MERCERDEFINED CONTRIBUTION INVESTING GUIDING PRINCIPLESSEPTEMBER 2014

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DEFINED CONTRIBUTION INVESTING GUIDING PRINCIPLES

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Mercer has established a set of fundamental beliefs and guiding principles on which all investment decisions should be based. These beliefs and principles apply across the world and cover the continuum of services provided by Mercer, from investment consulting to fiduciary fund management.

This document sets out the guiding principles for adapting Mercer’s fundamental investment beliefs and guiding principles specifically to Defined Contribution (‘DC’) plans, given their unique investment characteristics.

BaCkGROUND

DC plans have become the primary source of retirement income for many workers around the world and with this trend, the focus has moved from legacy defined benefit arrangements to offering best in class defined contribution programs.

Fiduciaries of DC plans are looking for ways to improve their plan and facilitating the effective investment of their plan members’ assets is a key priority.

Best practice DC investment approaches will vary across geographical regions and need to reflect each country’s norms, the availability of products and legislative influences. Despite these regional differences, Mercer believes that investment decisions should be based on a consistent set of guiding principles across regions.

The starting point for identifying global DC guiding principles is Mercer’s fundamental investment beliefs and guiding principles. However, when applying these beliefs and principles to DC investing, they need to be viewed through a “DC lens”.

Note that this use of the DC lens can also apply at a client level where a client’s general investments beliefs should be seen through the “DC lens” to establish the client’s DC Guiding Principles.

LOOkING THROUGH THE DC LENS

The “DC lens” reflects the specific constraints that apply to DC plans. These constraints can have a meaningful impact on the investment arrangements that can practically be implemented within a DC plan. These include:

• Members are the key decision makers, not the fiduciary: the fiduciary’s role is to control the investment options available to members, but most importantly they should also assist members in making the best decisions possible. as part of this role, it is important that the investment options available should be understandable to “lay members”.

• Member needs are not uniform: the customisation of DC plan options may focus on the majority of the membership base, but at times specific consideration needs to be given to the needs of a minority of members too.

• The range of strategies and asset classes will often be limited by the administrative platform, product availability and norms of each region. While the solutions in different geographic region continue to converge, we expect that there will always be specific differences between them.

• There is an elevated focus on fees and expenses from fiduciaries, members and regulators. While Mercer acknowledges that member benefits can be impaired significantly by fees over their working lives, Mercer believes that fees should not be considered in isolation and therefore the best net of fee and expense outcomes should be targeted.

• Liquidity and regular (fair) pricing are key considerations: the availability of daily pricing and daily liquidity at the member level is a key feature of most developed DC markets, however, this does not mean that illiquid or less regularly priced investments cannot be accommodated as part of a fund offered to members.

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Despite regional differences, Mercer believes that investment decisions should be based on a consistent set of guiding principles across regions.

Mercer’s fundamental belief is that a best practice DC plan should distinguish between, and address, the different needs of members. The following broad groupings capture the characteristics typically observed across a diversified DC membership base:

Mercer encourages DC fiduciaries to apply the above groupings in structuring their plan line-ups, as this will enable the plan to efficiently respond to the specific needs of each group.

The guiding principles for each grouping are set out in the remaining sections as follows:

Section A: Guiding principles for “Do it for me” members.

Section B: Guiding principles for “Help me do it” and “Leave me to it” members.

• No member engagement in investment decision• Rarely reviews portfolio• May be lacking:• Investment knowledge• Time or inclination to make and/or review active investment decisions

• Invested in default option

“Do it for me”

• Some member engagement in investment decision• Occasionally reviews portfolio – wants control over major shifts• Limited engagement over implementation, rebalancing, and other short-term issues

“Help me do it”

• Full member engagement in investment decision• Frequently reviews portfolio – wants control over all key decisions• Utilises full range of investment options – may desire additional options

“Leave me to it”

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SECTION a:GUIDING PRINCIPLES FOR “DO IT FOR ME” MEMBERS

Across the world, default options that apply a lifecycle switching approach over the working life of the DC member have become a popular investment option for “Do it for me” members. Mercer fully endorses such an approach. These default solutions include Target Date Funds (TDFs) in North America, Lifestyle solutions in the United Kingdom and Lifecycle strategies in Australia.

These default fund solutions are well suited to address the needs of those members, who would prefer to have someone else manage their portfolio, including adjusting their asset allocation, over time. They are typically well-constructed portfolios with effective diversification and an asset allocation tied to the members’ working lives.

However, designing an appropriate default solution that caters for the needs and requirements of the membership demographic can be daunting. The guiding principles we set out below can be used to assist in the design of lifecycle solutions or applied to assess existing “off the shelf” solutions.

From the beginning it is important to define the key principles that will guide the development of the default solution. In our view, the key considerations are around the members’ needs and how we can design the structure that best meets the needs of the “Do it for me members. We recognise that there is no “one size fits all” solution and that compromises are often required. However, the best design should seek to strike the right balance for each situation.

