# Going long: Should the DC industry reconsider participants' bond portfolios?

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By: Daniel Gardner, Defined Contribution Analyst MARCH 2011 Going long: Should the DC industry reconsider participants’ bond portfolios? Issue: In recent years, the defined contribution (DC) retirement plan industry has begun to focus on lifetime income, as opposed to lump-sum distributions, for participants. In light of this trend, should we reconsider the composition of Long bonds can participants’ bond portfolios? help “bridge the gap” between a nest Response: Yes. If the switch to retirement income provision is real, increasing egg and lifetime participants’ bond duration would target the objective better than the standard income solutions. intermediate-duration bond portfolio does. In particular, long bonds are better than shorter-term bonds at hedging retirement income needs. We’ve used a fixed life annuity as a proxy for this need. It makes sense for retirees to increase their bond durations as well. We’ve built simplified models to help illustrate these results. It will take time for the DC community to change its focus from wealth accumulation to retirement income provision and to realize the implications of this change – one being that long bonds can help “bridge the gap” between a nest egg and lifetime income solutions. Meanwhile, we present our case here, with the hope that we can help nudge the status quo. Background Providing for an income stream in retirement, in contrast to accumulating wealth for retirement, is rightfully becoming the primary goal of the U.S. defined contribution (DC) industry. Altering the composition of participants’ fixed income portfolios to better align with this objective can increase the likelihood of success. By use of a simplified model, Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios?

below, we demonstrate that careful consideration of bond duration could have a significantly positive impact on retirement outcomes. We’ll discuss the potential benefits of, as well as the barriers to, overhauling participant bond portfolios. Interest in lifetime income solutions is growing Unfortunately, DC plans have not evolved to replicate the retirement income-generating qualities of the defined benefit (DB) plans they replaced. Contribution rates are frequently too low, and workers have struggled to build investment strategies appropriate for generating adequate retirement income. According to the Employee Benefit Research Institute's Retirement Readiness Rating (RRR), 47.2% of “early boomers” and 43.7% of “late boomers” may not be able to cover basic expenditures and pay for uninsured health care costs in retirement.1 Fortunately, the government has recognized the problem. In February 2010, the Labor and Treasury departments issued a joint request for information on lifetime income and received nearly 800 responses. Russell participated in the hearing that followed, in September 2010.2 Meanwhile, retirement income products are proliferating. Many insurance companies have developed offerings for both the retail and institutional markets that give investors exposure not only to stocks and bonds, but also to diversified products designed to guarantee an income stream in retirement. Asset managers are getting into the retirement income space with distribution-oriented funds and, to a lesser extent, guaranteed products. For the right person, at the right time, an annuity purchase can increase retirement security in a big way The main tools for building the new guaranteed income solutions are annuities. In this paper, our discussion is based on the belief that annuities, in the right context, can improve retirement security. For decades, life annuities have provided retirees with arguably the best “bang for the buck” in terms of retirement income. For example, they offer retirees a higher level of income and/or a lower probability of running out of money than a systematic drawdown plan does. (See the table below, where we present “probability of sustainability” and annual income figures for a few types of drawdown strategies for a 65-year-old male with a nest egg of $500,000. The annuity income figures are derived from recently estimated quotes.3) 1 Employee Benefit Research Institute, “The EBRI Retirement Readiness Rating: Retirement Income Preparation and Future Prospects,” July 15, 2010. Available at http://www.ilretirementsecurity.org/reports?id=0027. 2 For more information, see Cohen, Collie and Gardner, “Russell’s beliefs on retirement income disclosure,” October 2010. Available at http://www.russell.com/institutional/research_commentary/PDF/Retirement_income_disclosure.pdf. 3 Estimated quote for a single life annuity, obtained at http://www.newretirement.com/services/annuity_calculator.aspx; accessed 9 February 2011. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p2

