Alternative Investments in
Retirement Accounts
Laura Starks
Charles E and Sarah M Seay Regents Chair in Finance
McCombs School of Business
University of Texas at Austin
Independent 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 Funds
in Retirement Accounts
• From an academic research perspective
• From 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 p
plans handle it
▫ Expected life changes over time
• Asset allocation choices
• Behavioral
B h i l opportunities
t iti and
d risks
i k
Whatt will
Wh
ill b
be sufficient
ffi i t iincome iin
retirement?
Average % of age 65 household expenses
at older ages
100%
%
90%
80%
70%
60%
50%
40%
30%
3
20%
10%
0%
81%
66%
48%
65
75
85
95
Source: Employee Benefit Research Institute
Issue Brief February 2012
U.S. Personal Savings Rate
12-month moving average as a % of disposable income
%
14
12
10
8
6
4
2
0
Data source: U.S. Department of Commerce
Common retirement plans in the U.S.
• 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)
 Employer takes on investment risk
▫ Defined contribution (DC plan - 401k, 403b, 457)
 Contribution defined
 Portable
p y – contribution,, asset allocation
 Choice of employee
 Employee takes on investment risk
• Individual retirement account (IRA)
(
)
• Social security
3-legged stool
Social security
Employer
Sponsored
Retirement
Savings
Growth in U.S. retirement assets
(outside of social security)
Trillions
$20
Total
$18
$16
$14
$12
$10
Defined
D
fi d b
benefit
fi
& other
$8
Defined
contribution
IRA
$6
$4
$2
$
$1990
1995
2000
2005
2010
2011
Data source: www.ici.org
• 69% of U.S. households have a tax-advantaged
retirement account
Effect
ect of
o tthe
e 2007-2008
00 008 financial
a c al ccrisis
sso
on
growth in U.S. retirement assets
Trillions
$20
Total
$18
$16
$14
$12
Defined
D
fi d b
benefit
fi
& other
$10
$8
Defined
contribution
IRA
$6
$4
$2
$0
2007
2008
2009
2010
2011
Data source: www.ici.org
Influence of retirement assets into U.S.
mutual funds
14,000
Total Value (in Billions US$
$)
12,000
10,000
Non‐
Retirement
8,000
6,000
4,000
Individual
Retirement
Account
IRA
2 000
2,000
Defined
D
fi d
Contribution
Plans
DC
0
1992
1994
1996
Total Assets
Source: ICI
1998
2000
2002
2004
Retirement Assets
2006
2008
DC Assets
2010
Influence of retirement assets into U.S.
equity mutual funds
7,000
Total Value e(in Billions US$)
6,000
,
Non‐
Retire‐
ment
5,000
4,000
Individually
selected
l t d
3,000
IRA
2,000
1,000
0
1992
DC
1994
1996
Total Equity
Source: ICI
1998
2000
2002
2004
Retirement Equity
2006
2008
DC Equity
2010
Selected
through
employer’s
plan
Common retirement plans in the U.S.
• 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
 Employer
l
takes
k on iinvestment risk
i k
▫ Defined contribution (e.g., 401k, 403b, 457)
 Contribution defined
 Portable
 Choice of employee – contribution, asset allocation
 Employee takes on investment risk
• Individual retirement account (IRA)
• Social security
IIncreasing
i g lif
life expectancy
t
ffor retirement
ti
t
income
• How long a 22-year-old entering the workforce
could expect to live :
Year
1933
1953
1973
973
1993
2009
Age
68
72
74
77
80
Data source: http://www.mortality.org/
DB plan guarantees
With most DB plan structures, participant receives
annuity for life
Implication:
p
p
plan sponsor
p
((employer)
p y ) is taking
g on a
lot of risk
Coverage of DB versus DC plans
% of workers of medium and large businesses in U.S.
US
90
80
70
60
50
5
40
30
20
10
0
DB plans
DC plans
Data Source: EBRI
Coverage of DB versus DC plans
% of workers of state and local
governments in U.S.
DB plans
100
90
80
70
60
50
40
30
20
10
0
DC plans
1987
1990
1992
1994
1998
2007
2008
2009
2010
Data Source: EBRI
Risk factors to retirement income
• Investment risk
• Inflation risk
All the DB plan
is taking on
Participant has the rest
• Longevity risk
• Risk of a costly unexpected event
• Risk of tax policy changes
• Risk of regulatory or employer changes
Why are alternative asset strategies
popular with retirement funds now?
• Higher correlations among asset classes
Why are alternative asset strategies
popular with retirement funds now?
