The Markets May 29, 2018

J.P. Morgan Retirement Leader Examines Sequence of Returns Risk in TDF Context

The latest though leadership from the firm asks an increasingly important question: “What should the TDF glide path look like as participants move from accumulating asset balances to spending down those balances in retirement?”

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Talking through the 2018 Guide to Retirement with a small group of financial services trade journalists, Anne Lester, head of retirement solutions for J.P. Morgan Asset Management, highlighted the deep analytical work her team has done regarding the optimal shape of target-date fund (TDF) glide paths during investors’ retirement years.

This is a subject of renewed attention among asset managers, defined contribution (DC) plan sponsors and their advisers and consultants, Lester said. And this is for good reason, as “waves of retiring Baby Boomers are foregoing paychecks for plan payments—distributions from DC plan balances accumulated during their working lives.”

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Lester recounted a commonly told but important story. Until really the last decade or so, DC plans were a nice-to-have supplement to defined benefit (DB) pension plans. Today, for many members of the U.S. workforce, they are a critical source of retirement income that will need to be spent down carefully and with ongoing diligence. Additionally, Lester noted that more than 75% of DC plans with qualified default investment alternatives (QDIAs) have chosen a TDF as their default offering.

With all of this in mind, it is easy to see why the topic of how well target-date funds serve investors near and in retirement is increasingly prevalent. One of the first questions Lester advocates asking is, “What should the glide path look like as participants move from accumulating asset balances to spending down those balances in retirement?” And, the related question will come up, “Should the allocation to equity risk assets continue to decline, increase or plateau?”

The J.P. Morgan view, under Lester’s leadership, is that the allocation to equity risk assets should gradually decline through the working years, reaching its lowest point at or near retirement and remaining static in retirement. Interestingly, Lester explained that her team has come to agree with independent academic research that shows some theoretical merit to re-risking later in retirement from a mathematical/portfolio theory perspective. But she also talked about how behavioral constraints have to be considered here, arguing her firm’s approach takes an appropriate middle ground, balancing the capacity for risk in retirement with the willingness/cognitive ability to take risk effectively.

“We take the stresses of real-life participant saving and withdrawal behavior into account, and we rely on well-diversified glide paths to manage a range of participant-experienced risks associated with DC investing,” Lester explained. These include market, event, longevity, inflation and interest rate risks.

Lester says the firm has recently focused on understanding the behaviors of near-retirement and in-retirement clients. In doing so, the firm incorporated a sizable dataset from Chase on household spending, including the near-retirement years, supplementing the data on participant behavior that has traditionally informed glide path design. In addition, the firm seeks to “quantify and evaluate the implications of two opposing dynamics: the willingness and the capacity to take on risk during retirement.”

“Our latest analyses further validate our thinking on glide path design,” Lester said.

Lester pointed to recent J.P. Morgan research penned by her asset management colleagues Daniel Oldroyd, Katherine Santiago, Marissa Rose, and Livia Wu. As their analysis shows, as participants transition from the accumulation to the decumulation phase, the potential adverse effects of a market downturn on total lifetime wealth reach their peak. Simply put, as net spending continues to deplete balances, it becomes more and more difficult to recover from market losses, even with stronger returns in the later retirement years.

Further impacting glide path decisions is the fact that participant cash flows “are more volatile and varied in the near-retirement years than one might think,” Lester warned.

“Our earlier research on participant withdrawals showed that 14% of those over age 59 ½ withdraw, on average, 30% of their DC plan assets,” the researchers explain. “This volatility can intensify the risks associated with a market downturn near retirement if large spending withdrawals result in assets being liquidated at reduced valuations.”

The latest findings using Chase data on spending validates the team’s initial assumptions, Lester said. Spending in the near-retirement years is volatile and varied, “to a degree that can’t be ignored when structuring glide path allocations in this critical period.”

Another interested factor pointed out by the J.P. Morgan research team is that “average returns in retirement matter far less than the sequence of those returns.” As Lester summarized it, poor performance in the early (vs. later) years can have a far more destructive impact on a portfolio’s ending value.

