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RETIREMENT INSIGHTS Focus your aim Innovating the defined contribution core menu to help increase the odds of participant success ABOUT CROSS-ASSET SOLUTIONS FROM J.P. MORGAN The Global Multi-Asset Group (GMAG) is part of the Global Investment Management Solutions Group, which oversees more than $134 billion in multi-asset solutions worldwide.1 GMAG leverages its specialized investment expertise, together with the vast resources of J.P. Morgan Asset Management and its partners and affiliates, to provide customized solutions across asset classes for institutions, third-party intermediaries and individuals. GMAG blends its experience in capital markets investing, strategic and tactical asset allocation, portfolio construction and risk management with one of the industry’s broadest product offerings to develop and implement optimal portfolio solutions for a wide range of client needs. 1 As of September 30, 2014. FOREWORD The defined contribution (DC) industry has introduced numerous advancements to help participants achieve stronger retirement funding levels. One critical area of DC plan design, however, continues to fall short in meeting the needs of the vast majority of participants: the core investment menu. In the past, most plan sponsors relied on expanding core menu investment line-up choices to help participants better diversify their retirement portfolios. A growing amount of evidence, though, shows that this approach has not consistently delivered better investment results and may actually have been detrimental to participant success. In fact, our research has found that: • The existing core menu model is not serving most participants’ best interests. Many participants are overwhelmed by too many investment choices. This has resulted in greater inertia and frequently poor investment line-up usage. For example, the average participant invests in only 3.3 funds, even though the average DC plan includes 20 different investment options.2 This lack of diversification has increased participants’ exposure to extreme investment performance, particularly on the downside. • A more effective core menu simplifies participant decisions while ensuring expanded diversification. J.P. Morgan introduced Core Menu InnovationSM, which streamlines the core investment line-up to three easy-to-understand choices: a diversified equity portfolio, a diversified income portfolio and a diversified cash alternatives portfolio. These professionally managed strategies provide sophisticated diversification across traditional and extended asset classes to help ensure participant portfolios are better structured to potentially deliver more consistent and efficient investment results. • This new approach can help improve investment outcome potential for a greater number of participants. A rigorous analysis of how these Core Menu Innovation portfolios are likely to interact with real-world participant usage shows improved risk/ reward characteristics and potentially stronger investment performance through a wide range of possible market environments. Core Menu Innovation helps make it easy for participants to construct institutional-quality portfolios that exhibit greater return efficiency while maintaining a level of control over their asset allocation profiles. By replacing complex and often redundant line-ups with these three simplified, highly diversified choices, plan sponsors can help participants make smarter investment decisions that can lead to higher expected investment results. For more information about Core Menu Innovation or any of the other topics covered in this paper, please contact your J.P. Morgan representative. Sincerely, 2 Anne Lester Katherine Santiago, CFA Managing Director [email protected] Executive Director katherine.santiago @jpmorgan.com Source: J.P. Morgan retirement research data as of March 31, 2014. J.P. MORGAN ASSE T M A N AG E ME N T 1 TABLE OF CONTENTS 3 Overview 5 The DC disconnect 8 Rethinking the core menu 11 Better investment building blocks 13 Smarter diversification, stronger outcomes 17 A more complete plan line-up 19 Conclusion 2 FO CU S YOU R A IM OVERVIEW Despite 30 years of innovation and insights, DC plans and participants still struggle with a perplexing fundamental problem. Since their introduction, DC plans have morphed from supplemental investment offerings into the cornerstone of the country’s retirement system beyond Social Security. Yet the fact remains that most plan participants are largely unprepared to make the effective investment decisions required by these primarily self-directed retirement programs. Inadequate levels of retirement savings is one distinct and persistent problem. Setting that aside, the crux of the issue is that participants find it difficult to achieve adequate diversification and appropriate asset allocation. By far the most significant DC investment advancement to date has been the introduction of professionally managed target date funds and other types of qualified default investment alternatives (QDIAs), which simplify the asset allocation process into one efficient investment choice. Given the expanding body of research illustrating that participants often make bad investment decisions on their own, most plan participants are probably best served by a target date strategy. Core menu line-ups that include target date strategies can also be effective. Unfortunately, many participants who invest in core menu options make choices that do not provide adequate diversification and/or do not appropriately match their risk tolerance. As a result, the retirement security of millions of Americans is threatened. J.P. Morgan’s Core Menu Innovation offers plan sponsors and their advisors a practical solution to help overcome this challenge. We think plan sponsors should aspire to move as many participants as possible into a target date strategy to help increase the odds that more participants will receive adequate levels of income replacement in retirement. Core Menu Innovation provides an effective way to offer flexibility to those who continue to desire a more active role in their investment choices, while helping to mitigate many of the common investment mistakes participants tend to make. J.P. MORGAN ASSE T M A N AG E ME N T 3 In this paper, we examine: • How current core investment line-ups are failing to address participant needs CORE MENU INNOVATION THE CONCEPT: • Why Core Menu Innovation offers better investment choices for participants who prefer a more active role in determining their asset allocation and risk profile • Consolidate the entire core menu into three easy-tounderstand investment portfolios: diversified equity portfolio, diversified income portfolio and diversified cash alternatives portfolio. • How successful implementation can deliver a more complete plan line-up • Each provides a single entry point into a broadly diversified portfolio of underlying traditional and extended sectors within the specific asset class category. By applying the sophisticated investment