defined contribution investing: bringing theory to reality

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Defined Contribution InvestingBringing Theory to Reality

May 25, 2010

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Today’s Presenters

Robyn Credico, Senior Retirement Consultant

Sue Walton, Senior Investment Consultant


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Today’s Discussion

Theory vs. Reality

Thinking Outside the Investment Boxes

Holistic Approach to DC Plan Management


44

DC Plan Theories

DC plans Are a supplemental savings vehicle for participants Provide a well constructed vehicle to facilitate participant investment decision-making

DC participants Are sophisticated investors Have the time, interest and knowledge to invest their portfolios Maintain a long-term investment time horizon Can easily distinguish investment styles and asset classes Rebalance their portfolios to maintain an appropriate asset allocation Save enough and invest appropriately for their age Carefully read and review all communications and education materials provided Take advantage of all plan features and benefits Will be able to retire with dignity with the DC plan and personal savings

THEORY VS. REALITY


55

DC Plan Realities

Defined contribution plans now account for 42% of global pension assets in the seven largest pension markets, compared with only 32% in 1999*

67.1% of workers considered their employer-sponsored DC plan as their PRIMARY retirement plan in 2006, compared to 25.8% in 1988

*Towers Watson Global Pension Survey 2010,

Source: Employee Benefit Research Institute, April 2, 2009.

THEORY VS. REALITY


66

Note: For most years, data is based on the following year’s Fortune list. The today column reflects data throughMay 6, 2009 (based on the 2009 Fortune list) and includes future announcements for plan changes in 2009 and 2010.

1985 1998 2002 2004 2005 2006 2007 2008

DB plan

DC plan Only

2008 marks the first time less than half of the Fortune 100 offered a DB plan to new hires.

Today

9083

74

6358

5449

45

10 1017

51 55

90

4642

26

37

0

20

40

60

80

100

Nu

mb

er

of

Co

mp

an

ies

THEORY VS. REALITY

DC Plan Prevalence Among Fortune 100 Companies (For Newly Hired Employees)


77

Social Security Can No Longer Be Relied Upon As Part of the Retirement Equation In 2009, more than 51 million

Americans received $672 billion in Social Security benefits

Social Security benefits represent approximately 40% of the income of the elderly

In 1935, the life expectancy was 77.5 years old, today it’s 83 years old

By 2034, there will almost twice as many older Americans as today – from 39.9 million today to 74.6 million

There are currently 3.2 workers for each Social Security beneficiary, by 2034, there will be 2.1 workers for each beneficiary

Source: Fact Sheet published by the Social Security Administration

THEORY VS. REALITY


88

Future of Social Security?

In May 2009, The Social Security Board of Trustees project that program costs will exceed tax revenues in 2016 – one year sooner than last year’s report By 2016, there will not be enough workers to pay scheduled benefits at current tax rates.

The projected point at which funds for the program will be exhausted in 2037 – 4 years sooner than last year’s report

Source: Center for Retirement Research at Boston College, 2009.

By 2037, the trust fund will be sufficient to pay

only 76% of program costs.

THEORY VS. REALITY


99

Worker Confidence that Social Security Will Continue to Provide Benefits of at Least Equal Value to Benefits Paid Today

THEORY VS. REALITY


1010

DC Plan Realities

DC participants Regardless of background, education, and circumstances, an overwhelming

majority of participants are not engaged in making on-going investment decisions or do not consider a long-term time horizon

— Most participant do not

– Rebalance– Opt out of defaults– Make changes at the right time

— Many participants

– Take loans, hardships withdrawals Participants do not maximize plan benefits

— Participants save under the match level

— Participants not saving to the legal limits

THEORY VS. REALITY


11

Relationship of 401(k) Balance to Current Pay for Participants Close to Retirement

*Age 55+, >10YOS, Active, >$30k in Pay

*100 equal a balance of 1 times pay

THEORY VS. REALITY

0

100

200

300

400

500

600

700

800

900

1000

55 60 65 70

Participant Ages

Acc

ou

nt

Bal

ance

/ P

ay


1212

Note: Due to rounding, percentages in the change column might not be equal to the difference between percentages in the 2007 and 2009 columns.

Sources: Watson Wyatt’s 2009 survey on The Effect of the Economic Crisis on Americans’ Retirements – Employee and Retiree Views. 2007 numbers based on T. Hill (2008), Watson Wyatt’s 2007 U.S. Surveys of Older Employees’ and Retirees’ Attitudes Toward Lump Sum and Annuity Distributions From Retirement Plans.

THEORY VS. REALITY

The percentage of workers aged 50-64 who are very confident in having enough resources to live comfortably five years into retirement has

dropped 19 percentage points, from 63% in 2007 to 44% in 2009.

5 YEARS INTO RETIREMENT 15 YEARS INTO RETIREMENT

2007 2009 CHANGE 2007 2009 CHANGE

Not at all confident 6% 10% 5% 9% 15% 6%

Not too confident 4% 10% 6% 15% 21% 6%

Somewhat confident 27% 35% 8% 42% 46% 4%

Very confident 63% 44% -19% 34% 18% -16%

Financial Market Turbulence: Older Workers’ Retirement Security Confidence Declines


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Plans for Retirement

Mean: 67 years

Source: Towers Watson 2010 Global Workforce Study — U.S.