Mercer has identified the following guiding principles that provide the framework for our approach to designing appropriate default options:

Figure 1. guiDiNg PriNCiPLeS FOr “DO iT FOr Me” MeMBerS

enabling better outcomes is the key consideration

The focus of the solution design should be to deliver an adequate and sustainable income in retirement.

Take a “whole of life” approach to solution design

Our preference is for solutions that consider the changing requirements across a member’s whole life,

including what happens at, and after, retirement.

Need to protect against the worst outcomes

From a utility perspective, the negative utility from poor outcomes is far more significant than the

positive utility from better outcomes, particularly in terms of ultimate retirement income. When

assessing solutions, while the upside potential of a strategy is of interest, there should be a greater focus

on protecting against the worst outcomes.

intelligent diversification is essential

Diversification can help to reduce the impact of investment market volatility and ideally solutions should be designed to harvest multiple sources of

return.

investment strategy should be set according to risk tolerance and time horizon

Given their relatively long investment horizon, younger members can afford to take more risk.

As members age, their tolerance for adverse investment outcomes declines.

Member behaviour needs to be considered

From an investment perspective, member behaviour may require solutions to incorporate “sub-optimal”

investment approaches.

Members often prefer simple and flexible investment solutions that are easy to understand.

There is no free lunch

While a lifecycle default solution can help to manage to investment risk over the course of a member’s life,

there is no free lunch. Investment risk needs to be taken in order to generate the desired outcomes

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TakING a “WHOLE OF LIFE” aPPROaCH

Mercer advocates that DC retirement solutions should be designed from a “Whole of Life” perspective, incorporating both pre and post-retirement phases. This is because it is inefficient to design pre- and post-retirement solutions independently.

We believe that whole of life solutions provide a framework to enable the generation of adequate and sustainable incomes in retirement – the primary objective for a member in a DC plan. However, it is acknowledged that a number of countries regulate the pre-retirement phase of retirement saving separately from the post-retirement phase and therefore it may be difficult or impractical to incorporate both phases seamlessly into a single default solution. Despite this, it is recommended that any pre-retirement default option should be designed with the transition to the post-retirement phase in mind, taking into account that for most members certain optionality exists around retirement that can impact their post-retirement strategy.

In considering a whole of life approach in the design of a lifecycle strategy, the different priorities shown in figure 2 should be considered.

Importantly, at certain times investment issues are the top priority and at other times investment issues are less important.

Figure 2 also highlights that investments are not necessarily the only consideration. For example, in regions where saving for retirement is not compulsory, at younger ages the key issue is to entice members to contribute. In this instance; the selection of a particular investment strategy is a secondary objective.

This explains why in certain instances a lifecycle strategy can potentially be more conservative at younger ages; to avoid the possibility that younger members will be dispirited by poor performance and stop contributing.

It is recommended that any pre-retirement default option should be designed with the transition to the post-retirement phase in mind

Figure 2

Age

Component

EARLY CAREER (~20+)

ESTABLISHED CAREER (~40+)

PRE-RETIREMENT (~60+)

AT RETIREMENT (~65)

“ACTIVE” RETIREE (~65-75)

“PASSIVE” RETIREE (~75-85)

“FRAIL” RETIREE (~85+)

ACCUMULATION PRIORITY

•Saving for retirement (and remaining a saver)

•Smart investing (diversified growth investments)

•Smart investing integrated with potential retirement strategy

•Optimising retirement strategy

•Sustainability of retirement assets/income

•Absolute volatility of investments

•Sustainability of retirement assets/income

•Draw rate/absolute volatility

•Sustainability of retirement assets/income

•Draw rate from assets

•Long term care, medical costs

SECONDARY ISSUES

•Smart investing •Escalating contributions

•Absolute volatility an increasing concern

•Absolute volatility

•Draw rate from assets

•Retiree inflation

•Retiree inflation •Absolute volatility

•Retiree inflation

POTENTIAL INTERVENTIONS

•Mandatory contributions

•Matching contributions

•Auto-enrolment

•Foundation investing

•Diversified growth investing

•Matching contributions

•Auto-escalation

•Reduction of growth exposure

•Downside risk mitigation

•Inclusion of deferred retirement options

•Optimising social security

•Optimising which fund to draw from

•Selection of retirement products

•Longevity protection

•Long term care

•Guidance over draw rates

•Conservative diversified growth assets

•Annuitisation and/or other longevity protection

•Guidance over draw rates

•Conservative diversified growth assets with an income focus

•Annuitisation and/or other longevity protection

•Guidance over draw rates

•Conservative diversified growth assets with an income focus

•Annuitisation and/or other longevity protection

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In these cases the strategy may be initially more conservative, but then get more aggressive or equity centric and thereafter reduce again as the member approaches retirement.

As a starting point, we believe that adjusting a member’s asset allocation according to their age goes some way to tailoring the investment portfolio with respect to their risk tolerance. Importantly it is also achievable given the current capabilities of record keepers and administrators.

Figure 3 illustrates how a member’s investment needs change over time and how this corresponds to a change in risk tolerance. These changing characteristics can be used to influence the design of a lifecycle strategy.