thinking behind target date strategies to the core menu, plan sponsors can help ensure that participants’ portfolios are better structured to achieve potentially more consistent and efficient investment results. • Underlying allocations are professionally managed to optimize asset class-specific portfolio efficiency and systematically rebalanced to maintain proper risk/ reward characteristics. PARTICIPANT BENEFITS: • Simpler and smarter investment choices • Better diversification with access to institutional- quality strategies • Higher probability of better investment outcomes • Potentially greater engagement PLAN SPONSOR BENEFITS: • Open architecture • Fee transparency and parity • Manager risk reduced and brand bias eliminated • 404(c) protection 4 FO CU S YOU R A IM The DC disconnect The history of DC investing is marked by enhancement and change, as plan sponsors, regulators and investment managers have introduced ongoing refinements to help participants make better retirement savings choices. Through the years, three types of participants have emerged, each taking a different approach to investment decision making. The industry has responded to the particular needs of the three segments with specific offerings. The three types of participants: • Participants who struggle with granular investment choices and prefer professional management • Participants who value professional oversight but prefer a level of control • Self-directed participants who are well versed in investing and prefer significant flexibility and choice Most participants fall into the first two groups, with only 1.1% considering themselves self-directed. This extremely small segment accounts for a modest 2% of overall DC assets and is usually best served by self-directed brokerage accounts that offer a high degree of autonomous investment selection. For the remaining 98% of assets, participants are normally investing in either professionally managed investment solutions or selecting individual strategies from a core menu to build their own portfolios. A growing body of research, however, has highlighted two major weaknesses with this approach. Though both plan sponsors and participants lack confidence in participants’ ability to invest effectively, 80% of DC assets reside in do-it-yourself core menu options (Exhibit 1, next page). Most DC product innovation has centered on participants who favor professional management by introducing professionally managed, asset allocation solutions such as target date strategies. These offerings provide a viable way to invest assets more efficiently and do not require extensive investment knowledge. We believe, however, that adoption rates for these solutions have remained too low. Though more than 70% of plans now offer target date funds, according to a report from the Investment Company Institute (ICI) and Employee Benefit Research Institute (EBRI), as of year-end 2012 only 41% of participants invested in target date funds. This relatively low share mainly reflects the fact that the industry has generally taken a more passive approach to incorporating these innovative investment vehicles into existing plan line-ups.3 Often only a select group of participants—those who have been defaulted into a 401(k) through an automatic enrollment program—are proactively placed into these strategies.4 This covers a relatively small population. Typically participants can actively select a target date fund as an investment option from the core menu, but most fail to do so either due to inertia or a general lack of understanding about the benefits of these strategies. Based on the low level of target date adoption by participants, it is clear that too few of the participants who admit they need and prefer professional investment guidance are taking advantage of the solutions the industry has developed to address this very issue. Although core menus support the bulk of DC assets, most have not been constructed to foster optimal investing based on realworld participant behaviors. A large part of this problem can be attributed to how core menus have evolved over the years. When DC plans were first introduced, they initially offered participants a selection of only three to four institutional portfolios. The tremendous growth in 401(k) plans during the late ’80s and ’90s, however, prompted participants to start demanding more investment choices, often in the form of commercially branded mutual fund products. Plan sponsors responded to this by steadily adding new options to their core menus and transitioning from institutional separate accounts to more retail-oriented mutual funds. By 1998, the average plan had expanded to 10 fund choices, and this figure has climbed to an average of 20 funds today, with some plans offering in excess of 50 different investment options.4 3 4 Source: Hewitt, 2013 Hot Topics in Retirement. Source: PSCA’s Sixth Annual Survey of Profit-Sharing and 401(k) Plans, 2013. J.P. MORGAN ASSE T M A N AG E ME N T 5 EXHIBIT 1: THE LACK OF CONFIDENCE IN PARTICIPANTS’ ABILITY TO ALLOCATE... Plan spo nso rs Pl a n p a rtic i p a n t s Participants’ confidence in knowing how to best allocate 401(k) contributions across investment options Note: Total n = 1,009. Totals may not equal 100% due to rounding. Source: J.P. Morgan Plan Sponsor Research, 2013. Note: Total n = 796. Source: J.P. Morgan Plan Participant Research, 2013. Intuitively it may seem that greater choices should help participants achieve better investment results, but in practice the opposite has proven to be true. Many of the expanded fund options are more redundant than additive from a diversification standpoint. In addition, mounting industry research has illustrated that menu proliferation has largely confused and overwhelmed participants. Regardless of their degree of investment knowledge, they must now select from an increasingly complicated fund line-up. The ingrained structural problems with today’s typical core menu become painfully obvious when evaluating the second segment of participants, those who value professional management but prefer to maintain a level of control. As a group they have been unsuccessful in building their retirement portfolios. Research has identified these problems for the broad universe of participants: • Most remain underdiversified. The average participant invests in just 3.6 funds, regardless of line-up size.5 • Most have skewed risk exposure. Many participants congregate inadvertently at the extremes of the risk/reward spectrum by making random fund selections, chasing returns and/or concentrating exposure in investments that are misaligned with their risk profile.5 • Most fail to make any portfolio adjustments over time. Participants rarely move into new line-up additions, and only 7% rebalance their portfolios in any given year.5 J.P. Morgan retirement research data as of March 31, 2014. 