Is there a default default?Benefits Canada

DC Investment Forum

Toronto, September 2014

Scott Lothian | Schroders Global Strategic Solutions

September 2014 | For professional investors only. This material is not suitable for retail clients

So why is it so hard to figure out?

It’s a simple equationIt applies in all DC markets

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Size of your DC pension account at retirement

= How much you/your employer saves

+ how much interest/return you get on your savings

- fees/costs for managingyour money

Why is it so hard to figure out?Lots of uncertainties

How much to contribute?Who will contribute on my behalf?

How long will I be able to contribute for?What costs will I incur?

How much will I need to retire on?What returns will I get?

What will I need to buy in retirement?How will prices increase?

What if I change my job?What if I lose my job?

When will I retire?What other savings do I have?

Will I get a state pension?What if I die early?

What if I die late?2

ContributionsTime

Returns

The main stages in a DC member’s lifetime

3

Earning and saving Pre-retirement Early retirement Late retirement

Understanding DC risksKey risks change over a member’s lifetime – inflation never goes away

4

Source: Schroders. For illustration only

Earning and saving

Insufficient savings/ contributions

Inflation

Excessive costs

Pre-retirement

Capital impairment

Rapid inflation of post-retirement costs

Low growth

Conversion risk

Early retirement

Capital impairment

Rising cost of living (inflation)

Late retirement

Longevity/will it last?

Healthcare costs (where applicable)

Will anything be left for survivors?

1/2

1/2

3/4 1/4

DC

Acc

ount

Val

ue

Age

The member’s saving and retiring lifetimePrimary and secondary objectives

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Source: Schroders. For illustration only

Earning and saving

Primary:GrowthSecondary:Reduce capital losses

Pre-retirement

Primary:ProtectSecondary:Grow more than inflation

Early retirement

Primary:CollectSecondary:Protect

Late retirement

Primary:ComfortSecondary:Last / bequeath

Criteria for a good DC investment strategyStable Real Growth

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Stable Real Growth

What?Dependable return stream in varying market conditions

Keeping pace with, or exceeding, relevantinflation measures over medium and long terms

Returns considerably in excess of inflation over the long term

Why?Avoidance of sequencing risk, psychology of steady accumulation, ‘sleep-well’ factors

Erosion of purchasingpower is a key threat to the achievement of long-term retirement goals

Allow better living standards in retirement, avoid need for more contributions or delayed retirement

How?Diversification across asset classes,geographies and time; flexibility in asset allocation

Outcome-based real return targets; responsiveasset policy;

Inclusion of growth assets throughout savings period (and beyond)

The key requirement for a successful DC investment strategy is to deliver:

Default investment designThe investment options

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Source: Schroders. For illustration only

G1: Cash/bond family

G2: Equity family

G3: Balanced family

G4: Target date fund (‘TDF’)

family

G5: Outcome-Oriented family

Types of fundsGeneration of fundStable value/money marketGuaranteed fundsBond funds (‘plain vanilla’)

Domestic equitiesSectors/regions/styles

‘Static’ 60/40, 70/30 etc.Active range-based tactical allocations

TDF – mainly domestic assetsTDF – differing glide-path periodsTDF – improved diversification

Dynamically adjusting to the marketInflation plus x%Cash plus y%

Trends in DC productsUS

Default funds required– Trend in the US towards ‘professionally managed allocations’ (target date/target risk/balanced)– Specifically a trend towards funds that change risk over time most common option is target date– Shift in responsibility for decision making from participant back to employer/advice programs– DB sponsors now have DC in their sights

Choice outside of the default– Too much fund choice can lead to

confused members (on average 19 options offered)

– Too much choice can lead to short cuts in fund choice, inappropriate switching etc.

– Many do not have financial education/time/interest to make a choice

Fiduciary oversight– Responsible for the operational aspects of

the plan and the investment of the retirement funds

– Required to act in the best interests of the plan and the participants

– Failure to comply can result in significant personal liability/penalties

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Source: US data – www.401khelpcenter.com, 2012

68%67%

47%27%

21%17%

14%9%9%

0%0%

0% 20% 40% 60% 80% 100%

Target retirement date/lifecycleDomestic equity

Fixed incomeMoney market

International/global equityLifestyle

Managed accountOther

Company stockBrokerage window

Real estate

“Please indicate the 3 investment choices most often selected by employees, in terms of the percentage of employees participating. (Choose up to 3)” (n=335)