Exhibit 1 / Comparison of basic retirement nest egg drawdown policies Initial annual Probability of Drawdown policy Asset allocation income sustaining4 4% of starting nest egg, 3% annual 40% U.S. equity, $20,000 76.8% step-up 60% U.S. bonds 5% of starting nest egg, 3% annual 40% U.S. equity, $25,000 47.8% step-up 60% U.S. bonds Immediate fixed life annuity, 3% N/A $27,204 Near 100% annual step-up Sources: Russell Investments and newretirement.com. While life annuities do provide for more certain income than a systematic withdrawal approach does, we recognize that they aren’t for everyone. Some examples: Retirees in poor health should avoid them. Those with hardly any savings should keep what they have for emergency expenses. Wealthy or frugal retirees who expect to spend a very small portion of their wealth each year don’t need annuities. But for everyone else, annuities should not be immediately dismissed as a source of retirement income. Of those retirees who could benefit from an annuity, many don’t like to make the liquidity sacrifices associated with purchasing one. Allocating all of one’s nest egg to an immediate life annuity can be a bit of a gamble. If our hypothetical 65-year-old, with a $500,000 nest egg, follows one of the drawdown policies listed above he doesn’t face much risk of running out of money in the near term. Why should he buy an annuity and expose his estate to the risk of forfeiting his nest egg if he dies at age 70? Here, there’s a good argument to be made for purchasing a deferred life annuity, or longevity insurance. At a recent industry conference, my colleague Don Ezra described the value of allocating a portion of one’s retirement nest egg to a systematic drawdown approach and the other portion to longevity insurance. It makes sense for retirees to insure an income for the latter years of retirement, because the value of the protection an annuity provides increases with age (i.e., the mortality credits become larger).5 At the 4 This is the probability of being able to follow the drawdown policy for 20 years and then buy an annuity to provide the same income level for life. (See the appendix for capital market assumptions.) We think most retirees don’t have much use for a metric that shows their probability of running out of money, because it represents a completely undesirable outcome. Knowing the probability of being able to sustain an income should be more relevant to their goals. 5 For example, imagine a group of 10 retirees, each of whom has a 10% risk of dying this year. They get together and put $1,000 each into a single bank account that pays 5% interest annually. They agree to divide the account balance equally among those still alive after 1 year. If at the end of the year 1 of the 10 has indeed died, that means the other 9 would split $10,500. This amounts to $1,167 each – or a 17% return on investment. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p3

mere cost of 10%–15% of an immediate life annuity, a retiree could buy longevity insurance where payouts would kick in around age 85.6 Life annuities as a proxy for retirement income needs There are several inputs to a calculation of the nest egg needed to fund one’s retirement standard of living: cash flow (how much will I need each year?); time (how many years until I retire?); mortality (how likely am I to reach age 85, 90 or 95?); and the discount factor (what interest rate[s] should be applied to the cash flows? Should I use different interest rates for short-term and long-term cash flows?). Here are some reasonable assumptions we could make about the inputs to the nest-egg calculation. Number of years until retirement: While this is a crucial decision, it’s not a complicated one: retire earlier, and you’ll need more money; retire later, and you’ll need less money. It may be worth plugging in multiple retirement ages to see which are realistic. Annual cash flow needed: This will be the final pre-retirement salary less Social Security benefits and any other income derived from sources aside from the retirement account. Its calculation takes into account the tax savings that may accrue from moving into a lower tax bracket, from not paying into Social Security and Medicare, and, of course, not having to save for retirement. For a typical retiree, we expect this amount to be about 42% of final salary.7 If we want to include a periodic step-up to meet inflation expectations, the needed cash flow will be a little bit higher each year, and the cost of funding the cash flows will increase. Expected mortality: This can be estimated by use of mortality tables for individual annuitants. We’ll assume our retirement saver will survive to age 65, and then we’ll use the mortality rates for age 65 and beyond to calculate the likelihood of survival to any specific post-retirement age.8 Discount factor/interest rates: Interest rates can be modeled by choosing the appropriate term rate on a spot curve. Values shown in this paper are based on a spot curve for AA-rated corporate bonds. Using a market rate, as opposed to a Treasury rate, is appropriate in this case, because we think retirement plan participants should consider eventually buying an annuity. This rate better represents the credit rating of an annuity provider. It turns out that the retirement income need can be priced like a fixed life annuity that begins payments at retirement.9 This annuity pays out a predetermined amount in each of the annuitant’s remaining years. On average, it will pay out in line with the mortality experience of all annuitants. Further, the discount rate used to price annuities is based on an entire spot/zero-coupon interest rate curve. Anyone looking to calculate the Similarly, if the risk of death is 20%, those alive at the end of the year could expect to see a 31% return on investment if any other(s) among the retirees did not survive. Clearly, the higher one’s risk of dying (i.e., the older one is), the more attractive mortality credits become. 6 Note that the relative likelihood of the retiree’s being around to collect that initial age-85 payment is factored into the price of longevity insurance, so purchasing a deferred annuity now is cheaper than delaying until later in retirement. 7 See the Aon Consulting/Georgia State University “Replacement Ratio Study: A Measurement Tool for Retirement Planning,” Aon Consulting (2008), p. 2. The 42% replacement rate corresponds to a pre-retirement income of $90,000. For someone who makes less than $90,000, the targeted replacement rate would be slightly lower. 8 Why? Because if you die before you retire, you won’t need your retirement savings. 9 This is a reasonable assumption for essential and desired lifestyle expenses. However, medical expenses can be unpredictable. To protect against these expenses, keep a “rainy day fund” for emergencies and consider purchasing a long-term-care insurance policy. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p4

