

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2

Target Date Utilization is Expected to

Continue to Increase Significantly

Sources: Callan, Casey Quirk. As of June 30, 2013.

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WHY TARGET DATE FUNDS WORK FOR

RETIREMENT PLANS AND THEIR PARTICIPANTS

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4

Benefits of Target Date Funds

for Participants



Provide broad diversification



Asset allocations shift gradually over time



High acceptance and adoption among participants



Very little engagement required from participants in order

to implement the solution

The principal value of target-date funds is not guaranteed at any time, including at or after the target date, which is the approximate date when investors plan to retire. These funds typically invest in a broad range of underlying mutual funds that include stocks, bonds, and short-term investments and are subject to the risks of different areas of the market. In addition, the objectives of target-date funds typically change over time to become more conservative.

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Target Date Funds Address Three Key

Components of 401(k) Plans

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6

Target Date Funds Address 401(k) Plans’

Primary Investment Objectives

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Primary Investment Objectives of

401(k) Plans

TARGET DATE FUNDS ADDRESS THE PRIMARY OBJECTIVES OF A RETIREMENT ACCOUNT

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8

Target Date Funds Address the

Investment Risks of Participants

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10

Market Risk

The two primary objectives of plan sponsors should determine how the three investment risks are balanced.

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Market Risk

2008 WAS NOT THE FIRST BEAR MARKET AND IT WON’T BE THE LAST

The S&P 500 Index has returned less than -5% approximately one out of five calendar years since 1926.

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12

Addressing Market Risk

IMPACT OF EQUITY ALLOCATION ON SHORT-TERM LOSSES

1_{The remainder of the allocation is assumed to be in fixed income and would be the percentage required to equal 100%.}

These charts show the percentage of the time that specific equity and fixed income allocations were able to provide the stated withdrawal rate, adjusted for CPI to last throughout a 20-year or 30-year retirement period based on the historical performance of the indices representing equities and fixed income securities. Please see slide 18 for information about this analysis.

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Longevity Risk

LIFE EXPECTANCIES HAVE INCREASED DRAMATICALLY AND ARE EXPECTED TO CONTINUE INCREASING

ODDS OF AT LEAST ONE MEMBER OF A 65-YEAR OLD COUPLE LIVING TO AGE…

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14

Addressing Longevity Risk

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Inflation Risk

CPI MAY NOT FULLY REPRESENT INFLATION RISK IN RETIREMENT

COMPARISON OF CPI VS. CPI – MEDICAL CARE

January 1961 through December 2014

CPI

SINCE 1960:

● CPI annual growth was 3.91%

CPI – Medical Care

CPI

SINCE 1960:

● CPI – Medical Care annual growth was 5.66% ● CPI annual growth was 3.91%

EQUIVALENT OF $100,000 30 YEARS AGO

CPI

$223,542.10 2.72%

CPI – Medical Care $400,517.24

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16

Addressing Inflation Risk

IMPACT OF INFLATION ON RECEIVING A 4% OR 4.5% WITHDRAWAL RATE THROUGHOUT A 30-YEAR HORIZON

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Target Date Funds Address Challenges in

Participant Behavior

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18

Participants’ Savings Behaviors Indicate

a Need for Adequate Equity

1_{PSCA’s 56}th_{Annual Survey of Profit Sharing and 401(k) Plans (reflecting 2012 plan experience).} 2_{Non-highly compensated workers.}

Participants undersave for retirement, indicating a need for help through adequate capital appreciation.

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Participants’ Asset Allocation Decisions

TARGET DATE FUNDS ADDRESS PARTICIPANTS’ LACK OF ASSET ALLOCATION KNOWLEDGE AND PROPER UTILIZATION

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Participants’ Asset Allocation Decisions

MANY PARTICIPANTS IMPLEMENT EXTREME ASSET ALLOCATIONS

Source: T. Rowe Price Retirement Plan Services 401(k) accounts that are currently active, have a positive balance, and do not include any assets invested in target date funds. Cash includes money market and stable value funds.

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