JOURNEY Fall 2011

WITH THEIR EMPHASIS ON one-stop diversification and active asset allocation, target date funds (TDFs) are taking center stage in DC offerings. The DC landscape, however, faces a fundamental dilemma. While everyone from plan sponsors and recordkeepers to investment managers and advisors is trying to increase the certainty of participants’ retirement income, the participants them-selves still determine how much to save, where to invest and when to withdraw from the plan. Building a successful target date approach requires an understand-ing of the interactions among participants’ inputs into the DC dilemma.

ACTIVE, PASSIVE OR CUSTOM?Choosing the right target date strategy for plan participants

Data as of December 31, 2010.

Powered by Lipper, a Thomson Reuters Company. Of the mutual funds available in Lipper’s databases, as of 12/31/10, 47 fund suites were identified by Lipper as open end target date funds and are available for purchase by qualified retirement plans. (The ETFs—iShares and TDX Independence Funds—are excluded.) Percentage of equity exposure among 2010 TDFs at age 65: Strategic allocation to non-fixed income asset classes at target date, typically age 65. Asset class diversification: Determined by exposure, across each company’s suite of target date funds, to 12 separate asset classes as reported to Lipper through asset allocation, capitalization, credit quality, sector, region and country data as well as underlying fund categorization. Please see the Target Date Compass Methodology booklet for additional information.

EXHIBIT 1: SAME TARGET, DIFFERENT BULL’S EYEDIVERSIFICATION, EQUITY EXPOSURE AMONG 2010 TDFs CAN VARY WIDELY

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Target date funds are poised to dominate the DC market TDFs are set to become the primary investment vehicle in DC plans. Cur-rently, TDFs make up about 11% of the $4.9 trillion DC market and are forecast to grow to 40% to 60% of the market by 2015, according to a September 2010 McKinsey & Co. report, “Win-ning in the Defined Contribution Mar-ket of 2015.” Meanwhile, nearly 70% of plan sponsors have chosen a TDF for their Qualified Default Investment Alternative (QDIA), according to Callan Investments Institute’s 2011 Defined Contribution Trends Survey. Plan sponsors are implementing TDFs in a number of ways. Some are opting for an unbundled, or “open architecture,” approach over an off-the-shelf, single manager approach. Others are adding passive blend approaches in their TDF design that combine active management in less efficient markets and asset classes with index management in more efficient areas, such as U.S. stocks. Meanwhile, as more plan sponsors consider strategies like

re-enrollment to drive more assets into the QDIA, some are evaluating customized TDF solutions where they can tailor a glide path for their partici-pants or use the existing managers in their plan line-up.

Making sense of the target date funds universe With over 30 different TDF approach-es to choose from, selecting the appro-priate solution for a specific plan can be challenging. J.P. Morgan Asset Management’s Target Date Compass is a tool that can help plan sponsors and their advisors compare TDFs across providers and identify those that most closely align with their overall goals. Using publicly available information, each fund family is mapped into one of four quadrants based on its percentage of equity expo-sure at the projected retirement date (X-axis) and the level of asset class diver-sification across the TDF suite (Y-axis). As Exhibit 1 illustrates, there is a wide variance in TDF objectives. The level of equity at retirement, for example, can

range from less than 10% to as much as 65% in 2010 TDFs. Many TDFs have changed their strategies in response to the finan-cial crisis. In 2007 and 2008, for ex-ample, many of the TDF managers in the Southeast quadrant (higher equi-ties, lower diversification) shifted up on the model as they added more as-set classes, while more investment firms also launched new TDFs in the Northeast quadrant (higher equities, higher diversification). In 2009 and 2010, TDFs continued to shift upward, but there was also a slight shift to the center axis as managers reduced their equity exposure in response to mar-ket volatility and the financial crisis. This year, more TDFs are moving from the south to north quadrants even as more firms launch TDFs in the Northwest quadrant (lower equity, higher diversification). Where the TDFs are in their respec-tive quadrants will shed light on their glide paths. As Exhibit 2 illustrates, TDFs in the Northeast quadrant con-tinue to hold higher levels of equity at retirement, while TDF managers in the Southwest quadrant tend to have a more conservative approach and typi-cally pare back the equity positions to about 20% at retirement.

