Speaker NOTES: We know that there are multiple sources of retirement income that participants may rely upon. We anticipate social security to be available, particularly for those who need it most: the lower income employees. We know that DC will be vital as an added source of Income especially for the lower and middle income earners. Others may be fortunate to have DB, deferred compensation or other assets to rely on. Many Need to tap into their home equity to make ends meet.
Speaker NOTES: Are the current DC plans sufficiently Diversified? Unfortunately not. Over time assets that were once diversifying, have become less diversified. Here you see that relative to the S&P 500 all of the other equity categories are closely correlated. This is even true of non-U.S. equity both in the developed and emerging markets. The only diversifying asset class on the typical DC menu is the bond fund.
Speaker NOTES: As you can see adding these types of asset classes introduces diversification relative to the S&P 500.
Stacy Schaus, CFP, SVP, Defined Contribution Practice Leader ...
Defined Contribution Concerns <ul><li>Majority of American workers will rely on DC assets as core element of retirement income </li></ul><ul><li>Recent market performance has prompted fear and some to run to stable value and fixed income in DC plans </li></ul><ul><li>DC plans are unlikely to meet retirement income goal given savings and investments today </li></ul><ul><li>DC investment menus lack true diversification </li></ul><ul><li>Protection from credit and inflation concerns is lacking in majority of plans </li></ul>
DC Savings Can be Critical For Achieving Adequate Retirement Income Replacement + + Lower Income Employees Higher Income Employees ? = Greater Relevance For: SOURCE: Research Foundation of the CFA Institute * Default investment options, such as target date strategies, seek to increase the total value of DC Savings by improving the investment returns on contributions. Note that the wealth contribution from investment returns can be positive or negative, depending on the success of the investment strategy over the individual’s specific time horizon. 20% - 40% Social Security 40% - 60% DC Savings (contributions + investment returns*) Varies Widely <ul><li>Other Wealth </li></ul><ul><li>Defined Benefit Pension </li></ul><ul><li>Health Savings Account </li></ul><ul><li>Deferred Compensation </li></ul><ul><li>Home Equity </li></ul><ul><li>Personal Savings </li></ul>
Typical DC Savings and Asset Allocation Likely to Fall Short Assumptions: Starting salary - $50,000 Real wage increase – 1% Savings rate – 6%-9.8% over 40 years Employer match – 3.5% * Results are approximate, hypothetical, and based on a simulation. 37% of participants may fail to reach 50% real income retirement goal! 99% 100% 37% 50% 91% 75% Probability of not meeting income replacement goal* Projected DC real income replacement
Current DC Core Options May Show Little Real Diversification Bond Risk Equity Risk Despite Typical DC investment Menu of 15 Offerings…majority are within the below asset classes which reduce to only two risk categories Small/Mid Cap Core International Equity Large Cap Growth Large Cap Equity Index Large Cap Value Core Bond Stable Value/Money Market
Core Line Up May Hold More Risk Than Desired… While 70% May be Invested in Equities SOURCE: Callan DC index approximate allocation by asset classes
96% of DC Investment Risk May Be Driven by Equities SOURCE: PIMCO 1 60% / 40% capital allocation to S&P 500 Index and LBAG, respectively 2 The basic formula for standard deviation of a two asset portfolio is used to create the exhibit above. Standard deviation is computed as the square root of the following three components 1. [the weight of asset 1 squared multiplied by its variance] plus 2. [the weight of asset 2 squared multiplied by its variance] and plus 3. [2 multiplied by (the correlation of assets 1 and 2 multiplied by the product of their weights multiplied by the product of their individual standard deviations]. The time period is January 1987 – December 2007. 70% [Equity] / 30% [Bond] Capital Allocation = 96% [Equity] / 1.25% [Bond] Risk Allocation % of Capital Allocation does NOT equal % of Risk Exposure
