alternative investments in retirement accounts...dc plan accounts accounts • selected by investors...

Alternative Investments in Retirement AccountsLaura StarksCharles E and Sarah M Seay Regents Chair in FinanceMcCombs School of BusinessUniversity of Texas at AustinIndependent Director, TIAA-CREF

Roundtable on Board Oversight of Alternative Investments

Mutual Fund Directors Forum and the Center for Financial Policy at the University of Maryland's Robert H. Smith School of Business

Viewing Alternative Investment Fundsin Retirement Accountsin Retirement Accounts

• From an academic research perspective• From an academic research perspective

• From a 401k/457 plan sponsor perspectiveFrom a 401k/457 plan sponsor perspective

• From a board oversight perspective

• From an individual participant perspective

Outline

• Importance of retirement plans

• Retirement income and risks▫ How DB plans handle itp▫ Expected life changes over time

• Asset allocation choices

B h i l t iti d i k• Behavioral opportunities and risks

Wh t ill b ffi i t i i What will be sufficient income in retirement?

%100%

Average % of age 65 household expenses at older ages

81%

66%

60%70%80%90%

48%

30%40%50%60%

0%10%20%3

65 75 85 95

Source: Employee Benefit Research InstituteIssue Brief February 2012

U.S. Personal Savings Rate12-month moving average as a % of disposable income

12

14%

8

10

2

4

6

0

2

Data source: U.S. Department of Commerce

Common retirement plans in the U.S.Employer sponsored• Employer sponsored▫ Defined benefit (DB plan - traditional pension plan) Benefit at retirement defined by formula (generally based

on last few years of salary and tenure at firm)on last few years of salary and tenure at firm) Employer takes on investment risk

▫ Defined contribution (DC plan - 401k, 403b, 457)Defined contribution (DC plan 401k, 403b, 457) Contribution defined Portable Choice of employee – contribution, asset allocationp y , Employee takes on investment risk

• Individual retirement account (IRA)( )

• Social security

3-legged stool

Social security

SavingsEmployerSponsored

Social security

Retirement

Growth in U.S. retirement assets(outside of social security)

$20 Trillions

$16

$18

$20

Total

$10

$12

$14

D fi d b fi

$6

$8

$10 Defined benefit & other

Defined contribution

$

$2

$4 contributionIRA

$-1990 1995 2000 2005 2010 2011

Data source: www.ici.org

• 69% of U.S. households have a tax-advantaged retirement accountretirement account

Effect of the 2007-2008 financial crisis on ect o t e 00 008 a c al c s s o growth in U.S. retirement assets

Trillions

$16

$18

$20Total

$12

$14

$16

D fi d b fi

$6

$8

$10Defined benefit & other

Defined contribution

$2

$4

$6 contributionIRA

$02007 2008 2009 2010 2011


Influence of retirement assets into U.S. mutual funds

12,000

14,000

$)

8,000

10,000

(in Billions US$

Non‐Retirement

2 000

4,000

6,000

Total Value

IRA

IndividualRetirementAccount

D fi d

0

2,000

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

DCDefined ContributionPlans

Total Assets Retirement Assets DC Assets

Source: ICI

Influence of retirement assets into U.S. equity mutual fundsequity mutual funds

6,000

7,000

4,000

5,000

,

e(in Billions US$)

Non‐Retire‐ment

Individuallyl t d

1,000

2,000

3,000

Total Value

DC

IRAselected

Selected through

01992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Total Equity Retirement Equity DC Equity

through employer’splan

Source: ICI

Common retirement plans in the U.S.• Employer sponsored• Employer sponsored▫ Defined benefit (DB plan - traditional pension plan) Benefit at retirement defined by formula generally based

on last few years of salary and tenure at firml k i i k Employer takes on investment risk

▫ Defined contribution (e.g., 401k, 403b, 457) Contribution definedContribution defined Portable Choice of employee – contribution, asset allocation Employee takes on investment risk

• Individual retirement account (IRA)

• Social security• Social security

I i g lif t f ti t Increasing life expectancy for retirement income

• How long a 22-year-old entering the workforce could expect to live :

Year Age1933 681933 681953 721973 74973 741993 772009 80

Data source: http://www.mortality.org/

DB plan guarantees

With most DB plan structures, participant receives annuity for lifeannuity for life

Implication: plan sponsor (employer) is taking on a p p p ( p y ) glot of risk

Coverage of DB versus DC plans% of workers of medium and large businesses in U S% of workers of medium and large businesses in U.S.

