RPS-0210-53DF 2010 ACUL Conference & Annual Meeting Scott D. Knapp, CFA Director – Investment Strategy April 30, 2010.

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2010 ACUL Conference & Annual MeetingScott D. Knapp, CFA

Director – Investment Strategy

April 30, 2010

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Agenda

Brief Macroeconomic Review

Post-Crisis Trends in Retirement

Future Trends with Retirement Plans

Investing Retirement Assets

Questions

Scott Knapp, CFA

Director of Investment Strategy

800.356.2644, ext. 8486

[email protected]

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Brief Macroeconomic Review

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Opinions about the economy are like noses…

…everyone has one, but some get more attention than others.

CUNA Mutual Group Proprietary Reproduction, Adaptation or Distribution Prohibited © CUNA Mutual Group

“We have two kinds of economic forecasters: Those who don’t know, and those who don’t know they don’t know.”

- John Kenneth Galbraith

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Cyclical Influences

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A Slow Recovery, But it is a Recovery

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Easy Comparisons in First Half of 2010

Many indicators are relatively good and still very weak.Comparisons get harder later in the year.

Source: Mastercard

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Inventory Build-Out Provides Lift

But it’s mostly over. Final demand must continue to increase to keep the engine running.

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Weak Employment Continues

U-6 unemployment peaked at 17.3% in December ’09 - the highest ever recorded.The marginal cost of adding employees has gone up considerably.

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U.S. Government Incentives Driving Existing Home Sales

The housing market is still not standing on its own

Source: National Association of Realtors

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Secular Influences

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Massive U.S. budget deficits…

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…create massive long-term debt.

U.S. public debt = 63% of GDP in 2010

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Entitlements Explain It All

Alan Greenspan:

“I fear that we may have

already committed more

physical resources to the

baby-boom generation in

its retirement years than

our economy has the

capacity to deliver.”

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Growth in Spending Before Obamacare

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The press is starting to catch on…

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…because it’s a huge story!

• $1.4 trillion equaling 10% of GDP in budget deficits in 2009 – the highest since WWII.

• $775 billion in new taxes would have to be raised to stabilize the budget deficit at 2% of GDP (47% of Americans currently pay no income taxes, VAT?).

• $10 trillion will be added to the national debt in the next decade.

• $5.6 trillion will be spent on interest costs alone in the next decade.

• 63% debt-to-GDP ratio expected in 2010, up from 37% in 2007.

• $20 trillion of debt equaling 90% debt-to-GDP expected within the decade (crisis!).

Remedies: 1) far-above-trend economic growth, 2) huge spending cuts,

3) massive tax increases, 3) debt monetization

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Cyclical versus Secular

Cyclical:

– Employment and housing are still soft

– Most indicators are pointing to near-term recovery:

• Inventory build-out and government stimulus has helped (but it’s mostly over)

• Blue Chip estimate: 2.7% GDP growth (5 – 6% is normal at this stage of a recovery)

• Corporate profit margins, cash flow, and balance sheets have improved dramatically

– YOY comparisons easy in first half of 2010 and will provide good news

Secular:

– Major restructuring of U.S. economy – What are the rules?

– U.S. government expanding influence and/or control – What is the Fed’s exit strategy?

– Massive budget deficits lead to massive long-term debt – A crisis appears inevitable!

– Setting the stage for a secular bear market in bonds?

Rising interest rates and commodity prices will be a Rorschach test for analysts

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Post-Crisis Trends in Retirement

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How the Financial Crisis Impacted Retirement Planning

According to the 2008 EBRI Retirement Confidence Survey:

– Only 13% of workers feel very confident they will have enough money for retirement – a 50% decline from 2007

– Over 28% of workers said they have adjusted their retirement age

– The number of current workers expecting to work during “retirement” has grown to 72% (only 34% of current retirees work for pay)

– Only 44% of workers have calculated retirement savings needs

– Only 20% of current retirees feel very confident about their retirement security

One in four workers age 56 to 65 held 90% or more of their 401(k) investments in common stocks. Two in five held 70% or more.

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Annual U.S. Stock Market Index Returns Since 1825

A retirement saver’s nightmare!

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Financial Crisis!

Congress Debates Pension Reform

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The Current State of Retirement

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The Current State of Retirement?

July 29, 2002!

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President George W. Bush proposes plan for Social Security reform

Evolution of Retirement Plans

President Eisenhower signs a law permitting disability payments to workers of any age and to their dependents

1935

Social Security Act creates a program to pay workers age 65 and older a continuing income after retirement

1960 1974 1981 2005 2006 2018

ERISA sets framework for benefit plan and protects employees enrolled in benefit programs. It also permits tax-deductible IRAs

PPA

Verizon and IBM plan for pension

freezes

First year in which the Social Security Board of Trustee projects tax revenue will fall below the program’s costs

401(k)!