present value of their retirement nest egg should use interest rates that correspond to the number of years until the retirement cash flows are needed. Longer bonds are better than short-term bonds for hedging the retirement income need A 25- to 30-year-old worker saving for retirement at age 65 or later ideally won’t be (or shouldn’t be!) drawing funds out of the plan for quite some time. Given that relatively long horizon, the annuity price that represents the retirement income need (described earlier) is very sensitive to small changes in interest rates. Here’s a simplified example: At a 5% interest rate, an investment presently valued at $7,102 will have increased to $50,000 40 years from now. But at a 5.5% interest rate, a lesser present value – $5,873 – would be needed to realize $50,000 40 years from now. Since small changes in interest rates can have such a big impact on the value of retirement income, it makes sense to somehow hedge the impact of those changes. An In the context of appropriate hedge would need to be equally sensitive to interest rate changes. Long duration bonds fit this description.10 In the context of funding retirement expenses, long funding retirement bonds behave more like a risk-free asset, as seen below. On the left, we have a typical expenses, long short-term risk and return chart. On the right, we plot the same chart, but with risk and return relative to the retirement income need (represented by a life annuity). bonds behave more like a risk-free asset Exhibit 2 / For future retirement income needs, long bonds can be a low- risk asset above life annuity return Expected surplus return Expected return Equity Long bond Intermediate bond Cash Equity Surplus volatility Long bond relative to life annuity Life Annuity Intermediate bond Volatility Cash Source: Russell Investments. For illustrative purposes only. Please note that we aren’t advocating for long bonds as a stand-alone option in a DC plan. Rather, they should be incorporated into a holistic retirement income-focused strategy, such as a target date fund or managed account. In fact, we argue that DC participants can improve their retirement outcomes by holding bond portfolios with 10 In other words, long-term interest rates and annuity rates are highly correlated. Plan sponsors with a DB plan should be familiar with this notion – it is at the root of liability-driven investing programs. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p5

durations and credit ratings that align with the goal of funding retirement income through annuity purchase.11 We realize readers may not agree with this goal. We have two responses. First, as we’ve discussed, annuities provide an easily quantifiable answer to the question of “how much wealth does an investor need to provide adequate retirement income?” Further, the bond portfolio change we’re arguing for is robust with regard to retirement income approach – the argument holds just as well for a long-lived systematic withdrawal plan as with an annuity since both have long durations. How long should the bonds be? Very long Our research shows that the average “duration” of the retirement income need described earlier, including mortality rates by age, will be about 8.4 years at retirement. In other words, the weighted average time until cash flows are disbursed for a fixed immediate life annuity for a 65-year-old male will be about 8.4 years.12 Similarly, if we assume that all plan participants survive to retirement, the duration of the annuity for a 25-year-old will be about 48.4 years.13 Since none of the cash flows occur until retirement, we can simply add 40 years to our initial 8.4-year duration calculation. How does this insight apply to the participant’s bond portfolio? The duration of the ideal long bond depends primarily on the remaining time to retirement and on the nature of the participant’s future stream of savings, or “human capital.”14 Since human capital provides a steady return over many years, it acts like a bond. So, we want the combination of human capital and the bond portfolio to have a duration in line with the retirement income need. Yet the bond-like cash flows from human capital fall short of the ideal duration, as they all come prior to retirement. To compensate, a participant’s (especially a young participant’s) bond portfolio, which could be much smaller than the stream of future savings, would need to be of very long duration – potentially hundreds of years. We’ve included an explanation of this concept in the Appendix. (Keep in mind that the duration in the early years is highly skewed by the combination of low financial wealth and a low bond allocation.) Nonetheless, we clearly don’t expect any investor, much less a DC participant, to implement a portfolio with a bond duration hundreds of years long. We recognize that, for practical purposes, a DC participant cannot hold a bond portfolio longer than 10 to 15 years in duration. Even with this constraint, participants can improve their retirement income outlook by taking a small step: increasing the duration of the bond portfolio to a maximum of about 15 years during the accumulation phase. 11 Note that this is not an implementable strategy, but rather a simple model – duration is only one measure of interest rate sensitivity. However, it’s the most significant measure, and it’s fairly simple to model, which is good enough for this paper. 12 The weighting is according to the present value of future cash flows – in other words, the Macaulay duration. If we include an annual step-up adjustment of 2.5% to account for inflation, the duration is a bit higher (9.4 years). 13 There are two small adjustments from 48.4 to consider. One is the possibility that significant mortality improvements will occur over the 40 years until retirement, which would increase the duration slightly. The other is the term structure of interest rates. A 25-year-old attempting to hedge a 40-year deferred fixed annuity will likely face a higher discount rate than a 60-year-old attempting to hedge a 5-year deferred fixed annuity. 14 Per Morningstar: “Financial capital is defined as an investor’s current savings, such as money already saved in a retirement account. Human capital is an investor’s future potential savings, and is often the single largest asset an investor has.” http://corporate.morningstar.com/us/asp/subject.aspx?xmlfile=174.xml&filter=PR4233. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p6