8090

DB plans

50607080

2030405

DC plans

010

Data Source: EBRI

Coverage of DB versus DC plans% of workers of state and local governments in U.S.

100DB plans

708090

100

30405060

DC plans

0102030

1987 1990 1992 1994 1998 2007 2008 2009 2010

Data Source: EBRI

Risk factors to retirement incomeAll the DB plan

• Investment risk

• Inflation risk

All the DB plan is taking onParticipant has the rest

Inflation risk

• Longevity risk

• Risk of a costly unexpected event

• Risk of tax policy changes

• Risk of regulatory or employer changesRisk of regulatory or employer changes

Why are alternative asset strategies popular with retirement funds now?popular with retirement funds now?• Higher correlations among asset classes

Why are alternative asset strategies popular with retirement funds now?popular with retirement funds now?• Higher correlations among asset classes ▫ so they are searching for more diversification ▫ so they are searching for more diversification

through alternatives• Higher volatility g y

M k t l tilit 1990 2012Market volatility 1990-2012(Level of the VIX)

90

70

80

90

50

60

20

30

40

0

10

20

Data Source: Yahoo! Finance

Why are alternative asset strategies popular with retirement funds now?popular with retirement funds now?• Higher correlations among asset classes ▫ so they are searching for more diversification ▫ so they are searching for more diversification

through alternatives• Higher volatility g y▫ so they are searching for ways to reduce the portfolio

volatility, either through less downside risk or greater diversificationgreater diversification

• Lower returns▫ so they are searching for additional opportunities to so they are searching for additional opportunities to

find alpha

Rationale for alternative strategies

• Uncorrelated returns (diversification)

• Downside risk protection

• Return enhancement

• Inflation hedges

What are institutional investors saying What are institutional investors saying about portfolio asset allocation into alternatives?alternatives?• 76% consider the use of alternative investments

essential to diversify portfolio risk.y p• 25% say they are increasing their allocations to

alternative/non-correlated assets91% sa that alternati es are ke to risk red ction• 91% say that alternatives are key to risk reduction Natixis Global Asset Management survey July 2012

• Institutional investors will increase their allocations to real estate and infrastructure from 5-10% to 25% within the next decadewithin the next decade. JP Morgan report

Changes in worldwide DB plan asset allocations

60%

70%

40%

50% Equity

20%

30% Bonds

0%

10%

20%

Other

Data Source: Towers Watson

0%1995 1999 2003 2007 2011

How are DB plans using alternative asset strategies?

• Commodities• Managed futures

R l t t

• Mining and metals• Hedge funds

B k l• Real estate• Private equity• Infrastructure

• Bank loans• Natural catastrophe risk• Agriculture

•

g• Timber

Problems for traditional mutual funds with offering alternative investment strategiesoffering alternative investment strategies• Liquidity • Concentration• Concentration• Use of leverage• Daily valuationDaily valuation

Differences in objectives of DB versus DC plan sponsorsplan sponsors• DB plan sponsors▫ Need to consider the tradeoff between current and future

retirees’ benefits as well as the risk to the employerretirees benefits as well as the risk to the employer▫ Need to consider diversification from a total portfolio

perspective

• DC plan sponsors▫ Need to consider what funds on the plan menu will be of

attraction to the participants N d t id i k t ti i t▫ Need to consider risks to participants

▫ Need to consider diversification from the perspective of the participants as they choose among investment options

▫ Need to consider recordkeeping issues and costsNeed to consider recordkeeping issues and costs▫ Need to consider regulations and laws

Defined contribution plan sponsors

• They have control over the menu of investment opportunities for participants to choose amongopportunities for participants to choose among.

• Average # of options in DC plans across time:▫ 7 investment options in 1990’s▫ 17 investment options in 2007▫ 21 investment options in 2010

Mutual Fund ChoiceTraditional mutual fund DC plan accountsaccounts

DC plan accounts

• Selected by investors directly. • Plan sponsor (i.e., employer) offers a limited number of mutual

• Investors have complete flexibility to choose among the universe of mutual funds

fund investment options• Plan sponsor adjusts these

options by removing or adding mutual funds or other universe of mutual funds.

• Subject to individuals’ preferences

mutual funds or other investments.

• Employee allocates DC account balances to the available investment optionsp investment options.