6 FO CU S YO U R A IM 18% Asset allocation strategies 2% Brokerage 80% Core menu 76% Not confident Plan sponsor confidence that majority of participants have the appropriate asset allocation 5 W h e r e p a r t i ci p a n t s ’ a s s e t s r e s i d e 24% Highly confident 33% Highly confident 66% Not confident DOES NOT ALIGN WITH HOW INVESTMENT DECISIONS ARE MADE Source: J.P. Morgan Retirement Plan Services, 2013. These types of poor investment decisions have had a direct negative impact on the portfolio returns for many participants in our second segment: those who value professional management but prefer a level of control. There is both notably lower performance as well as increased risk of more extreme outcomes. CHOICE OVERLOAD Behavioral research shows that although most people are attracted by the idea of having more choice, they actually prefer less. In fact, research has revealed that too much choice often leads to inaction. In one famous study, an alternating assortment of 24 and six jam samples were offered in a gourmet market.6 The larger selection drew in 60% of customers, with the smaller attracting only 40%. In both cases, customers sampled an average of two jams. Only 3% of those presented with the 24 options decided to buy a jar, while 30% selecting from the smaller group made a purchase—a full 10 times higher response rate. A similar dynamic can be found in DC plans that offer excessive core menu options. Too much investment choice risks overwhelming participants, who often simply decide to make no choice at all. 6 Source: Iyengar, S.S. and M.R. Lepper. (2000). “When choice is demotivating: Can one desire too much of a good thing?” Journal of Personality and Social Psychology, 79, 995–1006. However, median annualized performance for target date fund users was 14.2%, compared to 13.6% for the other group of participants. The bottom performance range was significantly worse for the non-target date fund participants, at an average negative return of -2.2% per year vs. a positive average annual return of 8.5% for the target date fund group. Such performance disparities have sparked greater awareness of the structural vulnerabilities of the current core menu model. In response, some plan sponsors have begun implementing a degree of menu consolidation in the hope that it will help promote better participant investment decisions. Nevertheless, we believe that greater efforts must be made to further strengthen the core menu model. Indeed, we think the industry has an extraordinary opportunity to reframe the core menu in a whole new light. E X HI BI T 2 : A NNU A L I Z E D F I V E - Y E A R S R E TU R NS : HI G HS , L O W S A ND M E D I A N BY I NV E S TM E NT S TR AT EG Y 30 27.7 25 Rate of return (%) We recently evaluated five-year performance for more than 770,000 participants based on whether they were invested in target date funds or constructing their own investment portfolios from core menu line-ups (Exhibit 2). When assessing these results, plan sponsors concerned with providing the broadest participant base with the strongest performance potential should focus on participants who fall at median return levels or below. This represents 50% of each group, a sizable portion from a fiduciary perspective. On the upside, top performing participants in this group achieved substantially higher returns during the period, delivering an average 27.7% per year compared to the highest 19.8% annualized return for target date fund users. 20 19.8 15 14.2 13.6 10 5 8.5 0 -2.2 -5 -10 Target date fund users Do-it-yourselfers Source: J.P. Morgan retirement research data. *Rates of return are standardized using the interquartile methodology. The analysis measurement period is December 31, 2008 through December 31, 2011. The above data represents an analysis of 515,634 participants’ rate of return. It does not represent the returns of any individual product or portfolio. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular manner. Rate of return for the measurement period is aggregated by investment strategy and calculated for active participants using the Modified Dietz method and is based upon volatility between the highest rate of return and lowest rate of return associated with each investment strategy among such participants. Historical rate of return is not a guarantee of and may not be indicative of future results. Services associated with the identified investment strategies were available as of the last day of the measurement period but may not have been available throughout the measurement period. Target date fund users are participants with at least 70% of their account balance invested in target date funds as of the first and last day of the measurement period. Do-it-yourselfers are those with less than 70% of their account balance invested in another investment strategy as of the first and last day of the measurement period and includes those using online advice services, if applicable. J.P. MORGAN ASSE T M A N AG E ME N T 7 Rethinking the core menu Any discussion about the design of a more effective core menu must start by defining the overarching goal plan fiduciaries hope to achieve with their investment line-ups. At a high level, most would probably agree that the menu should help participants capture solid investment returns while narrowing the range of extreme investment outcomes. This requires the line-up to: • Provide participants with adequate investment diversification choices across asset classes • Deliver these strategies in a way that cultivates constructive investment behavior and helps protect against improper usage When evaluating how best to accomplish these objectives, it is important to assess what drives portfolio returns. Investment performance is generally derived from two sources. “Beta” represents the return that reflects an investment’s sensitivity to market risk. “Alpha” refers to return generated by portfolio manager’s skill. Since beta, in essence, represents market exposure, it plays the larger role in providing adequate diversification, since diversification is principally about spreading market risk. FOCUSING ON THE BIG PICTURE Core Menu Innovation helps plan sponsors and participants spend time and energy on areas that can change potential investment outcomes in a meaningful, positive way. It helps them avoid getting distracted by the details of navigating a complicated plan line-up. Two primary issues truly drive retirement funding success: • Getting participants to save more • Making those assets work more efficiently By presenting participants with three core menu investment choices, plan sponsors can focus education and communication efforts on fewer, more powerful messages, such as how to save enough and how to develop the right allocation strategy. In practice, market exposure is typically proxied by a broad market index, such as the S&P 500 Index or the Barclays Capital U.S. Aggregate Bond Index (Barclays Agg), although most investments exhibit sensitivity to more than one type of market exposure. Equity and fixed income classifications are perhaps the most common way to group investments, but subasset classes and various investment styles may also introduce distinct market exposures. One of the principal limitations of the existing