Compliance May 29, 2018

Court Dismisses Lawsuit Over Inclusion of Former Parent Stock in Retirement Plan

A judge agreed that the plaintiffs failed to plead facts to state a claim for breach of the duty of prudence and the duty to diversify against the investment committee for the Phillips 66 Savings Plan.

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A federal district court has dismissed a lawsuit against the Phillips 66 Savings Plan investment committee for continuing to offer company stock of the company’s former parent, ConocoPhillips, in the plan’s investment menu.

U.S. District Judge Sim Lake of the U.S. District Court for the Southern District of Texas disagreed with the committee’s argument that it is exempt from the Employee Retirement Income Security Act’s (ERISA)’ s diversification requirement because the ConocoPhillips shares retain their character as employer securities after the spinoff of Phillips 66 under ERISA Section 407(d)(1)8; however he agreed that the plaintiffs have failed to plead facts to state a claim for breach of the duty of prudence and the duty to diversify.

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Among other arguments, the judge found the plaintiff’s citation of the Internal Revenue Service Private Letter Ruling 201427024 which supported the argument that because ConocoPhillips ceased to be the employer of the participants of the plan after the spinoff, its shares are not employer securities with respect to the plan, to be persuasive. “Having carefully considered the parties’ arguments and authorities the court concludes that shares of ConocoPhillips stock are not employer securities and that Defendants are therefore not exempt from ERISA’s diversification requirement with respect to the ConocoPhillips Funds,” Lake wrote in his opinion.

In support of the investment committee’s motion to dismiss the claim that it violated ERISA in failing to diversify investments, it argues that the plan offered a diverse menu of investment options in which participants could invest their assets; the extent of the plan’s holdings in ConocoPhillips was attributable to the participants’ elections to retain the ConocoPhillips stock; and section 404(c) of ERISA relieves plan fiduciaries of liability for losses that result from a participant’s exercise of control.

Lake quoted Young v. General Motors Investment Management Corp. in saying “because ERISA requires that fiduciaries diversify ‘the investments of the plan,’ the statute ‘contemplates a failure to diversify claim when a plan is undiversified as a whole.'” He noted that the participants in the Phillips 66 plan decide how to allocate their contributions among the plan’s investment options, and the plaintiffs do not challenge the diversity of the investment options. Lake found that because the investment committee did not mandate that participants’ assets remain in ConocoPhillips Funds and because the plaintiffs do not allege that the plan’s other investment options are not diversified, the plaintiffs fail to allege that the plan was not diversified on its face. “Plaintiffs have therefore failed to state a claim for relief based on a duty to diversify,” he wrote.

Lake also quoted Fifth Third v. Dudenhoeffer in which the Supreme Court held that “where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances.” He disagreed with the plaintiffs’ argument that Dudenhoeffer does not apply to the current case. “Plaintiffs have neither alleged in their Complaint nor argued in their Response that any ‘special circumstances’ are present. Because Plaintiffs have not identified any plausible special circumstances undermining the market price as a measure of ConocoPhillips’ value, Plaintiffs fail to state a claim for breach of the duty of prudence based on public information,” he wrote.

Citing court precedent, Lake said “[T]o plead plausibly a breach of the duty of prudence for failure to investigate, plaintiffs must allege facts that, if proved, would show that an adequate investigation would have revealed to a reasonable fiduciary that the investment at issue was improvident.” He found that the plaintiffs’ complaint contains only legal conclusions with no specific factual allegations about the process the investment committee engaged in. In addition, Lake said the plaintiffs fail to allege that an adequate investigation would have revealed anything other than the publicly available information allegedly establishing that the ConocoPhillips Funds were a risky investment option. “Because Plaintiffs’ allegations restate their claim for breach of the duty of prudence based on public information, Dudenhoeffer forecloses their claim. Therefore, Plaintiffs fail to state a claim for failure to engage in an adequate process for evaluating the prudence of continuing to hold the ConocoPhillips Funds,” he wrote.

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