Even a small change is beneficial In a retirement income framework, the primary goal of a DC plan should ASSUMPTIONS FOR MONTE CARLO be for participants to afford an adequate retirement standard of living. SIMULATION We will set up a simple Monte Carlo simulation to determine if use of Age to begin contributions: 25 long bonds can help participants achieve this goal. Specifically, we will examine two types of zero-coupon bonds.15 They are: Retirement age: 65 1. A constant 4-year duration AA-rated bond. This bond represents the Rate of real salary growth: 1.5%. intermediate bond portfolios used in most diversified DC investment Inflation is modeled products. stochastically, so the nominal rate of real salary growth is 2. A AA-rated bond that has a constant 15-year duration until a few variable, and hence the amount years before retirement, when duration gradually decreases to our contributed each year varies. aforementioned 8.4 years at retirement. This is to model a bond portfolio that provides some hedging benefit and could realistically Initial portfolio balance: $0. be implemented in a DC plan. Contribution rate: Start at 6% In our simulation, it turns out that even the 15-year duration bond, which and gradually increase to around does not come close to being an optimal hedge, can nonetheless bolster 12%, including company participants’ chances of obtaining an adequate retirement income matches. This is a typical stream. contribution schedule for “well- behaved” participants The assumptions we use in our simulation are similar to those Russell (unfortunately, even these uses to optimize target date fund glide paths, with the goal of purchasing participants likely don’t save a fixed life annuity at retirement that replaces 42% of final salary. (For a enough). list of assumptions, see the sidebar on this page.) No loans or hardship withdrawals We model 24 hypothetical participants. Half of them invest in the 4-year from the plan. Again, we strive to bond, and the other half in the 15-year bond. Within each group, all model how a “well-behaved” participants invest in portfolios of U.S. equity and the bond for 40 years. participant might invest. Eleven of the participants in each group hold static balanced funds (with varying stock/bond mixes), and the twelfth participant holds a fund that Initial starting salary: $50,000 uses the generic Russell target date glide path. Afterward, we evaluate (although assuming a different what percentage of final pre-retirement salary a participant can achieve salary would have no qualitative from an annuity purchase. impact on the final result). We generate 5,000 different outcomes for the participants using a set of Investment policy: the participant capital markets scenarios, including annual bond returns from scenarios invests in either a balanced fund for the AA spot curve. With that data, we calculate, for each participant: or the generic Russell glide path strategy, starting at 90% equity Reward – the median replacement rate (typically, how much of and 10% bonds and ending at final salary can be replaced by purchasing the annuity) 32% equity and 68% bonds. Risk – the 5th percentile replacement rate outcome, an intuitive measure of the downside associated with each approach. 15 We use zeros to isolate the duration component of these bonds. Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities), are the primary zero-coupon security available in the U.S. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p7

Here is a graph depicting our results. Exhibit 3 / Reasonable duration lengthening can improve outcomes 60% Median age 65+ replacement rate (% final salary) Target Date 100% Equity strategies 55% 50% 45% 40% 35% 22% 21% 20% 19% 18% 17% 16% 5th percentile age 65+ replacement rate (% final salary) ShortBond_Bal ShortBond_TD LongBond_Bal LongBond_TD Source: Russell Investments. Hypothetical analysis using assumptions outlined in this paper. There’s a lot to digest here, but we’ll walk through it. First, focus on the light-blue curve. The upper-right point on the curve represents 100% equity and 0% bonds static asset allocation. The next point down the curve represents 90% equity and 10% bonds. This pattern continues down to the lower-right point on the curve, which represents 0% equity and 100% bonds. Next, focus on the large blue diamond. It represents a generic target date strategy using equities and bonds with Russell’s glide path. This strategy is less risky than the lowest-risk balanced strategy, and yet it provides significantly higher upside. This provides a great illustration of the benefits of a target date fund. Despite the bad publicity they’ve received lately, target date funds remain a quality default option for participants, particularly relative to static balanced funds. Next, focus on the grey curve and the large brown diamond. This curve uses the same asset allocations as the light-blue curve, and it represents what may be obtained through the aforementioned long bond strategy. For each static asset allocation, a participant who uses these long bonds instead of constant 4-year duration bonds can expect a better standard of living in retirement.16 16 Although we do not present results here, long bonds provide a similar benefit when hedging an indexed annuity (e.g., cash flow increases by 2% each year). For truly inflation-protected annuities, a real-return long bond may be a better hedge than our nominal long bond. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p8