line-up structure is the fact that many participants remain overly exposed to too few asset classes, and are inadequately diversified within asset classes, despite the fact that most plans offer a wide assortment of investment choices. This makes many participants vulnerable to sub-par performance, a challenge further complicated by the often duplicative nature of most expanded line-ups. A portfolio that includes a diverse set of market exposures can benefit from a broader range of return streams, which helps expand investment potential and also limits the possible damage that might be inflicted by any one market’s negative returns. Hence, effective market exposure diversification is crucial to the concept of portfolio efficiency, which measures a portfolio’s expected performance compared to its expected risk level. The right mix of various market exposures can increase portfolio efficiency, and as portfolios become more efficient, they generate stronger risk-adjusted performance. For example, a menu that offers multiple large cap equity strategies with different investment styles and managers may appear diversified because it expands investment choice. But these different strategies do not expand market exposure. The average participant invests in just three or four investment options. 8 FO CU S YO U R A IM As noted earlier, if most or all of those options end up having similar asset class exposures, the investment risk can be considerable. Accordingly, it seems prudent to embed a broader E XH IB IT 3: A SIMP L IF IED, Y ET MORE S OPH I S T I C AT ED CO R E M E NU Current model: 13 funds Core Menu Innovation model • Large cap growth • Large cap value • Large cap core – passive • Large cap core – active • Mid cap growth • Mid cap value • Small cap growth • Small cap value • International developed large equity • REITs • U.S. aggregate bond – passive • U.S. aggregate bond – active • Money market or stable value Diversified equity portfolio Diversified income portfolio Diversified cash alternatives portfolio Broadly diversified across equity sub-asset classes, geographies and investment styles Broadly diversified across capital structure and geography, anchored in high-quality investment grade bonds Money market or stable value Source: J.P. Morgan Asset Management. Information is hypothetical and shown for illustrative purposes only. set of asset allocation exposures into the investment selection process as do-it-yourself participants construct their portfolios. Furthermore, an effective core menu must be modular in nature, but it should be far less complicated to use than the current configuration. The industry has been much too optimistic about the average participant’s ability to grasp differences between relatively nuanced strategies such as large, mid and small cap funds, even if these distinctions are very apparent to anyone with an investment background. However, a participant who prefers some level of control over investment choices is likely to understand the basic differences between broader asset class categories such as equities, fixed income and cash alternatives. Because plan sponsors make such pragmatic assessments in structuring their core menus, J.P. Morgan developed its Core Menu Innovation. It is a straightforward solution that applies a deep understanding of retirement trends and real-world participant 401(k) usage to plan line-up design. This evolutionary new approach entails complete line-up consolidation into three institutional-quality investment portfolios (Exhibit 3): • A diversified equity portfolio • A diversified income portfolio • A diversified cash alternatives portfolio By streamlining the core menu (for example, from 13 fund choices to three highly diversified investment options), plan sponsors can help make certain that do-it-yourself participant portfolios are more likely to generate stronger investment results. The improved choice architecture of Core Menu Innovation offers a number of strategic benefits: • It is easy to understand and simple to use. Participants need only select from three basic investment options to maintain an active role in determining their asset allocation and risk profiles. • It automatically invests participant assets more efficiently. Each Core Menu Innovation portfolio incorporates broad diversification across traditional and extended asset classes, which significantly enhances risk-adjusted return potential. • It is more consistent. Systematic rebalancing maintains proper risk/reward characteristics within each portfolio. J.P. MORGAN ASSE T M A N AG E ME N T 9 With this consolidated menu of equity, fixed income and cash alternatives, participants experience a single entry point for each primary asset class, while instantly gaining access to multiple underlying sub-asset classes. This optimizes participant decision making to focus on asset allocation choices rather than the minutiae of individual fund selection. These three highly diversified portfolios significantly reduce the risk that participants might experience extreme negative returns through improper usage of a more expanded fund line-up. Each Core Menu Innovation portfolio automatically diversifies return streams within its respective asset class. For that reason, participants can effectively control their exposure to the broader equity, fixed income and cash alternatives categories without also having to worry about investment decisions related to market capitalization, geography, investment style and other fund choices that usually fall outside most participants’ comfort zones. 10 FO CU S YO U R A IM A MORE PRUDENT FRAMEWORK Plan sponsors are increasingly under scrutiny to ensure they fulfill their legal obligations for the prudence and suitability of participant investment decisions. Core Menu Innovation can help support these responsibilities by providing participants with access to professionally managed diversified portfolios where the focus is on making simpler decisions at the asset allocation level, rather than the individual fund level. This can potentially help position participants to attain better investment outcomes. From a fiduciary perspective, anything that facilitates improved investing with accessible and easily understood options makes a positive contribution. The open architecture aspects of Core Menu Innovation also offer plan sponsors greater control when they want to quickly make a change in their underlying strategies. This can help ensure a higher level of compliance with investment policy statements, while avoiding the adverse participant reactions that often accompany individual fund line-up adjustments. Better investment building blocks J.P. Morgan has developed the following Core Menu Innovation strategic asset allocations: Diversified equity portfolio 38% U.S. large cap equities 12% Multi-cap equities 9% U.S. small cap equities A CONCEPT WITH BROAD APPLICATIONS Though the current Core Menu Innovation model consists of just three portfolios, the concept can be applied to a wide spectrum of investment challenges as the DC industry evolves. One example is inflation protection. Plan sponsors might want to provide participants with a professionally managed portfolio designed to provide a reliable stream of real returns through changing inflation cycles, an issue particularly important for those closer to retirement. 