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Evolution of Retirement Plans

1980s 1990-2008 2008+

• Mostly DB plans

• Vast majority of cost/risk borne by employer

• 401(k) just starting

• Minimal investment choices

• Theme: “We must take care or our people”

• Transition from DB to DC plans

• 401(k) plans become primary retirement plan

• Investment choices proliferate

• Theme: “We must allow our people to ride the stock market”

• Mostly DC plans

• Vast majority of cost/risk borne by employee

• Many DB plans freezing or going away

• Theme: “We must make it easy for our employees to achieve a financially secure retirement”

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Retirement Plans Prior to 2008

Decisions were primarily driven by process mandates:

1. Choose a service provider

2. Adopt an Investment Policy Statement

3. Select investments and evaluate fees

4. Offer the plan to employees

5. Switch providers based on fees and fund performance

Process-Based Goals: Excellent fund performance and low fees

Plan sponsors followed processes that didn’t

necessarily lead to positive outcomes.

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Outcome-Based Retirement Plans

Achieving retirement security is contingent on:

• Employer’s decision to offer a quality retirement plan

• Employee’s decision to save

• Employee’s decision to save enough

• Employee’s decision to invest properly

A successful retirement plan gets these four things right.

Outcome-Based Goal: Retirement Security

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Measure, Measure, Measure!

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Investing Retirement Assets

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Retirement Plans Prior to 2008

Decisions were primarily driven by process mandates:

1. Choose a service provider

2. Adopt an Investment Policy Statement

3. Select investments and evaluate fees

4. Offer the plan to employees

5. Switch providers based on fees and fund performance

Process-Based Goals: Excellent fund performance and low fees

Plan sponsors followed processes that didn’t

necessarily lead to positive outcomes.

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Trying to choose best-of-breed funds…

Peer-Average Return

Salesman: “I can offer funds that are MUCH better than yours.”

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…has never worked…

Peer-Average Return

Peer-Average Return

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Peer-Average Return

…so the best way to win the “hot fund” game is to not play.

Good plans will always have some funds that outperform, some that underperform, and some that are about average.

36

Asymmetric Value Framing

Fund A

Fund A

Fund B

Fund B

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1997 2008

Relative-ReturnValue Framing

Absolute-ReturnValue Framing

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Asymmetric Value Framing

Fund A

Fund A

Fund B

Fund B

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1997 2008

Relative-ReturnValue Framing

Absolute-ReturnValue Framing

“Losers!”

“Winner!”

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Post-Crisis Retirement Investment Strategy

Adopt a broad definition of risk:

• In MPT, risk is volatility (standard deviation)

• To most participants, risk is the chance of losing money (Value at Risk)

• Standard deviation and Value at Risk are not the same thing

• Investment strategy should be mindful of participants’ definition of risk

Investment strategy should emphasize active risk management:

• Tactical overlay shifts money based on a macro forecasts, relative value among asset classes, or changes in risk budget

Accommodate investors’ asymmetric value framing:

• Absolute returns matter

• Participate and protect!

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The Industry Responds: Target-Date Funds

40

Data Indicates Target-Date Fund Leadership in DC Plans

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What’s right with Target-Date Funds?

• They make participating in a 401(k) plan easy

– A single fund with an optimal mix of asset classes

– Help participants maintain a long-term perspective

– Professional management

– Approved as QDIAs

• Increase the probability of participants’ success

– Success is adequate income replacement during retirement

– Success is NOT outperformance versus peers or the market

• Expected to lead in the 401(k) space

– Cerulli and ICI expect TDFs to grow faster than any other fund category

– Plans with QDIAs choose TDFs far more than their alternatives

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What’s wrong with Target-Date Funds?

• No standard glide path

• Most assume nothing changes at retirement

• Participants don’t understand them:

– Many think they mature like a CD

– Many think they guarantee an income like a DB plan

• Most don’t accommodate of investor behavior

• Performance versus peers driven entirely by glide path decision:

– Standard performance measures don’t work

• Unmet expectations:

– Random and self-directed portfolios have outperformed

– Do not address sequence-of-returns risk. Near-term retirees got killed in 2008!

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Target-Date Funds did not perform as expected…

2008 Returns

Random or self-directed portfolios outperformed during the financial crisis

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…and here’s why.

Asset Class Max Min Range Average

Stocks 83% 0% 83% 56%

Bonds 158% 0% 158% 40%

Cash 44% -79% 123% 2%

Other 90% -2% 92% 2%

n=246

2020 Fund Asset Allocation

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What does a good Target-Date Fund look like?

• Designed with an outcome-based strategy in mind:

– They increase the chance of achieving retirement security

• Employ sophisticated institutional management:

– Combine the best of actuarial science and investment management

– Managed like DB plans that have significantly outperformed 401(k) participants

• Make it very easy for participants to make good decisions:

– A single source of investment value

– Discourages random fund selection

– Built with “real people” in mind

• Allows the plan sponsor to confidently adopt auto features:

– Approved by the DoL as QDIAs

– Support fiduciary oversight

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Future Trends in Retirement Plans

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Future Trends

Continued trends to outcome based plans - the DBization of 401(k)s

Fewer investment options (but more broad-based)

Delivery of more guidance

Increased attention to Target Date Funds

Proliferation of DC/DB hybrids

1

2

3

4

5

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Questions?

Scott D. Knapp, CFA

Investment Strategist

CUNA Mutual Group

[email protected]

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Thank you! Questions?

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