Now, let’s look at the two target date outcomes. The “long bond” participant achieves slightly higher median income replacement (53.0% vs. 50.4%) with lower risk (21.9% replacement, vs. 20.1% replacement in the bad case). That’s an 8.9% improvement in the bad case outcome and a 5.4% improvement in the median outcome. Further, the probability of a successful outcome improves by 5.9% (65.2% vs. 61.6%), and the “shortfall function” decreases by about 11.3% (8.1% shortfall vs. 9.1%).17 If we relax the bond duration cap from 15 years to 30 years, gains can be even greater. If we perform the same “percent improvement over short-term bond” calculation, but with a 30-year instead of a 15-year cap on duration, the improvement is 11.3% in the bad case outcome and 7.1% in the median outcome. Likewise, the probability of success improves by 7.5% and the shortfall function decreases by 14.9%. Simulation discussion In addition to the results, there are two key simulation takeaways for readers: 1. The long bond strategy does not require an annuity purchase at retirement to be effective. Since our strategy seeks to hedge retirement income needs at all times, a participant could stay in the strategy during retirement. The next section will describe how the long bond strategy might look for a retiree. 2. Bond duration, not a term premium, drives the improved outcome. A reasonable reader, skeptical of the results, could ask, “Aren’t you just getting Duration extension compensated for taking on increased term risk? A 15-year bond has higher is not a gimmick; it expected return than a 4-year bond.” In response, we set up a simulation where we really does hedge “flattened” the yield curve, so that any difference in outcomes between the 4-year and 15-year bond strategies would be based on duration.18 In all the metrics the retirement mentioned earlier, the long bond strategy still provided better outcomes than the income objective. short bond strategy did. For example, the 5th percentile income replacement metric for the target date strategy with long bonds fell from 21.9% to 21.1%. Yet it was still higher than the 20.1% outcome for the short bond strategy. Duration extension is not a gimmick; it really does hedge the retirement income objective. It works in retirement, too The results described above hold for a retiree. While the goal during the accumulation phase was to purchase an annuity to replace as much income as possible, we realize that most participants don’t buy an annuity. Instead, we’ll model the retiree’s situation by using a common retirement rule of thumb: the retiree makes annual withdrawals of 4% of the initial age-65 portfolio balance, plus an annual 2.5% step-up adjustment to combat inflation. After 20 years, the retiree takes all remaining wealth and purchases an immediate life annuity. The goal is to replace 100% of the final account withdrawal. If the money runs out before 20 years are up, we assume the retiree borrows to meet expenses. This way, our 5th percentile risk measure will show a “worse bad case” outcome if the retiree runs out of money earlier on. 17 This shortfall metric translates to “if the participant does not meet the goal, by what amount would we expect her to fall short?” If she never saves at all, this number will be 42% – the targeted income replacement goal. So, this metric will always fall between 0% and 42%. (We think this is actually a better, more holistic way to measure retirement risk than the 5th percentile outcome. In fact, we optimize our off-the-shelf glide path on the basis of a similar risk metric. However, we feature the 5th percentile outcome here because it’s more intuitive.) 18 We found the average return of the 4 year bond across all scenarios was about 4.9%, while the average return of the 15-year bond was about 5.4%. So we re-simulated the long bond strategy, but knocked 0.5% off the bond return each year. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p9

We use two bonds in the simulated portfolios: the 4-year bond described earlier, and a longer, duration-matching bond. The duration of the latter corresponds to the duration of the remaining disbursements until age 85 and the cost of the age-85 life annuity, not to the total retirement disbursements. On average, the duration is 9.8 years at age 65,19 6.7 years at age 75 and 4.3 years at age 85. Here are the results: Exhibit 4 / Attention to duration pays in retirement, too 400% 100% Equity 350% Median age 85+ replacement rate (% final withdrawal) 300% 40/60 Allocations 250% 200% 150% 80% 60% 40% 20% 0% -20% -40% -60% -80% 5th percentile age 85+ replacement rate (% final withdrawal) ShortBonds_Bal LongBonds_Bal Source: Russell Investments. Hypothetical analysis using assumptions outlined in this paper. For a moderate 40% equity and 60% bond strategy, the matching strategy increases the median replacement rate by about 3.3% and the bad case replacement rate by about 16.5% as compared to the 4-year bond strategy. Notice that it’s important to have a conservative asset allocation in retirement, but with some equity exposure. With an allocation to equities of 60% or greater, there’s a very real chance of running out of money in 20 years – as you can see, the 5th percentile outcome at age 85 was around $0 (or less) remaining in these cases. In retirement, particularly the early years, one or two years of bad returns can make funding the later years a long shot. Russell has written about this in many previous papers.20 On the other hand, holding an equity allocation of less than 20% or so may feel safe, but by our measure of risk it may be less safe than some more aggressive strategies. 19 This is different than the 8.4-year duration mentioned in the previous section. Why? In this case, we assume certain payments until age 85, whereas earlier, these payments were discounted based on average life expectancy assumptions. 20 I recommend “The date debate: Should target date fund glide paths be managed “to” or “through” retirement?” by Josh Cohen, Yuan-An Fan, and Grant Gardner, April 2010. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 10