Source: Trends in 401(k) Plans and Retirement Awards – American Benefits Institute, March 2013

Trends in DC productsUK

4 in 5 members are in the default fund– Lifecycle– Initial phase is equities– DGF is increasing in use for second phase

Trust-based schemes offer 5 – 15 options (i.e. where a fiduciary is involved)

Contract-based offer more than 50 options

Restricted core list and enhanced list common– Core: global equities, fixed income,

diversified growth, index-linked bonds, cash, ‘Sharia compliant’

– Enhanced: emerging market equities, property, ethical

Most trust-based schemes use white-labelled funds

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Source: Towers Watson FTSE 100 DC pension scheme survey 2013

Management of the default option

62%

68%

5%

7%

5%

3%

22%

16%

6%

6%

Global equities (which includes UK) UK equities onlyManaged/balanced fund Diversified growthOther

Trust-basedPortfolio at start of growth phase

Portfolio at end of growth phase (before de-risking phase commences)

Trends in DC productsAustralia

Retail, industry and corporate Superannuation funds

Superannuation funds are risk graded funds:– Growth – invests around 85% in shares or property– Balanced – invests around 70% in shares or property, and the rest in fixed interest and cash– Conservative – invests around 30% in shares and property with the majority in fixed interest and cash– Cash

Default funds are chosen by the employer – typically a balanced option

MySuper– New accumulation default required from 1 January 2014 (existing to be transferred by 1 July 2017) – Lower fees (and restrictions on the type of fees that can be charged)– Simple features so members don't pay for services they don't need– Single or life stage investment options (so far over 90% offer a balanced MySuper)

Peer group benchmarking is common

10

Concentration risk for Canadians

Canadian equities represent 3.7% of the global market but…

…. Canadian equities often represent around 50% of the equity portion of balanced and target date funds

11

The need to diversify the growth asset

Source: MSCI, Bloomberg. As at 31 July 2014

0%

5%

10%

15%

20%

25%

30%

35%

40%

Financials InformationTechnology

ConsumerStaples

Industrials ConsumerDiscretionary

Energy Healthcare Materials Telecoms Utilities

% of index

TSX Composite

MSCI EAFE

S&P 500

Set-and-forget can be improved

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Source: Schroders, DataStream, to July 2014

0%5%

10%15%20%25%30%35%40%45%

-2 -1 0 1 2 3 4 5 6 7 8

Frequency

Month end real yield %

1991 - 2007

2008 - 2014

0%

5%

10%

15%

20%

25%

30%

35%

40%

-1 0 1 2 3 4 5 6 7 8 9

Frequency

Month end real yield %

1986 - 2007

2008 - 2014

CAD 10yr bond yields CAD 3m LIBOR

Lower yields mean more expensive bonds Risk-free return became return-free risk

When accountability breaks down…Autopilot is not always the best solution

13

Source: Schroders, for illustration only

Triangle of Complacency

Member

ManagerSponsor

Dynamically managing risks, actively balancing objectivesSteps in default fund design

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Top 25% Top 25%

Top 25%

Bottom 25% Bottom 25%Bottom 25%

Bottom 5% Bottom 5% Bottom 5%Outcome

Median Median

Median

0

2

4

6

8

10

12

TDF DGF

DC Account at retirement (multiple of final salary)

Balanced FundMoney Market

Source: Schroders, for illustration only. Balanced fund based on 70% allocation to equities, 30% bond allocation throughout. TDF strategy based on equities switching 65% of the portfolio to domestic bonds and cash over 20 years to retirement. Diversified strategy based on Schroder Diversified Growth Fund (DGF). Starting pot is $0, annual contributions of 10% of salary. Starting age is 25. Retirement age is 65. Numbers are in nominal terms. Salary assumed to grow in line with the rate of inflation. Please see forecast risk warning in the Appendix.

Return generation through the earnings phaseUp to age 55

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Source: Schroders, for illustration only. Balanced fund based on 70% allocation to equities, 30% bond allocation throughout. TDF strategy based on equities switching 65% of the portfolio to domestic bonds and cash over 20 years to retirement. Diversified strategy based on Schroder Diversified Growth Fund (DGF). Starting pot is $0, annual contributions of 10% of salary. Starting age is 25. Retirement age is 65. Numbers are in nominal terms. Salary assumed to grow in line with the rate of inflation. Please see forecast risk warning in the Appendix.