49 or younger

50 – 54

55 – 59 60 – 64

65 – 69

70 – 74

75 or older

1%

Plans to Work After Reaching Retirement Age

Will work because I have to

Will work, but not because I have to

Will have a traditional non-working retirement

Expected Retirement Age

THEORY VS. REALITY


1414

Delayed Retirement Will Most Likely Cause Increased Labor Costs and Reduced Employee Engagement If Older Workers Unable to Retire

DB Pension

Retiree Medical

Active Medical

Other (e.g., LTD)

401(k)

FICA

Total pay PTO

Savings from lower pay and reduced

benefit costs

Active Medical

Retiree Medical

DB Pension

Other (e.g., LTD)

401(k)

FICA

Total pay PTO

Lower cost if younger age

Lower cost if lower pay

Working 55 – 64 Younger Replacement

Lower pay

Pay Benefits

TotalLabor

Cost

Overall labor cost savings may outweigh cost of retiree medical

Considerations

Skill levels

Productivity

Replacement

Engagement

ADEA/age discrimination

Caution on softness of savings; highly variable and difficult to predict

(lower % of pay)

Engagement scores for employees who have to delay retirement for financial reasons are 10 percentage points lower than average (Towers Watson 2010 Global Workforce Study)

THEORY VS. REALITY


Thinking Outside the Investment Boxes

Large

Medium

Small

Value Blend Growth

OUTSIDE THE BOX

High

Medium

Low

Short Interm Long

Equity Style Box Fixed-Income Style Box

Source: Investopedia.com


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Thinking Outside the Investment Boxes (cont’d)

16

Index target retirement date or

balanced funds

Active core funds

Mutual fund windowIndex funds

Participant engagement

Go

vern

ance

leve

l

Active target retirement date or

balanced funds

Custom target retirement date or

balanced fundsCustom core funds

Managed accounts

(professional management

using core funds)

Self-directedbrokerage account

High

HighLow

OUTSIDE THE BOX

Tier 1

Tier 2

Tier 3

Tier 4


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TW Investment Beliefs: Number and Type of Investment Options to Offer Participants

The total number of investment options offered to defined contribution plan participants should be limited to maximize governance budget, preserve asset buying power and facilitate participant engagement

Tiered investment approach is appropriate Meet the needs of the different types of participants in the plan Facilitate more effective communication Drive participant investment behavior

The use of active management should be reserved for the higher governance and higher manager conviction structures

The delineation of investment style (value versus growth) has not proven to be additive for portfolio efficiency due to an increase for potential volatility and inconsistent utilization by participants to balance style effectively

PLAN MANAGEMENT


18

Investment Structure Options

Tier 3 Funds

Doers

Tier 4Take Charge

Investors

Tier 1 Funds

Delegators

Different solutions for different participant needs

Asset allocation funds

Core funds

All passive funds in major asset classes to allow participants ability to construct a diversified portfolio on their own

Individual funds or mutual funds allow participants to create customized asset allocations with primarily active funds

Mutual fund windowor self-directed

brokerage account

Individual securities or mutual funds outside of the plan offer flexibility for customizing portfolios

Target retirement date funds either through a mutual fund, commingled fund or custom funds

Portfolio automatically rebalanced to maintain target allocations

Tier 2 Funds

Allocators

Indexfunds

Participant engagement18

PLAN MANAGEMENT


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TW Investment Beliefs: Target Date Funds

The target date fund selected by a plan sponsor should have a glide path, asset allocation and implementation appropriate for the plan

— Plan sponsors should consider investment beliefs, level of plan governance, participant demographics and behavior, and other retirement benefits available to participants

— Availability of retirement benefits outside of a defined contribution plan may allow for a more aggressive equity glide path

— High participant use of company stock in a defined contribution plan may lead to the selection of a more conservative equity glide path

— Active management increases the governance burden because the plan sponsor must monitor the underlying active strategies in addition to monitoring the target date funds themselves

— Active management should be considered only if it improves the likelihood that plan participants will be compensated for the risks they will bear

— Glidepath driven by human capital approach or time horizon approach

Plan sponsors wanting a low governance or low cost solution should consider “off the shelf” passively managed target date funds

Custom target date strategies are recommended for plan sponsors who wish to customize the glidepath, investment manager selection, or both

PLAN MANAGEMENT


2020

TW Investment Beliefs: Target Date Funds (cont’d)

Target date funds should incorporate all major global asset classes without any biases (style, cap, geography, etc.) to provide adequate diversification

The glidepath and asset allocation should be based on efficient frontier analysis and Monte Carlo stochastic forecasting using reasonable assumptions and methods that are fully explained

Target date fund managers should seek to maximize investment efficiency net of fees and should continually look to improve investment efficiency by considering modifications and new investment strategies as opportunities become available

Tactical asset allocation should be viewed as an active management strategy— For those managers who incorporate tactical asset allocation into the fund management

process, the strategy should have a long track record of consistent value added, follow a disciplined repeatable process, and represent a small portion of total active management risk