Long bonds as a bridge to fixed annuity products Right now, many plan sponsors are interested in learning how to incorporate retirement income options, including products with annuities, into their plans. Yet they’re discouraged by operational complexities and a dearth of regulatory safe harbor provisions. Rather than deal with complex products and fiduciary concerns, we suggest that these sponsors consider using long bonds as a bridge to annuity solutions. In other words, sponsors could implement a long bond program now with the intention of adding an in- plan annuity or out-of-plan rollover option later. Used appropriately, long bonds can approximately track the price movements of fixed annuities, preparing participants for an eventual annuity purchase. There are other reasons to consider long bonds: Long bonds are less complex than fixed annuities. DC plans live in a world of daily liquidity and valuation. It’s not clear that fixed annuities are adaptable to this environment. How will record keepers, insurance providers and plan sponsors all get on the same page? How often could the annuities be traded? And what happens if a participant changes jobs, or if the sponsor wants to replace the annuity provider or product? Long bonds are more liquid than fixed annuities. A participant should not lock a big amount of her nest egg into an annuity without careful prior consideration, because the decision is often irreversible. A deferred fixed annuity can lock in a Why do typical significant portion of her nest egg at an early point in her career. To get it out, there portfolios have such may be a high surrender fee. Long bonds can track the price movements of these annuities without these concerns. short durations? Long bonds may incur less fiduciary liability than fixed annuities. Another The simple answer common barrier to including fixed annuities in a plan is the fear that the annuity may be that we’ve provider will experience financial hardship, or worse, go out of business. While never thought about unlikely, the consequences could devastate participants’ retirement adequacy and provoke litigation. In general, plan sponsors appear hesitant to adopt such products it. in the absence of regulatory safe harbor provisions. In contrast, a well-diversified bond portfolio puts the participants’ nest eggs into many baskets. Nonetheless, a good way for plan sponsors to avert costly legal battles is to always document in detail the processes they followed in reaching their decisions. Top 5 obstacles to implementing longer bond portfolios It’s clear that careful consideration of bond duration can benefit both DC participants and retirees. However, we found that 15 top target date fund families hold a “moderate”- duration fixed income portfolio, which roughly corresponds to a duration of 3 to 6 years21 Why do typical portfolios have such short durations? The simple answer may be that we’ve never thought about it – we are stuck in old ways of thinking that are not consistent with funding retirement income. Specifically, DC plans still focus predominantly on assets, not on future spending needs. This may be due to the lump- sum-distribution nature of DC plans. 21 Source: Morningstar Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 11

WHAT ARE SOME KEY BARRIERS TO OVERCOME IN IMPLEMENTING LONG BOND STRATEGIES IN PLANS? Here are our top 5, in descending order of significance: 1. We want to stabilize wealth, not income. Having stable retirement income is not our sole concern. We also value stability of wealth, and we want to avoid having to work longer to make up for any financial losses. Holding short-duration bonds, which are much less volatile than long bonds, would increase the stability of wealth near retirement. On the basis of our simplified model, we found that using long bonds in a target date strategy added about 2% to 3% incremental annualized volatility at retirement, as compared to using an aggregate bond strategy. Yet if the plan’s objective is to provide retirement income, long bonds are better than short-term bonds at hedging this objective. This brings us to the next point… 2. We can’t make a rational choice between wealth and consumption. Behavioral biases stop us from making a decision that could be in our best interests. Research from Mathew Greenwald & Associates, Inc., indicates that retirees are hyper- focused on the present, have a strong preference to maintain principal and have a high need for liquidity.22 These preferences may be inconsistent with the goal of funding a retirement income stream. Again, this leads to our next point… 3. We don’t like annuities, so there’s no point in hedging an annuity purchase. Annuities have a mediocre reputation in this country, for reasons such as the retiree preferences mentioned above. But the beauty of this strategy is that one need not annuitize upon retirement for it to be effective. The change we’re arguing for could apply to either an annuity or systematic withdrawal approach. 4. Practical/product-development issues. The long bond strategy we describe in previous sections is based on a very simple model. DC asset managers would need to develop a portfolio that more robustly replicates the bond portfolio held by a fixed annuity provider. Really-long-duration instruments are not readily available, but managers can construct these with bond futures. In addition, the strategy could require consistent duration adjustment, particularly in the years immediately prior to retirement. This presents a significant implementation problem for a static balanced fund. Target date funds, however, with their dynamic asset allocation strategies, are well equipped to implement the strategy. 5. Tactical concerns. Strategically, the long bond portfolio makes sense, but tactically, it may not. To some investors, it is conventional wisdom that interest rates will rise in the near future, and so bond values could decline sharply. Long bonds, which are most sensitive to interest rate changes, would suffer the most. We have two responses: most importantly, we aren’t encouraging plan sponsors to dramatically alter their participants’ bond durations overnight. A disciplined, thoughtful approach to researching and potentially implementing a duration- extension program is best for all parties involved. By the time you complete your due diligence, interest rates may no longer be a significant headwind. And as a secondary issue, the conventional wisdom is not necessarily correct – for example, market bond prices may already reflect assumptions about the future of interest rates. 22 Greenwald, M. (2010, October). Opportunities Created by the New Retirement. Presented at the Russell Retirement Summit, Tacoma, WA. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 12