• Higher correlations among asset classes
▫ so they are searching for more diversification
through alternatives
• Higher
g
volatilityy
Market
M
k t volatility
l tilit 1990
1990-2012
2012
(Level of the VIX)
90
80
70
60
50
40
30
20
10
0
Data Source: Yahoo! Finance
Why are alternative asset strategies
popular with retirement funds now?
• Higher correlations among asset classes
▫ so they are searching for more diversification
through alternatives
• Higher
g
volatilityy
▫ so they are searching for ways to reduce the portfolio
volatility, either through less downside risk or
greater diversification
• Lower returns
▫ 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
about portfolio asset allocation into
alternatives?
• 76% consider the use of alternative investments
essential to diversifyy p
portfolio risk.
• 25% say they are increasing their allocations to
alternative/non-correlated assets
• 91% say
sa that alternati
alternatives
es are ke
key to risk red
reduction
ction
 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 decade.
decade
 JP Morgan report
Changes in worldwide DB plan asset
allocations
70%
60%
50%
Equity
40%
Bonds
30%
20%
Other
10%
0%
1995
1999
2003
2007
2011
Data Source: Towers Watson
How are DB plans using alternative asset
strategies?
•
•
•
•
•
•
Commodities
Managed futures
R l estate
Real
t t
Private equity
Infrastructure
•
•
•
•
•
•
Mining and metals
Hedge funds
B k loans
Bank
l
Natural catastrophe risk
Agriculture
g
Timber
Problems for traditional mutual funds with
offering alternative investment strategies
•
•
•
•
Liquidity
Concentration
Use of leverage
Daily valuation
Differences in objectives of DB versus DC
plan sponsors
• DB plan sponsors
▫ Need to consider the tradeoff between current and future
retirees’ benefits as well as the risk to the employer
retirees
▫ 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
▫ Need
N d tto consider
id risks
i k tto participants
ti i
t
▫ Need to consider diversification from the perspective of the
participants as they choose among investment options
▫ Need 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 among.
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 Choice
Traditional mutual fund
accounts
• Selected by investors directly.
• Investors have complete
flexibility to choose among the
universe of mutual funds.
funds
• Subject to individuals’
preferences
p
DC plan accounts
• Plan sponsor (i.e., employer)
offers a limited number of mutual
fund investment options
• Plan sponsor adjusts these
options by removing or adding
mutual funds or other
investments.
• Employee allocates DC account
balances to the available
investment options.
options
• Subject first to preferences of
plan sponsors, affected by
regulations, then subject to
participants’ preferences
participants
Typical types of DC plan choices
• Someone else takes control
▫ 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 2010
by age
Source: Investment Company Institute 2012 Factbook
Asset allocation of 401(k) accounts in 2010
by age
Source: Investment Company Institute 2012 Factbook
Comparison of allocations
Participants in their
20’s
GICs and stable value
Money funds
Bond funds
Bond funds
Equity funds
Target date funds
B l
Balanced funds
df d
Company stock
Other funds
Source: Investment Company Institute 2012 Factbook
4.4%
2.6%
7.2%
36.9%
27.0%
10 4%
10.4%
6.7%
4.9%
Participants in their
60’s
16.5%
6.2%
14.7%
34.1%
9.1%
6 9%
6.9%
7.0%
5.4%
Comparison of allocations
Participants in their
20’s
GICs and stable value
Money funds
Bond funds
Bond funds
Equity funds
Target date funds
B l
Balanced funds
df d
Company stock
Other funds
14.2%
Source: Investment Company Institute 2012 Factbook
Participants in their
60’s
4.4%
2.6% 37.4%
7.2%
36.9%
27.0%
10 4%
10.4%
6.7%
4.9%
16.5%
6.2%
14.7%
34.1%
9.1%
6 9%
6.9%
7.0%
5.4%
Comparison of allocations
Participants in their
20’s
GICs and stable value
Money funds
Bond funds
Bond funds
Equity funds
Target date funds
B l
Balanced funds
df d
Company stock
Other funds
Source: Investment Company Institute 2012 Factbook
4.4%
2.6%
7.2%
36.9%
27.0%
10 4%
10.4%
6.7%
4.9%
Participants in their
60’s
16.5%
6.2%
14.7%
34.1%
9.1%
6 9%
6.9%
7.0%
5.4%
But allocations vary within age cohorts
• Participants in their 20’s
▫ 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
zero in
i equities
iti
Source: Investment Company Institute 2012 Factbook
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 funds
• Potential strong growth from DC plan adoptions of
these types of funds
• Competition
p
is less crowded than for traditional
mutual fund offerings
• Potentiall ffor more profitable
f bl offerings
ff
(e.g., h
higher
h
expense ratios, less competition for lowering
expense ratios)
Where are flows into defined contribution
plans going?