• Subject first to preferences of plan sponsors, affected by regulations, then subject to participants’ preferencesparticipants preferences

Typical types of DC plan choices

• Someone else takes control▫ Managed accounts (personalized for participant)▫ Managed accounts (personalized for participant)▫ Target date funds (packaged for participants of

certain ages)• Advice plus choices• Complete do it yourself

Asset allocation of 401(k) accounts in 2010by age

Source: Investment Company Institute 2012 Factbook

Asset allocation of 401(k) accounts in 2010by ageby age


Comparison of allocationsParticipants in their 20’s

Participants in their 60’s

GICs and stable value 4.4% 16.5%Money funds 2.6% 6.2%Bond funds 7.2% 14.7%Bond funds 7.2% 14.7%Equity funds 36.9% 34.1%Target date funds 27.0% 9.1%B l d f d 10 4% 6 9%Balanced funds 10.4% 6.9%Company stock 6.7% 7.0%Other funds 4.9% 5.4%


Comparison of allocations



GICs and stable value 4.4% 16.5%Money funds 2.6% 6.2%Bond funds 7.2% 14.7%

14.2% 37.4%Bond funds 7.2% 14.7%Equity funds 36.9% 34.1%Target date funds 27.0% 9.1%B l d f d 10 4% 6 9%Balanced funds 10.4% 6.9%Company stock 6.7% 7.0%Other funds 4.9% 5.4%


Comparison of allocations



GICs and stable value 4.4% 16.5%Money funds 2.6% 6.2%Bond funds 7.2% 14.7%Bond funds 7.2% 14.7%Equity funds 36.9% 34.1%Target date funds 27.0% 9.1%B l d f d 10 4% 6 9%Balanced funds 10.4% 6.9%Company stock 6.7% 7.0%Other funds 4.9% 5.4%


But allocations vary within age cohorts

• Participants in their 20’s▫ 60% had more than 80% in equities and 9% had ▫ 60% had more than 80% in equities and 9% had

zero in equities

• :Participants in their 60’s▫ 21% had more than 80% in equities and 18% had

i itizero in equities


Implications for alternative funds

• Who is the fund targeting?

▫ Stand alone differentiated alt funds▫ Stand alone combined alt funds▫ Alt funds to be put in target date funds

• Requires different types of educational strategies

Benefits to fund management companies from offering alternative strategy fundsfrom offering alternative strategy funds• Potential strong growth from DC plan adoptions of

these types of fundsthese types of funds

• Competition is less crowded than for traditional pmutual fund offerings

l f f bl ff h h• Potential for more profitable offerings (e.g., higher expense ratios, less competition for lowering expense ratios)expense ratios)

Where are flows into defined contribution plans going?plans going?• Target date (lifecycle) funds▫ 52% of new employees in their 20’s are putting their ▫ 52% of new employees in their 20 s are putting their

retirement savings into target date funds (EBRI).▫ 77% of plan sponsors now report that target date

funds are their default investment vehicle (Deloitte survey).

▫ Vanguard estimates that by 2016 over 55% of ▫ Vanguard estimates that by 2016 over 55% of defined contribution participants will have their entire assets invested in a single target date fund. That percentage is last year was 24%.

Growth in target date fund assetsBillions

$350

$400

$250

$300

$150

$200

$50

$100

$02001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011


Current debate on target date fundsTo or Through retirementTo or Through retirement

• Do you invest in target date funds to the retirement date and then reallocate date and then reallocate

Or

• Do you invest in target date funds throughretirement?

Philosophy on this question influences the glide path Philosophy on this question influences the glide path for target date funds

Glide path in target date fundsGlide path refers to the changes in allocation to Glide path refers to the changes in allocation to

equities in the fund as the date gets closer to retirement

Example

95 95 95 95 9590

90100

Example

90 8679

726660

7080

% in equities

20304050

01020

2055 2050 2045 2040 2035 2030 2025 2020 2015 2010

Glide paths for 4 example target date series (% in equities)series (% in equities)

90

100

60

70

80

30

40

50

0

10

20

30

02055 2050 2045 2040 2035 2030 2025 2020 2015 2010

Examples of target date fund glide path

From www.ici.org frequently asked questions about target date funds

Another current debate – should one’s total defined contribution retirement account be invested in one target date fund?

• Yes▫ Target date fund is a portfolio with shifting balances Target date fund is a portfolio with shifting balances

toward retirement date• No

T t d t f d t h th i k th ▫ Target date fund may not have the risk the participant desires. By investing across target date funds, the participant can achieve a more preferred i k filrisk-return profile

▫ Target date fund is a core portfolio from which participant can invest in other portfolios and p p pinvestments

What are DB and DC plan providers searching for in alternative strategy managers?

• Greater transparency/less opaqueness• Greater transparency/less opaqueness• Less conflict of interest• Effective risk managementEffective risk management• Solutions in terms of liquidity

How do behavioral finance issues affect the desire or need for alternative investment desire or need for alternative investment strategies in DC retirement accounts?