PLAN MANAGEMENT


2121

Target Date Fund Selection

Process, process, process Determination of appropriate glidepath

— Human capital versus time horizon

— Needs of participants

— Other plan benefits

— Participant investment behavior

Off the shelf versus custom— Size of plan

— Administrative flexibility

— Plan governance

Active versus passive— Plan governance

— Participant engagement

— Sensitivity to fees

Potential impact from legislation and other governing bodies Participant disclosure and education Plan sponsor checklist/selection process

PLAN MANAGEMENT


2222

TW Investment Beliefs: Stable Value

Considerations for today’s market environment Continued constraints on wrap contract capacity Investment portfolio structure changes Tightened wrap underwriting standards Decline in fund crediting rates Impact of financial reform legislation

What should plan sponsors do? Understand current stable value structure, investment characteristics and

contract terms Confirm objectives for option Evaluate underlying participant investment demographics in stable value

option Review stable value strategies and managers relative to other alternatives

PLAN MANAGEMENT


2323

TW Investment Beliefs: Active Options

The use of active management should be reserved for higher governance structures

Investment manager implementation should be considered as part of the investment selection process

— Multi-manager approach should be employed for active mandates to ensure diversification and limit volatility

— Vehicle selection should be driven by asset buying power, governance oversight capabilities and administrative flexibility

PLAN MANAGEMENT


Benefits of Diversification

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0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Pro

bab

ility

of u

nde

rper

ofr

man

ceof

ove

rall

stru

ctu

re

Number of managers

Benefits of diversification in a manager structure assuming 1 rated managers: Expected probability of meaningful underperformance from the overall structure at some point over a 10 year period

probability of at least 5% underperformance

probability of at least 7.5% underperformance



Probabilities are approximated assuming individual manager tracking error of 5% pa, Net Information Ratio of 0.33, average ma nager active correlation of 0.3 and normal distribution of manager returns. Underperformance defined as peak to trough cumulative, not annualized.

Probability of underperformance from the overall structure decreases rapidly initially. Assuming you can find enough high conviction managers there is a strong case for including at least 4 managers in a manager structure to protect against the possibility of extreme underperformance

PLAN MANAGEMENT


2525

VariableIncome Strategy Fixed

Guaranteed Income Guaranteed Minimum Withdrawal Benefit (GMWB)

Type of Purchase Immediate Deferred or Accumulation

Distribution Options

25

PLAN MANAGEMENT

Postretirement Income options


2626

TW Investment Beliefs: Distribution Options

Consideration of retirement income solutions and the appropriate selection thereof should be driven by:

— The governance capacity of the plan sponsor

— The needs of the participants based on a review of plan demographics and investment behaviors

— The availability of appropriate products to meet plan objectives

Plan sponsors must also consider regulatory requirements of annuity (or retirement income solution) selection:

— Engage in an objective, thorough, and analytical search for selection of annuity providers for DC plans

— Consider costs (including fees and commissions) in relation to benefits and services provided

— Conclude that the annuity provider is financially able to make all future payments and that cost is reasonable

— If necessary, consult with an appropriate expert for purposes of complying with safe harbor

PLAN MANAGEMENT


2727

TW Investment Beliefs: Distribution Options (cont’d)

Retirement income solutions should exhibit the following essential features

— Guaranteed lifetime annual income

— Purchasing power protection

— Actuarially fair product pricing

— Simple to understand and communicate

— Ability to implement under plan’s recordkeeping and advice systems

Retirement income solutions ideally exhibit the following desirable features

— Greater investment customization flexibility and participant control over assets

— Guaranteed income floor with potential for higher income tied to investment performance

— Transferability to other investment options

PLAN MANAGEMENT


2828

TW Investment Beliefs: Distribution Options (cont’d)

Unfamiliar with market offering 24%

Market offerings are not satisfactory 26%

Lack of participant demand 56%Administrative complexity 36%Other 13%

Reasons Why Companies Do Not Offer Lifetime Annuities

Companies cite lack of participant demand as the primary reason they do not offer a lifetime annuity option.

WW 2009 Surveyn=149n=113Note: Because respondents could choose more than one option, the percentages do not add up to 100 percent.

PLAN MANAGEMENT


2929

Participant’s

Retirement

Outcome

Approach to SavingsHow much to save?Where to save?

Approach to InvestingHow to construct a risk–adjusted financially efficent investment program tailored to unique goals and constraints?

Approach to DistributionsHow much to withdraw? When?How to mitigate longevity risk?

PLAN MANAGEMENT

Participant’s Retirement Outcome is Uncertain


3030

Plan Design & Governance

Effective DC Plan Management

PLAN MANAGEMENT

Plan Design and Governance

Participant Engagement

Fiduciary Investment Oversight


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Contact Details

Robyn Credico

Senior Retirement Consultant 901 N. Glebe Road, Arlington, VA 22203 703.258.8142 [email protected]

Sue Walton

Senior Investment Consultant 191 North Wacker Drive, Suite 2100, Chicago, IL 60606 312.525.2364 [email protected]

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Disclaimer

The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm or accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments.

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