• Target date (lifecycle) funds
▫ 52% of new employees in their 20’s
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
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 assets
Billions
$400
$350
$300
$250
$200
$150
$100
$50
$0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Data source: www.ici.org
Current debate on target date funds
To or Through retirement
• Do you invest in target date funds to the retirement
date and then reallocate
Or
• Do you invest in target date funds through
retirement?
Philosophy on this question influences the glide path
for target date funds
Glide path in target date funds
Glide path refers to the changes in allocation to
equities in the fund as the date gets closer to
retirement
Example
100
90
80
70
60
95
95
95
95
95
90
86
79
72
66
50
40
30
20
10
0
2055 2050 2045 2040 2035 2030 2025 2020 2015 2010
% in equities
Glide paths for 4 example target date
series (% in equities)
100
90
80
70
60
50
40
30
20
10
0
2055
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
toward retirement date
• No
▫ Target
T
td
date
t ffund
d may nott h
have th
the risk
i k th
the
participant desires. By investing across target date
funds, the participant can achieve a more preferred
risk-return
i k
profile
fil
▫ Target date fund is a core portfolio from which
participant
p
p
can invest in other p
portfolios and
investments
What are DB and DC plan providers
searching for in alternative strategy
managers?
•
•
•
•
Greater transparency/less opaqueness
Less conflict of interest
Effective risk management
Solutions in terms of liquidity
How do behavioral finance issues affect the
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
▫ Invest
I
t a llower percentage
t
iin stocks
t k if th
they d
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
2007
Difference in
current
stock
market
participation
(Old– Young)
8
1989
1962
1969
Difference in p
past stock market returns
over 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
participants invested
More behavioral issues that may impact
investments in alt funds
• Effects of inertia
▫ Many studies have found that DC plan participants
are slow to change
g their asset allocations or funds
53
Differences in clienteles and flows
Mutual funds without defined contribution investors
1
0.8
0.6
Fund Flow
Non‐DC
Poly. (Non‐DC)
0.4
0.2
0
0
20
40
60
80
100
‐0.2
‐0.4
Performance Rank
From Sialm, Starks, Zhang, 2012
Differences in clienteles and flows
Mutual funds with and without defined contribution
investors
1
0.8
With DC
investors
0.6
Fund Flow
DC
Non‐DC
0.4
Poly. (DC)
y
Without
DC
Poly. (Non‐DC)
investors
0.2
0
0
20
40
60
80
100
‐0.2
Plan sponsors remove the inertia
‐0.4
Performance Rank
54
From Sialm, Starks, Zhang, 2012
Implications for alt fund providers
Could be large flows in and out of funds due to
decisions byy p
plan sponsors
p
Overconfidence: People overestimate their
abilities and judgment
• Example
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
women
A d men llose more money th
And
than
women.
“The investor’s chief problem—and even his
worst enemy—is likely to be himself.”
Benjamin Graham
Father of Value Investing
Implications for alt funds
If the funds are offered as stand alones:
• Investors may buy high and sell low causing
volatilityy for the funds and lower outcomes for
participants
Anchoring
g
• Example: Stock prices anchored to past values
6000
NASDAQ
NASDAQ
5000
5048.62
4000
3000
2000
1000
0
Data Source: Yahoo! Finance
Anchoring:
g
Residential real estate prices
300
AZ Phoenix
AZ-Phoenix
CA Los Angeles
CA-Los
FL Miami
FL-Miami
NV Las Vegas
NV-Las
TX Dallas
TX-Dallas
250
200
150
100
50
0
Data Source: Case-Shiller Index
Implications for alt funds
Participants may not sell when they should
Anchoring on retirement date
Richard Thaler gives an example in his Nudges blog
that the U
U.S.
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-onp //
g
g/
/ 7/ 7/
when-to-take-social-security/
Optimism
p
and wishful thinking
g bias
The Lake Wobegon Effect
where all the women are strong, all the men are good looking, and all
the children are above average.
• People
p exaggerate
gg
p
probabilityy
that their team will win.
• People
p exaggerate
gg
p
probabilityy
that the candidate they favor
will win.
Implications for alt funds
• Individual participants may be overly optimistic on
the prospects for the funds
Naïve diversification
• Individual investors may have a tendency to
diversify in a naïve fashion.
fashion
401 (k)
( )
• Evidence exists that some individuals in 4
plans have a tendency to invest 1/n in their
investment option choices.
Implications for alt funds
• Individuals may invest too much or too little in the
funds.
funds
Conclusions
• Retirements are changing
▫ People are retiring later but living even longer
▫ Sources of income are changing
▫ Retirement investments are changing
g g
• These changes have implications for the presence of
alternative investments in retirement accounts.