PORTFOLIO CONSTRUCTION CONSIDERaTIONS

Portfolio construction plays an important part in the design of any investment solution and it is a critical component in a default investment option’s ability to successfully achieve its stated targets.

Mercer has developed sophisticated portfolio construction guidelines and these can be used to create reference portfolios that serve as a starting position for developing diversified portfolios.

The extent to which these portfolio construction principles can be captured within country specific solutions will naturally depend on the local regulations, tax, fee and liquidity requirements. However, the solution design should capture these best practice guidelines and adhere to the Mercer Investments beliefs and guiding principles where possible.

Figure 3

Age

Compenent

EARLY CAREER (~20+)

ESTABLISHED CAREER (~40+)

PRE- RETIREMENT

(~60+)

“ACTIVE” RETIREE (~65-75)

“PASSIVE” RETIREE (~75-85)

“FRAIL” RETIREE

(~85+)

INVESTMENT STRATEGY

Unimportant Important Very important Less important

VALUE OF HUMAN CAPITAL

Very high High to medium Medium to low Low

NEED FOR INFLATION PROTECTION

Very lowMedium (own salary

inflation)High (own salary

inflation)Retiree inflation

Aged care/ healthcare costs

SEQUENCING OF INVESTMENT RETURNS RISK

Low Moderate High Moderate Low

TOLERANCE FOR COMPLEXITY

Moderate Low Very low

TOLERANCE FOR SHORT-TERM VOLATILITY

Depends Low Very low

LONGEVITY RISK Low Moderate High

INCOME IN RETIREMENT FOCUS

Very low Low Fairly high High Very high

TAX CONSIDERATIONS

Country-specific but can have a material impact

Age is not the only factor that can be used in the design of a lifecycle strategy, but it is a very important one

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SECTION B:GUIDING PRINCIPLES FOR “HELP ME DO IT” aND “LEAVE ME TO IT” MEMBERS

Considering the needs and requirements of partially and fully engaged members through a “DC Lens” enables us to develop appropriate solutions for these sub-groups.

While it is true that the investment options for these members will vary greatly across regions and potentially across administrative platforms, the general principles for “Help Me Do It” and “Leave Me To It” members include:

Figure 4. guiDiNg PriNCiPLeS FOr “HeLP Me DO iT” AND “LeAVe iT TO Me”

MeMBerS

“Less is more”

Too many options can be counterproductive, potentially providing members with the “misery of choice” and even discourage active participation in

the plan

Sufficient risk-return variety should be provided

To manage the complexity of the plan and the number of investment options offered to members, consideration should generally be focused on those

options that would be attractive to of a majority of members

Characteristics should be explainable to “lay members”

While it is tempting to design overly sophisticated solutions that cater for all of the potential needs of

members, it is important that members can understand the characteristics of what they are

investing in

Specialised funds need to be used with caution (or with advice)

Specialised solutions can often have higher risk profiles than traditional options, and require clear

communication to members. Members choosing to invest in such options should be made aware of the relevant risks and it may be appropriate to suggest that they seek financial advice if selecting a higher

risk option.

White-labelling can make for more efficient portfolios

Offering white-labelled funds can provide more flexibility to the plan’s fiduciary, ensuring more

efficient portfolios that can cope more readily with fund manager changes.

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CONCLUSION

The DC guiding principles included in this document are not intended to be prescriptive or narrow in their application. Instead, they are designed to provide a consistent framework on which all investment decisions should be based.

These beliefs and principles apply across the world and cover the continuum of services provided by Mercer, from investment consulting to fiduciary fund management.

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IMPORTANT NOTICES

© 2014 Mercer LLC. All rights reserved.

This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold, or otherwise provided, in whole or in part, to any other person or entity, without Mercer’s prior written permission.

The findings, ratings, and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes, or capital markets discussed. Past performance does not guarantee future results. Mercer’s ratings do not constitute individualised investment advice.

Information contained herein has been obtained from a range of third-party sources. While the information is believed to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no representations or warranties as to the accuracy of the information presented and takes no responsibility or liability (including for indirect, consequential or incidental damages), for any error, omission, or inaccuracy in the data supplied by any third party.

This does not contain regulated investment advice in respect of actions you should take. No investment decision should be made based on this information without obtaining prior specific, professional advice relating to your own circumstances.

This does not constitute an offer or a solicitation of an offer to buy or sell securities, commodities, and/or any other financial instruments or products, or constitute a solicitation on behalf of any of the investment managers, their affiliates, products, or strategies that Mercer may evaluate or recommend.

For the most recent approved ratings of an investment strategy, and a fuller explanation of their meanings, contact your Mercer representative.

For Mercer’s conflict of interest disclosures, contact your Mercer representative or see www.mercer.com/conflictsofinterest.

Mercer’s universes are intended to provide collective samples of strategies that best allow for robust peer group comparisons over a chosen timeframe.

Mercer does not assert that the peer groups are wholly representative of and applicable to all strategies available to investors.

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Copyright 2014 Mercer LLC. All rights reserved.

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