6%REITs 22% International equities 13% Emerging market equities Benchmark: MSCI World Index Diversified income portfolio 68% U.S. aggregate bonds 8% U.S. investment-grade corporate bonds 16% U.S. high yield bonds 6% EMD 2% EMD local Benchmark: Barclays Capital U.S. Aggregate Bond Index Diversified cash alternatives portfolio 100%Stable value/ Money market fund Benchmark: Three-month U.S. Treasury bill Charts are shown for illustrative purposes only. May not add to 100% due to rounding. Each Core Menu Innovation portfolio seeks to outperform its respective benchmark on a risk-adjusted basis. Given these strategies’ expansive diversification characteristics, we selected two of the industry’s broadest indices to measure performance: the MSCI World Index vs. diversified equity portfolio and the Barclays Agg vs. diversified income portfolio. In both cases, the J.P. Morgan strategies include an even wider range of asset class sub-segments than those tracked by their indices. This high degree of institutional-quality diversification is designed to increase the portfolio efficiency of each asset class, by lowering the amount of risk required to generate the return expectation of each asset class. This level of diversification would generally be out of reach for participants drawing from a typical investment line-up. With Core Menu Innovation, however, this sophisticated approach becomes widely and easily accessible. For example, the Core Menu Innovation allocations offer the flexibility to include strategies found in many institutionally managed defined benefit (DB) plans that may be additive to expected performance but problematic as standalone DC menu options. We have included a number of these extended sub-asset classes in our strategic asset allocations, such as emerging market equity and REITs in the diversified equity portfolio and high yield bonds and emerging market debt in the diversified income portfolio. These asset classes have historically demonstrated lower correlations to the more traditional sub-asset classes that form each portfolio’s core holdings. Although these sub-asset J.P. MORGAN ASSE T MA N AG E ME N T 11 classes may be volatile on their own, controlled exposure to these investments as part of a comprehensive allocation strategy can potentially help enhance return and reduce overall risk. We also based our allocations on J.P. Morgan Asset Management’s 2015 Long-Term Capital Market Return Assumptions. These assumptions are used by many institutional investors, who employ them to develop and support their anticipated return assumptions for financial reporting purposes. In our judgment, using these assumptions will provide a far more realistic framework for performance expectation when compared with historical returns. Any portfolio based strictly on historical returns might be skewed by the extreme market environments that occurred over the past 25 years. What worked well from an investment perspective in the late 1990s was vastly different than what proved successful in the wake of the financial crisis. The most successful strategy in the years ahead may be a different approach altogether. Markets are continuously evolving and an asset allocation strategy most likely to deliver the strongest investment outcomes must be designed to address this reality. 12 FO CU S YOU R A IM THE LIMITATIONS OF INDEXING Similar to the target date fund concept, Core Menu Innovation is designed to optimize diversification in a manner well beyond any one market index. Even the broadest stock and bond indices have significant shortcomings in terms of subasset class exposure. Indices are designed to provide backward-looking snapshots of the size, structure and performance of various markets. They are not designed to improve forward-looking investment outcomes. Index allocations deliberately seek to mirror the market’s fluctuations, not improve upon them. In fact, indices often consist of outsized exposure to some market segments and may completely exclude others. Systematically improving risk adjusted return potential requires active management. Smarter diversification, stronger outcomes To test how well these Core Menu Innovation portfolios might stand up to the stresses of real-life retirement investing, we subjected each to a rigorous statistical simulation that projected the investment outcomes of 10,000 participants at age 65, covering a wide range of scenarios that might be experienced over a lifetime of investing. Each participant began with a $40,000 annual salary and ended with a $72,000 annual salary over a 40-year time horizon. The potential outcomes were quite varied because we included a diverse assortment of possible market environments from strong rallies to market crashes. Drawing on behavioral trends we identified in earlier research, we also included a broad range of participant saving patterns, from investors who contributed consistently and left accounts untouched, to those who saved more erratically, borrowed and/or made early withdrawals. When compared to the MSCI World Index, the diversified equity portfolio delivered better outcomes for all participants. It outperformed the S&P 500 for participants at both the top and the bottom range of returns—at the 5th, 25th and 50th percentile of returns. Of particular interest to plan fiduciaries, the diversified equity portfolio provided much stronger returns for participants unlucky enough to fall in the bottom two quartiles of returns, either as a result of difficult markets or poor saving and spending behaviors. The diversified income portfolio delivered similar out-performance. It provided significant investment HO W TO R E A D THE BO X - A ND - W HI S K E R S CHA R T As expected, the optimized J.P. Morgan portfolios delivered higher long-term, risk-adjusted performance relative to each respective benchmark (the diversified equity portfolio analysis included the widely used S&P 500 Index for comparison as well). This trend of improved performance with more limited downside exposure was consistent across the various market environments and participant investment behaviors used in the simulations (Exhibit 4). 