Need for Broader Asset Diversification, Enhanced Returns and Protection Drives DC Design Tier I: Custom Tier II: Core Offerings Target Dates Strategies: Created using “Mix of Core” plus special opportunities and tail risk management Tier III: Brokerage Stocks and ETFs Bonds Mutual Funds Cash / Stable Value Global Bonds Inflation Protection Global Equity Corporate and High Yield Treasuries Mortgages Non US Developed Emerging Markets Absolute Return, Opportunistic and Distressed TIPS Commodities and Direct Energy REITS and Direct Real Estate Infrastructure U.S. Large, Mid, Small International Developed Emerging and Frontier Markets Private and Venture Capital Long/Short Strategies
Real Assets Diversify and Add Inflation Protection to Core Offerings Correlation vs. Market/Time -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0 1.2 Jun-94 Jun-96 Jun-98 Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Correlation vs. S&P Dow AIG Commodity Index S&P 500 Lehman U.S. Treasury: U.S. TIPS Dow Wilshire REIT
An Improved Framework for Strategic Diversification Best : Stocks Mixed : Commodities & Nominal Bonds Worst : TIPS Best : Commodities Mixed : Stocks & TIPS Worst : Nominal Bonds Best : TIPS Mixed : Commodities & Nominal Bonds Worst : Stocks Best : Nominal Bonds Mixed : Stocks & TIPS Worst : Commodities Low/Falling High/Rising Low/Falling I N F L A T I O N High/Rising R E A L G R O W T H
Broader Asset Diversification and Best in Class Management Reduces Risk of Failure Assumptions: Starting salary - $50,000 Real wage increase – 1% Savings rate – 6%-9.8% over 40 years Employer match – 3.5% * Results are approximate, hypothetical, and based on a simulation. Now, only 1% of participants may fail to reach 50% real income retirement goal! 81% 100% 1% 50% 50% 75% Probability of not meeting income replacement goal* Projected DC real income replacement
Conclusion <ul><li>DC Plans are more likely to meet targets given improved asset diversification, inflation protection and skilled managers </li></ul><ul><li>Inflation protection is critical and can be added to plans via core, target strategies, as well as within brokerage window e.g., TIPS directly </li></ul><ul><li>Participants need to understand the true risk of failing to meet goals and be encouraged to save more rather than assume higher risk </li></ul>
Appendix Index descriptions Each Dow Jones Real Return Target Date Index is a composite of other indexes. The sub-indexes represent traditional stocks and bonds in addition to real return assets such as inflation-linked bonds, commodities and real estate securities that are considered to potentially counterbalance inflation. The component asset classes are weighted within each index to reflect a targeted level of risk at the beginning and end of the investment horizon. Over time, the weights are adjusted based on predetermined formulas to systematically reduce the level of potential risk as the index’s maturity date approaches. The Dow Jones AIG Commodity Total Return Index is an unmanaged index composed of futures contracts on 19 physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. The Dow Jones Wilshire Real Estate Investment Trust Index, a subset of the Wilshire Real Estate Securities Index (WRESI), is an unmanaged index comprised of U.S. publicly traded Real Estate Investment Trusts. Effective July 1, 2007, the Fund began tracking its performance against a float-adjusted version of the index as the full-market-cap version of the index ceased to be disseminated on June 30, 2007. The Lehman Brothers Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Lehman Brothers U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $250 million par amount outstanding. Performance data for this index prior to 10/97 represents returns of the Lehman Inflation Notes Index. The Morgan Stanley Capital International Emerging Markets Index is an unmanaged index that measures equity market performance in the global emerging markets. As of May 2005, the Emerging Markets Index (float-adjusted market capitalization index) consisted of indices in 26 emerging countries: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey, and Venezuela. The MSCI EAFE Net Dividend Hedged USD Index is an unmanaged index of issuers in countries of Europe, Australia, and the Far East represented in U.S. Dollars on a hedged basis. The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The Standard & Poor’s 500 Stock Price Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.