Concluding thoughts We’ve explained how DC plan sponsors have become aware of the retirement income problem and how the duration of the DC participant’s bond portfolio can be altered to more effectively target retirement income. We model a small change to current practice that reduces retirement income risk and describe how and why it might help to “bridge the gap” between a nest egg and a lifetime income stream. Finally, we discuss potential behavioral and practical barriers we’d need to overcome to widely adopt this change. Clearly, there’s room for improvement for the typical DC participant. The duration- extending bond strategy is one way to improve outcomes. For implementation purposes, it’s not a quantum leap, particularly in target date funds. The bigger problem will be convincing participants that this strategy, while potentially increasing the volatility of their account balances, actually may improve their odds of enjoying comfortable retirement. A retirement income framework lends itself to a rethinking of the construction of participants’ portfolios. In particular, it suggests a shift away from a strictly capital growth or capital preservation mind-set. Instead, we believe, we should adopt an asset growth or liability hedging model similar to those used in DB plans. The asset growth portfolio, which could include any asset, would be built to maximize return within a given risk tolerance. The liability hedging portfolio, on the other hand, would track the retirement income liability. It would most likely consist of long bonds, Treasury STRIPS, Treasury Inflation-Protected Securities (TIPS), and perhaps annuities. Our hope is that this paper will nudge the DC industry toward thinking not just about longer bond portfolios, but about outcome-driven solutions in general. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 13

Appendix A. Bond duration and the life cycle investment problem To help illustrate this concept, let’s examine a hypothetical DC participant’s experience. This participant shares many attributes with the model participant Russell uses to optimize its target date glide path, including age at beginning contributions (25); retirement age (65); rate of real salary growth (1.5%); initial portfolio balance ($0); and contribution level (starting at 6% and gradually increasing to near 12%, including company matches). We make many simplifying assumptions for ease of understanding: 1. The initial starting salary is $50,000 (but assuming a different salary would have no qualitative impact on the final result). 2. The participant invests in an equity asset with constant 8% annual return and a bond asset with constant 5% annual return (similar to the capital market assumptions used for the other graphs and outlined later in this appendix). 3. The participant invests according to the generic Russell glide path, starting at 90% equity and 10% bonds and ending at 32% equity and 68% bonds. 4. Inflation is 2% annually and constant. 5. For present value/duration calculation purposes, we assume a discount rate of 5%, in line with the return on the bond asset. On the basis of these assumptions, we calculated the value of future portfolio contributions (i.e., human capital) and the size of the bond portfolio over the participant’s career. This information appears on the chart below. Exhibit 5 / Evolution of bond wealth and human capital $1,000,000 $750,000 Present value at a particular age $500,000 $250,000 $0 25 30 35 40 45 50 55 60 Age HumCap BondWealth NetBondWealth Source: Russell Investments. Hypothetical analysis using assumptions outlined in this paper. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 14

“HumCap,” or human capital, refers to the present value of future contributions to the portfolio at a particular age. “BondWealth” is simply the value of the bond portfolio, and “NetBondWealth” adds the two. According to our calculations, the duration of HumCap is about 20.5 years at the start of the 40-year career. Ideally, we’d like the net bond portfolio to have about a 48.4-year (8.4 years plus 40) duration, decreasing by 1 each year. To achieve this, we’d need to hold a bond portfolio with duration near the “bond wealth duration” given below: Net bond duration = human capital duration * human capital / net bond wealth + bond wealth duration * bond wealth / net bond wealth. (In other words, the net bond duration is a present value-weighted average of the human capital duration and bond portfolio duration.) Based on our simple model assumptions, which include the participant allocating nearly all contributions to equities, we calculated the duration for human capital, the bond portfolio, and “net bond wealth” (starting at 48.4 years and gradually declining to 8.4 years) for each year until retirement. Exhibit 6 / Appropriate bond duration by age, duration less than 100 years 100 80 60 Duration (years) 40 20 0 25 30 35 40 45 50 55 60 65 Age HumCapDur BondDur NetDur Source: Russell Investments. Hypothetical analysis using assumptions outlined in this paper. As mentioned earlier, human capital duration (“HumCapDur”) starts at around 20.5 years and gradually declines to zero. On the other hand, the bond portfolio duration (“BondDur”) is quite startling – it doesn’t fall below 100 years until age 46. In fact, at age 25, it’s over 10,000 years! With the information provided here, we think readers could reconstruct this simple model for themselves in a spreadsheet. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 15