5th 25th 50th 75th 95th The box marks the range of the 25th, 50th (median) and 75th percentile outcomes, from top (best) to bottom (worst). The whiskers reaching out from the top and bottom of the box show the range up to the 5th and down to the 95th percentiles of the distribution of outcomes. As the dispersion of returns increases, the “box-and-whisker” becomes more elongated. E XH I B IT 4 : RANGE O F EX PEC T ED AC C OU N T B AL AN C ES A T R E TI R E M E NT Projected outcomes – Equities 2,500 Projected outcomes – Income 1,000 2,280 900 1,946 2,000 800 1,824 736 1,500 1,000 500 — [000s] [000s] 700 1,181 496 765 1,056 469 701 1,013 455 283 272 266 SmartAllocation Equity MSCI World S&P 500 677 645 600 500 400 577 386 476 512 344 423 300 200 271 242 SmartAllocation Income Barclay Agg 100 — Source: J.P. Morgan Asset Management’s 2015 Long-Term Capital Market Return Assumptions. MSCI World index allocations were replicated by custom calculating forward-looking statistics and simulations using 52% U.S. Large Cap and 48% EAFE Equity hedged. In these simulations, 5th and 25th percentiles indicate worst outcomes statistically, 50th median indicates mostly likely scenario and 75th and 95th are best-case scenarios. Note: These numbers are inflation-adjusted. See important Capital Market Return Assumptions disclosure on last page. J.P. MORGAN ASSE T MA N AG E ME N T 13 outcome improvement for all participants and especially helped to increase return expectations for participants in the lower percentiles. While this standalone performance is compelling, it is even more critical to assess how these portfolios might work together, since do-it-yourself participants will employ them to construct their own customized asset allocations. To help quantify if various combinations of these portfolios would help participants secure stronger outcomes, we re-ran the simulations with three frequently used types of allocations (Exhibit 5, next page): • A 60/40 portfolio of 60% diversified equity and 40% diversified income • A 40/60 portfolio of 40% diversified equity and 60% diversified income • A 1/n portfolio, which allocates an equal amount of assets in each investment option offered: equities, income and cash alternatives All of the participant-driven portfolio combinations exhibited consistently stronger risk/reward characteristics compared to equivalent benchmark allocations. These improved investment profiles would be expected, since each Core Menu Innovation portfolio automatically provides participants with optimized asset class-specific diversification. Of note, our analysis demonstrated that increasing allocations to the income and cash alternatives portfolios proved extremely effective in dialing down expected risk, without curtailing relative return advantages. Our analysis underscored the effectiveness of the Core Menu Innovation model, which offers participants three portfolio options (equities, income and cash alternatives) that can be selected based on a participant’s individual risk tolerance. The benefits of tightly controlled exposures to a broad set of sub-asset classes are firmly entrenched within each portfolio. 14 FO CU S YOU R A IM The inference of this model for plan fiduciaries is an ensured degree of relative portfolio efficiency, regardless of how participants mix the equity, income and cash alternatives portfolios together. Even if participants suboptimally allocate assets among these three choices, they will still gain exposure to a more limited range of downside risk. It is doubtful that a similar observation could be made about a line-up with 18-plus fund choices because the variability in underlying allocations would simply be too great to predict consistent success. This inherently greater portfolio efficiency of the Core Menu Innovation model is expected to deliver stronger investment outcome projections for the vast majority of participants across all three portfolio combinations, while minimizing downside risk (Exhibit 6, next page). In both the 60/40 and 40/60 portfolios, there was consistent—and often dramatic— improvement at the 5th, 25th and 50th percentiles for the Core Menu Innovation blends. This pattern remained consistent with the 1/n Core Menu Innovation mix as well. While there was improvement at the median percentile, it was more muted than the increase noted in the other portfolio mixes due to the stabilizing nature of cash in both the participant portfolio and the blended benchmark. Plan fiduciaries are undoubtedly concerned about increasing investment success for the greatest number of participants. For that reason, they should especially focus on the consistently stronger performance across these various Core Menu Innovation combinations at the median and lower percentiles. These segments face the greatest risk of falling short in accumulating enough to retire safely, due to bad investment decisions or challenging economic climates. The Core Menu Innovation portfolios help better protect these groups on the downside while still delivering compelling performance for participants in the higher projected ranges. E XH IB IT 5: C O MBININ G C ORE MEN U I N N OVAT I ON POR TF O L I O S OFFER S A HIGHL Y DIVERS IF IED AS S ET C L AS S MI X 60 diversified equity/ 40 diversified income portfolio EXHIBIT 6: RANGE OF EXPECTED ACCOUNT BALANCES AT RETIREMENT FOR PARTICIPANT-DETERMINED PORTFOLIO COMBINATIONS 60/40 portfolio projected outcomes $1,600 1% 2% 6% 3% 1,400 23% 1,365 1,151 1,200 1,110 7% 5% 4% 13% 8% [000s] 1,000 27% 800 883 600 477 781 650 444 590 400 200 — 40 diversified equity/ 60 diversified income portfolio 760 436 308 294 290 60 div equity/ 40 div income 60 MSCI world/ 40 agg 60 S&P 500/ 40 agg 578 40/60 portfolio projected outcomes 5% 41% 15% $1,200 5% 1,000 4% 2% 800 9% 5% [000s] 1% 4% 10% 600 1,077 910 763 454 590 420 400 200 1/n portfolio — 13% 1% 2% 5% 3% Equities $900 600 500 400 U.S. large cap equities U.S. aggregate core bonds 300 U.S. multi-cap equities 200 U.S. small cap equities U.S. investment grade corporate bonds REITs U.S. high yield bonds International equities EMD Emerging markets equities EMD local Cash alternatives Source: J.P. Morgan. Hypothetical information shown for illustrative purposes only. 415 527 292 289 40 div equity/ 60 div income 40 MSCI world/ 60 Barclays agg 40 S&P 500/ 60 Barclays agg 743 727 825 700 23% Cash alternatives 658 310 800 4% Fixed income 534 1/n portfolio projected outcomes [000s] 33% 4% 3% 2% 7% 669 883 615 390 493 567 369 463 559 364 272 260 258 Diversified 1/n 1/n MSCI world 1/n S&P 500 456 100 — Source: J.P. Morgan. Results are based on analysis derived from J.P. Morgan Asset Management’s 2015 Long-Term Capital Market Return Assumptions. See important Capital Market Return Assumptions disclosure on last page. See page 11 for a complete breakdown of the 60 diversified equity/40 diversified bond, 40 diversified equity/60 diversified bond and diversified 1/n portfolios. J.P. MORGAN ASSE T MA N AG E ME N T 15 Given this data, it seems evident that Core Menu Innovation provides a statistically sound line-up structure that delivers efficient diversification and facilitates positive participant usage. Based on our analysis, this smarter core menu approach: • Consistently optimizes investment outcome potential. The broader diversification characteristics of the three Core Menu Innovation portfolios helped produce higher account balances in our simulations, while narrowing the range of extreme downside performance. • Helps make do-it-yourself participants better investors. The streamlined Core Menu Innovation structure made it easy to assemble institutional-quality portfolios that captured greater risk/reward efficiency, regardless of how participants might combine the equity, income and cash alternatives portfolios. • Focuses participants on the right risk levers. Varying exposure to the equity, income and cash alternatives portfolios provided an effective and clearly defined means to customize portfolio risk/reward characteristics, in contrast to the haphazard approach required by more complicated line-ups. By simplifying participant investment decisions while broadening diversification, the Core Menu Innovation model provides a prudent framework for do-it-yourself participants to engage in an efficient and effective asset allocation process. This optimal convergence of participant behavior and portfolio structuring offers a strong set of core menu offerings that can help plan sponsors successfully increase participants’ odds for retirement funding success. 