These are just a few of many examples that could be proposed.

Stock market return experience

Individuals who have experienced low stock market returns in their lives have:▫ Lower willingness to take financial risk▫ Lower willingness to participate in the stock market

I t l t i t k if th d ▫ Invest a lower percentage in stocks if they do participate

▫ Are more pessimistic about future stock returns

▫ Malmendier and Nagel Quarterly Journal of Economics Volume 126 2011 “Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?”

Relation of differences between older and younger individuals in current stock market participation to past

stock market return experiences

1983

Difference in currentstock

1983

8

2007

stock marketparticipation(Old– Young)

1962

1989

Difference in past stock market returns

1969

pover previous 50 years less previous 20 years

Data source: Malmiender and Nagel, 2011

Implications

• Including alt funds that lower downside risk can be beneficial for investor psychology and keeping beneficial for investor psychology and keeping participants invested

More behavioral issues that may impact investments in alt fundsinvestments in alt funds• Effects of inertia

▫ Many studies have found that DC plan participants are slow to change their asset allocations or fundsg

Differences in clienteles and flows

53

Differences in clienteles and flowsMutual funds without defined contribution investors

0.8

1

0.4

0.6

low

Non‐DC

Poly. (Non‐DC)

0

0.2Fund F

‐0.2

00 20 40 60 80 100

‐0.4Performance Rank

From Sialm, Starks, Zhang, 2012

Differences in clienteles and flows

1

Mutual funds with and without defined contribution investors

0.8

1

With DC

0.4

0.6

Flow

DC

Non‐DC

Poly. (DC)Without DC

investors

0

0.2Fund

y

Poly. (Non‐DC)Without DCinvestors

‐0.2

0 20 40 60 80 100

Plan sponsors remove the inertia

54

‐0.4Performance Rank

From Sialm, Starks, Zhang, 2012

Implications for alt fund providers

Could be large flows in and out of funds due to decisions by plan sponsorsy p p

Overconfidence: People overestimate their abilities and judgmentabilities and judgment• Example82% of students believe they are in the top 30% of their 82% of students believe they are in the top 30% of their

class

Overconfidence in individual investors

• Traders who trade more often lose more money.

• Men trade more often than womenA d l th And men lose more money than women.

“The investor’s chief problem—and even his worst enemy—is likely to be himself.”

Benjamin GrahamFather of Value InvestingFather of Value Investing

Implications for alt funds

If the funds are offered as stand alones:

• Investors may buy high and sell low causing volatility for the funds and lower outcomes for yparticipants

Anchoringg• Example: Stock prices anchored to past values

6000

NASDAQ5000

6000

NASDAQ 5048.62

4000

2000

3000

1000

0

Data Source: Yahoo! Finance

Anchoring: gResidential real estate prices

AZ Phoenix CA Los Angeles FL Miami NV Las Vegas TX Dallas

250

300 AZ-Phoenix CA-Los Angeles FL-Miami NV-Las Vegas TX-Dallas

200

100

150

50

0

Data Source: Case-Shiller Index


Participants may not sell when they should

Anchoring on retirement date

Richard Thaler gives an example in his Nudges blog that the U S government creates an anchor for that the U.S. government creates an anchor for people to think about retirement as occurring at age 66 or 67 because the government labels those ages as full retirement age when the largest amount of social security payment will occur by delaying to age 70 70.

http://nudges.org/2011/07/17/richard-thaler-on-p // g g/ / 7/ 7/when-to-take-social-security/

Optimism and wishful thinking biasp g

The Lake Wobegon Effectwhere all the women are strong, all the men are good looking, and all

• People exaggerate probability

the children are above average.

p gg p ythat their team will win.

• People exaggerate probability p gg p ythat the candidate they favor will win.


• Individual participants may be overly optimistic on the prospects for the fundsthe prospects for the funds

Naïve diversification

• Individual investors may have a tendency to diversify in a naïve fashiondiversify in a naïve fashion.

• Evidence exists that some individuals in 401 (k) 4 ( )plans have a tendency to invest 1/n in their investment option choices.


• Individuals may invest too much or too little in the fundsfunds.

Conclusions

• Retirements are changing▫ People are retiring later but living even longer▫ People are retiring later but living even longer▫ Sources of income are changing▫ Retirement investments are changingg g

• These changes have implications for the presence of alternative investments in retirement accounts.

alternative investments in retirement accounts...dc plan accounts accounts • selected by investors...

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