Top 25%

Median

Bottom 25%

Bottom 5%

0

1

2

3

4

5

6

7

TDF DGF

DC Account at 55(multiple of salary)

Balanced Fund

MoneyMarket

Engagement at the pre-retirement phaseThe need for a better trade-off between returns and protection

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Source: Schroders, for illustration only. Balanced fund based on 70% allocation to equities, 30% bond allocation throughout. TDF strategy based on equities switching 65% of the portfolio to domestic bonds and cash over 20 years to retirement. Diversified strategy based on Schroder Diversified Growth Fund (DGF). Starting pot is 5x salary at age 55. Starting age is 55, annual contributions of 10% of salary. Retirement age is 65. Numbers are in nominal terms. Salary assumed to grow in line with the rate of inflation. Please see forecast risk warning in the Appendix.

Top 25%

Median

Bottom 25%

Bottom 5%

0

2

4

6

8

10

12

TDF DGF

DC Account at retirement (multiple of final salary)

Balanced FundMoney Market

SummaryBringing it all together

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Deciding on an appropriate default strategy is very important

The current ‘set-and-forget’ passive balanced or TDF approaches are hampered by their fixed asset allocation anchors

Our key recommendations are:– Members should target an outcome above inflation, not a peer group or a fixed/static

asset allocation. This will better align members’ investments with their needs.– Dynamic asset allocation can be used to target these real-world investment outcomes by

adapting to the market environment and casting off the anchor of prescribed asset allocations.

– Strategies with twin aims of real returns and downside protection are the most suitable default funds.

Real world objectives, Real life markets Stable Real Growth

Appendix

Managing the Earning and Pre-retirement stage risks Stable Real Growth

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Source: Schroders, Datastream. As at 31 December 2013. For illustration only Starting age 25 years, retiring at 65. Starting salary is $40,000, growing at 1% p.a. above inflation. Without auto-escalation: 10% p.a. contributions. Real return 3% p.a. Bothstrategies assume ten year lifestyling strategy (starting at age 50) switching from equities to bonds and cash

DC investors need real growth to meet expenditure needsContributions are not enough

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Source: Schroders. For illustration onlyStarting age 25 years, retiring at 65. Salary assumed to grow at the rate of inflation. Replacement rate based on 66% and 50% of final salary

7.9%

5.2%

3.5%

2.3%

1.3%

6.8%

4.1%

2.3%

1.0%

0.0%0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

5% 10% 15% 20% 25%

66% replacement rate 50% replacement rate

Required real return

Contribution rate

If real returns are 3.5% p.a. a member needs to contribute

15% p.a. to achieve 2/3 replacement ratio

Modelling assumptions for simulations

Starting Age: 25

Retirement Age: 65

Contribution Level: 10% of salary

Inflation (salary and price): 2%

Money-Market Fund: 100% allocation to 3m CAD Libor

Balanced Fund Allocation: 70% allocation to domestic (TSX Composite), US (S&P 500) and EAFE (MSCI EAFE) equities, 30% bond allocation (BAML Canadian Government Bonds) throughout

Target Date Fund Glidepath: Invested in domestic (TSX Composite), US (S&P 500) and EAFE (MSCI EAFE) equities in early years then switching 65% of the portfolio to domestic government bonds (BAML Canadian Government Bonds) and cash (3m CAD Libor) over the 20 years to retirement

Diversified Growth Fund: Based on Schroders Canadian Diversified Growth Fund strategy. Targeting CPI inflation+4%, with 2/3rds of the volatility of domestic equities.

Returns are based on Schroders’ long-term forecasts for each of the stated assets. Risk is based on long-term historical data for the stated indices.

For Financial Intermediary, Institutional and Consultant Use Only

The views and opinions contained herein are those of the Global Strategic Solutions team and do not necessarily represent Schroder Investment Management North America’s house view.

Issuers/sectors mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. Portfolio holdings may change at any time.

This paper is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroder Investment Management North America Inc. (SIMNA) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions.

The opinions stated in document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized.

Any forecasts stated in the presentation are the result of statistical modelling, based on a number of assumptions. Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. The forecasts are provided to you for information purposes as at today's date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things, as economic and market conditions change. We assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions, models or other matters change.

Schroders has expressed its own views and opinions in this document and these may change.

Past performance is no guarantee of future results.

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Important information

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