16 FO CU S YOU R A IM A more complete plan line-up Core Menu Innovation helps close the substantial gap between fully bundled target date funds and the current “go it alone” aspect of most current investment line-ups. Offering professionally managed asset class-specific portfolios presents do-it-yourself participants with a practical modular solution that allows investment choices while facilitating stronger riskadjusted return potential over the long term. In conjunction with a target date fund offering and a self-directed brokerage account, the addition of a set of Core Menu Innovation portfolios can help plan sponsors offer participants three compelling investment tracks from which they can choose based on their particular needs (Exhibit 7, next page). In our participant focus group research, we tested various approaches to core menu reconfiguration. Participants consistently told us that Core Menu Innovation, compared with other approaches, was the easiest to understand and the most likely to help them engage with their plans. These quotes highlight the common themes we heard again and again: • “I like it. I had too many options before. It’s something different, something new that’s easier for the investor.” • “It’s been thoughtfully planned for me.” • “I was overwhelmed with too many choices in the past.” • “It gives you a place to get started.” That sentiment is captured in this particular quote: “It doesn’t change what I’d do initially, but it makes me feel better knowing that I could go there if I wasn’t happy with the performance I was getting with the packaged investments.” Engaging in a plan re-enrollment is the most effective way to implement Core Menu Innovation. This implementation approach is used by many plan sponsors when making substantial investment menu changes to their plan. During the re-enrollment process, participants are informed of the new investment options and given the opportunity to make new investment elections. If they do not make an active election during the designated election window, their existing assets and future contributions will be defaulted into the plan’s QDIA, usually a target date fund. The plan sponsor may receive ERISA fiduciary safe harbor protection for the assets that are defaulted into the QDIA. This approach will ultimately move more participants into target date funds, while offering an improved core menu for those who desire to retain control over their asset allocations. It also effectively recalibrates the line-up to help plan sponsors lead participants to the investment solutions best designed to meet their specific needs. After the re-enrollment, this streamlined investment structure can help focus new participants on determining their investor type to decide which investment approach makes the most sense for their situation. • “This is great. They’ve simplified it by only having three options. Yet it speaks to every different kind of investor.” A few did say the strategy felt like a loss of choice, but those concerns dissipated when participants were informed of the diversity of investment styles and managers encompassed in each portfolio. When a plan sponsor based its communications on the premise that participants are not losing choice but rather gaining better access to choice, it helps place the Core Menu Innovation concept in the context of participants’ overall investment strategies. Additionally, offering a self-directed brokerage account for participants who want complete control over their investments also proved reassuring, even though most will never use this option. J.P. MORGAN ASSE T MA N AG E ME N T 17 E XH IB IT 7: BUIL DING T H E RIGH T PL AN L I N E-U P If participants prefer ... A ready-made solution They can choose their own mix More investment options • Feel uncertain about investing terms and concepts • Take the time to check their investments every few months • Thoroughly understand different types of investments • Lack the time or interest to study investment details • Feel comfortable with stock market terms, but don’t study day-to-day changes • Enjoy taking time to regularly study the stock market • Take comfort from having access to professional expertise • Prefer to balance choice with ease • Consider investments outside the retirement plan when forming an investing strategy They may want to consider ... Choosing the target date fund closest to their expected retirement year 2015 Selecting a mix from the plan’s three core investment options Diversified equity portfolio 2020 Exploring the range of choices available in a self-directed brokerage account Mutual funds Individual stocks 2025 2030 2035 2040 Diversified income portfolio 2045 2050 2055 Diversified cash alternatives portfolio Target date funds are funds with the target date being the approximate date when investors plan to start withdrawing their money. Generally, the asset allocation of each fund will change on an annual basis, with the asset allocation becoming more conservative as the fund nears the target retirement date. The principal value of the fund[s] is not guaranteed at any time, including at the target date. 18 FO CU S YO U R A IM CONCLUSION Core Menu Innovation represents J.P. Morgan’s best thinking on how to measurably move the needle toward a more financially sound retirement for participants making their own investment decisions. Plan sponsors are searching for ways to consolidate investment line-ups and increase participant engagement. Core Menu Innovation takes those efforts to the next level, simplifying participant choices while providing access to the professionally designed asset allocation and sophisticated diversification solutions found in many professionally managed defined benefit plans. There is a remarkable power in the simplicity of just three core menu options. Although the concept is simple, the logic behind it is quite advanced. These institutional-quality equity, fixed income and cash alternatives portfolios firmly root increased portfolio efficiency into do-it-yourself participants’ asset allocation choices. Our research has shown this approach to be conducive in significantly improving investment outcome potential, both by generating higher expected risk-adjusted performance and encouraging