Choosing an appropriate target date fund The first step in selecting a TDF starts with defining the goals for the DC plan as well as the desired outcomes for participants. The next step is to identify the TDFs that seek to produce outcomes that align with those goals. Conducting due diligence on those funds that are in alignment with your goals is the final step. To determine realistic plan goals, plan sponsors will need to examine what they know and don’t know about the current environment and their plan participants. What’s known, for exam-ple, in the current environment is that

plan sponsors are the plan fiduciaries and that 401(k)s and DC plans are fast becoming the primary source of retire-ment income outside of Social Security. The unknown variables in this case in-clude future legislative changes. When it comes to participant char-acteristics, plan sponsors know basic demographic data, such as partici-pants’ age, income levels, average ten-ure and contribution levels. Among the “safe” assumptions they can make: participants aren’t saving enough for retirement, many will start making withdrawals from the plan between the ages of 59 ½ and 65, and most aren’t

familiar with the best ways to use lump sums to extend retirement income. There are also many unknowns, such as what the market environment will be like when participants start making withdrawals. Choosing the appropriate strategy requires an understanding of how re-tirement outcomes are shaped by the TDF design and performance. In our view, outcomes are largely shaped by how a TDF manager approaches three key considerations: the risk- adjusted return potential, volatility management and the level of equity exposure at retirement.

EXHIBIT 2: TARGET DATE FUND DESIGNS ARE BASED ON DIFFERENT GOALS AND ASSUMPTIONS—REPRESENTATIVE ALLOCATIONS OF TARGET DATE FUND APPROACHES FOR COMPARISON

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Source: Industry prospectuses

Northwest Quadrant

Southwest Quadrant

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REITs

U.S. Small CapReal EstateU.S. Fixed Income CommoditiesEmerging Equity

U.S. Large CapEAFE

CashTIPSHigh Yield Emerging Debt

Insights into participant behaviors and their implications for DC investments One of the key insights learned from J.P. Morgan Retirement Plan Services’ participant survey is that participants remain “accidental” investors and saving for retire-ment is a distant second compared with other financial priorities. Consider participants’ responses to the 2008 financial crisis. According to the firm’s survey, less than 10% of people actually made any changes in their plans in the fourth

Source: J.P. Morgan Retirement Plan Services, 2010 Participant Survey.

2% Saving for children’s education

1% Other

5% Saving for emergency fund

5% Paying off/down car loan

49% Paying monthly bills

17% Saving for retirement

10% Paying off/down credit cards

12% Paying off/down mortgage

DAILY EXPENSES ARE MOST IMPORTANT TOP FINANCIAL PRIORITY

quarter of 2008. Meanwhile, only 17% of plan participants say that saving for retirement is a top financial priority, a distant second to pay-ing monthly bills, according to a J.P. Morgan 2010 Participant Survey. In another sign that plan participants are largely “accidental” investors, about 37% of new participants in J.P. Morgan’s recordkeep-ing complex in 2010 joined their DC plan through sponsor direction. In many cases, in-vestors aren’t maximizing the company match or making the full contributions for the year. Indeed, participant engagement—using online advice tools, contacting call centers to ask questions and checking balances—only starts to pick up closer to retirement. And within a few years after retiring, most participants—particularly those with larger balances—tend to quickly pull their assets out of the plan. For plan sponsors, participant behavior can have implications for investment selection. Participants’ lower engagement levels, for example, increases the importance of single, one-stop solutions for participants to make easy decisions. Meanwhile, plan sponsors may want to provide a range of solutions within the core line-up for participants who are accumu-lating assets and also for those who are in the decumulation phase.

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Plan sponsors also need to consid-er how the TDF strategy aligns with the plan’s objectives. TDFs with high-er levels of equity across the glide path will typically result in higher account balances at retirement but with potentially more ups and downs along the way. Conservative TDFs, meanwhile, may sacrifice potential upside but benefit from lower levels of volatility.

Designing a custom target date solution Larger plan sponsors—generally those with more than $500 million in DC assets—are moving today to a custom TDF approach where they have the ability to build a glide path designed for their partici-pants or can use the existing plan’s managers. Custom TDFs may also allow plan sponsors to include alter-native investment structures, such as insurance contracts, hedge funds or direct real estate investments.

Building a custom TDF portfolio can also allow plan sponsors to get more precise about setting their glide path objectives—whether, for instance, they want their glide path to be managed “to” or “through” retirement.

Looking forward A successful retirement program provides the most employees with the highest probability of maintain-ing their standard of living in retire-ment. Plan sponsors must establish realistic goals at the onset and con-sider a range of criteria, such as the current investment environment and participants’ demographic data. Fur-thermore, as more plan sponsors take into account participants’ engage-ment levels throughout their working years, there are opportunities to build better plan line-ups through custom-ized approaches or by adding strat-egies to address longevity, volatility and purchasing power risks.

Publications referenced in this material are presented for general educational purposes only. JPMorgan and its affiliates did not receive any compensation or consideration for refer-encing these titles. The opinions and information presented in these titles do not necessarily reflect the opinions of JPMorgan Chase & Co. and its affiliates.

This document is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to asset classes and financial markets are for illustra-tive purposes only and are not intended to be, and should not be interpreted as, recommendations. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein may employ proprietary projections of expected returns as well as estimates of their future volatility. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Discussions presented should not be construed as legal opinions or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity that you represent or advise. Past performance is no guarantee of future results.

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