B. Notes I. CALCULATION OF PRICE AND DURATION OF RETIREMENT INCOME NEED This paper frequently refers to “the retirement income need.” To calculate this, we used a simplified model that mimicked the price of an annuity. We assumed that the annuity would be paid out in annual installments. We then determined how many years remained until the first annuity payout,23 the second annuity payout, …, the 50th annuity payout. We then take this time and map it to one of 11 key term rates in a spot curve scenario file. From there, we can find the present value of each $1 annual payment on the basis of the appropriate spot rate given by our scenario files and by the probability of the retiree’s surviving to receive that particular payout. The present value of a particular $1 payout is: Lk Pk ,n , y (1 sn ,t , y ) k y Where Lk is the probability of surviving to the kth payout24 and sn,t,y is an appropriate spot rate for that payment, pulled from the nth scenario of the tth term length with y years to the target annuitization date. Note that if k = 1 and y = 0, then Pk,n,y will trivially be 1; we assume the participant survives to age 65. Using this calculation, the price of a $1/year deferred annuity for the nth scenario with y years to annuitization will be: An , y 50 k 1 Pk ,n , y , the price of a $1/year immediate annuity on the day of retirement will be: An 50 k 1 Pk ,n , the “duration” of any particular annuity25 will be: 50 k 1 Pk , n , y ( k 1) Dn , y y An , y , and the duration of the immediate annuity on the day of retirement will be: 50 P ( k 1) Dn k 1 k ,n An , since y = 0. 23 The income needed for the first year of retirement. This would be paid on the day of retirement. 24 We use the Society of Actuaries 1996 U.S. Annuity 2000, Male #887 table for mortality expectations. We assume that the likelihood of surviving to retirement is one. This table describes a single male annuitant. Lk would be higher for a single female annuitant, and higher still for a joint life annuity. 25 We multiply the present value of each payment by k – 1 instead of k, since the kth payment will be received at time t = k – 1, where t is the number of years after the retirement date. Further, the first payment is received in y years, which is why the duration formula for the deferred annuity starts with y. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 16

II. EXPLANATION OF CAPITAL MARKETS ASSUMPTIONS We used 5,000 simulations to construct Exhibits 3 and 4. In these simulations, the annual equity returns are calculated using Monte Carlo scenarios. The annual bond returns are calculated using AA corporate bond spot curve Monte Carlo scenarios, which include 11 key term interest rates. We present a statistical summary of these scenarios in the matrix below. While we used 11 interest rates in all, we feel that the 5, 15 and 30 year term rates provide a fair representation of the larger group. Exhibit 7 / Capital market assumptions Correlation 5-year 15-year 30-year Mean SD Equities spot/zero spot/zero spot/zero Inflation Equities 7.88% 18.28% 1.00 5-year 4.93% 2.71% 0.09 1.00 spot/zero 15-year 5.49% 2.09% 0.08 0.96 1.00 spot/zero 30-year 5.72% 1.38% 0.08 0.93 0.99 1.00 spot/zero Inflation 2.27% 3.68% 0.06 0.46 0.40 0.38 1.00 Source: Russell Investments. Assumptions are as of September 2010. III. EXPLANATION OF BOND RETURN CALCULATION The AA-rated interest rates form the basis for the bond returns. We select the longest term that is less than or equal to the bond duration. We then pull the spot rate for that term in the current year and the next year – since we calculate yields only on an annual basis, we use a simplified formula for the bond return: Rn , y Sˆ n , y D n , y ( Sˆ n , y 1 Sˆ n , y ) Where Ŝn,y is the interest rate in the nth scenario with y years to retirement, and Dn,y is the Macauley duration of the bond. (Technically, we should use modified duration, but it doesn’t make a significant difference in the results.) IV. EXPLANATION OF REPLACEMENT RATIO CALCULATION After calculating the final accumulated wealth for each of our 5,000 capital markets scenarios, we determine the ending salary “replacement ratio” for that wealth, where RR is the replacement ratio, W is the ending wealth, C is the final salary before retirement, and A is the price of a $1 immediate annuity on the day of retirement: Wn RR n C n An . To calculate the reward component of Exhibits 3 and 4, we calculate the median RRs for each asset allocation strategy. For the risk component, we use the 5th-percentile RR. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 17

Acknowledgments The author would like to acknowledge the contributions of the many colleagues who devoted their time to this paper. In particular, he thanks Josh Cohen, his boss, who gave him the time and encouragement needed to complete it; Tim Furlan, for helping with the investment model; and Grant Gardner, his father, for offering guidance along the way. For more information: Call Russell at 800-426-8506 or visit www.russell.com/institutional Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. There are no guarantees that any stated results will occur. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Target date fund investing involves risk, principal loss is possible. The principal value of the fund is not guaranteed at any time, including the target date. The target date is the approximate date when investors plan to retire and would likely stop making new investments in the fund. Target date funds are not intended to be a complete solution to investors retirement income needs. Investors must weigh many factors when considering to invest in these funds, including how much an investor will need, how long will the investor need it for, what other sources the investor will have and, if the investor is purchasing shares in an IRA account, whether the fund's target distributions will meet IRS minimum distribution requirements once age 70 1/2 is reached. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market. Copyright © Russell Investments 2011. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. The Russell logo is a trademark and service mark of Russell Investments. First used: March 2011 USI-8878-02-13 Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 18

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