more beneficial investment behavior. By streamlining the investment line-up with fewer but smarter investment options, plan sponsors can help participants make better investment decisions and place a greater number of people on a more secure retirement savings path. THE TARGET DATE FUND ADVANTAGE We believe target date funds remain the best choice for most participants because many find it difficult to articulate their risk preferences. For these investors, there is no substitute for a well-designed glide path. Core Menu Innovation replicates many diversification benefits of the target date fund experience at the asset class level; however, the concept is more closely related to riskbased strategies, given that these portfolios’ risk/reward characteristics remain static. Core Menu Innovation should not be viewed as a true unbundling of a target date fund’s asset classes. In addition to broader asset class allocation shifts, most glide paths also include changes within each asset class as retirement approaches. These are not reflected in a Core Menu Innovation portfolio. Some target date funds also add exposure to assets that sit outside the equity, fixed income and cash segments, such as inflation-protection strategies. J.P. MORGAN ASSE T MA N AG E ME N T 19 20 FO CU S YOU R A IM The projections utilized throughout, based on J.P. Morgan Asset Management’s 2015 Long-Term Capital Market Return Assumptions, are provided for illustration/ discussion purposes only and are subject to significant limitations. “Expected” or “alpha” return estimates are subject to uncertainty and error. For example, changes in the historical data from which it is estimated will result in different implications for asset class returns. Expected returns for each asset class are conditional on an economic scenario; actual returns in the event the scenario comes to pass could be higher or lower, as they have been in the past, so an investor should not expect to achieve returns similar to the outputs shown herein. References to future returns for either asset allocation strategies or asset classes are not promises of actual returns a client portfolio may achieve. Because of the inherent limitations of all models, potential investors should not rely exclusively on the model when making a decision. The model cannot account for the impact that economic, market and other factors may have on the implementation and ongoing management of an actual investment portfolio. Unlike actual portfolio outcomes, the model outcomes do not reflect actual trading, liquidity constraints, fees, expenses, taxes and other factors that could impact the future returns. The model assumptions are passive only — they do not consider the impact of active management. A manager’s ability to achieve similar outcomes is subject to risk factors over which the manager may have no or limited control. RISKS ASSOCIATED WITH INVESTING IN THE FUNDS. 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 specific securities, asset classes and financial markets are for illustrative 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 employs proprietary projections of expected return as well as estimates of their future volatility. The relative relationships and forecasts contained herein are based upon proprietary research and are developed through analysis of historical data and capital markets theory. These estimates have certain inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees or other costs. References to future net returns are not promises or even estimates of actual returns a client portfolio may achieve. The forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than original cost. Past performance is not a guarantee of future results. Cash alternatives are not federally guaranteed and may lose value. Cash alternative portfolios have interest rate, inflation and credit risks that are associated with the underlying assets owned by the portfolio. Bonds have the same interest rate, inflation and credit risks that are associated with the underlying bonds owned by the portfolio. Interest rate risk means that as interest rates rise, the prices of bonds will generally fall, and vice versa. Inflation risk is the risk that the rate of return on an investment may not outpace the rate of inflation. Credit risk is the risk that issuers and counterparties will not make payments on securities and investments held by the fund. The price of equity securities may rise or fall because of changes in the broad market or changes in a company’s financial condition, sometimes rapidly or unpredictably. These price movements may result from factors affecting individual companies, sectors or industries selected for the fund’s portfolio or the securities market as a whole, such as changes in economic or political conditions. Equity securities are subject to “stock market risk,” meaning that stock prices in general (or in particular, the prices of the types of securities in which a fund invests) may decline over short or extended periods of time. When the value of a fund’s securities goes down, an investment in a fund decreases in value. Certain underlying funds of the target date funds may have unique risks associated with investments in foreign/emerging market securities and/or fixed income instruments. International investing involves increased risk and volatility due to currency exchange rate changes, political, social or economic instability, and accounting or other financial standards differences. Fixed income securities generally decline in price when interest rates rise. Real estate funds may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector, including, but not limited to, declines in the value of real estate, risk related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by the borrower. The fund may invest in futures contracts and other derivatives. This may make the fund more volatile. The gross expense ratio of the fund includes the estimated fees and expenses of the underlying funds. A fund of funds is normally best suited for long-term investors. Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than original cost. Past performance is not a guarantee of future results. All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. They are based on current market conditions that constitute our judgment and are subject to change. Results shown are not meant to be representative of actual investment results. Past performance is not necessarily indicative of the likely future performance of an investment. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. J.P. Morgan Funds are distributed by JPMorgan Distribution Services, Inc., which is an affiliate of JPMorgan Chase & Co. Affiliates of JPMorgan Chase & Co. receive fees for providing various services to the funds. JPMorgan Distribution Services, Inc. is a member of FINRA/SIPC. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. © JPMorgan Chase & Co., January 2015 RI-WP-CMI J . P. M O R G A N A S S E T M A N A G E M E N T 270 Park Avenue I © JPMorgan Chase & Co. RI-WP-CMI New York, NY 10017