Q:  How has retirement investing evolved at Franklin Templeton and what led to the development of target date funds?

In 2000, most of the industry focused on target risk type of products, specifically portfolios that had a mix of equities, fixed income, and cash, but that mix was fairly constant over time. During the past 15 years or so, we’ve seen the growth of target date types of portfolio, which mirror the typical lifecycle of an investor, that is, more risk early in the fund’s life. Consequently, investors begin with a higher equity allocation and then progress over time to a more defensive portfolio as the individual’s retirement date approaches when a higher allocation goes into fixed income and a lower allocation to equities. To meet this growing demand, we launched our target date series in 2006. We manage eight target date portfolios with retirement years from 2015 through 2050. Four of which we launched in 2006, and we added the four additional ones in mid 2013. Total assets in those eight funds are just under $300 million currently. In addition to our original target risk funds, there are three target risk funds we launched in 1996, and those have grown to have about $6 billion in assets.

Q:  How did a change in regulation help the target date fund industry?

Certainly the ability to use target date funds as default options in 401(k) retirement plans specifically has really boosted this corner of the industry. Many investors don’t have the sort of financial expertise or desire to make selections from a suite of fund options within a particular 401(k) plan. Through target date funds they can allow a firm like Franklin Templeton to provide a professionally managed portfolio that is appropriate for them given their age and expected retirement date. I think that’s really a win-win for both the industry and for the investors as target date funds become the default choice in retirement plans.

Q:  What investment philosophy underpins target date fund management at Franklin Templeton?

We believe in combining both a bottom-up process of rigorous analysis and fund selection with a top-down macroeconomic view of the markets at any given point and using that result to adjust the portfolios. We focus on creating these portfolios with our best underlying fund options and building fully diversified portfolios, so investors have exposure to many different in a risk-controlled atmosphere with the portfolios constructed to meet the investment objective. Our target date portfolios are populated with high quality underlying funds across a broad swath of asset classes. We strive for diversified exposure through different asset classes and then, on top of that, apply a tactical overlay of a macroeconomic view to adjust portfolios based on what’s going on in the marketplace. It’s something we do by using the expertise of our global investment professionals through a weekly global meeting and assessing what’s going on in the marketplace and taking advantage of opportunities to add value. Working for a global organization like Franklin Templeton, we would be shortsighted to not leverage the insights of the over 590 investment professionals across the globe in order to help form our investment decisions. When you look at target date funds, they all, for the most part, are there to serve a singular purpose, and that’s to help investors stay in the market, remain diversified, and get appropriate levels of risk for where they are currently in their investment lifecycle. But within each firm’s target date portfolio, you can see some differences. One of the things we alluded to was not only getting access to the right managers for the long term but also to take advantage of opportunities that come along in a tactical way. If you’re looking at the preretirement years, for example, for someone starting at age 25 and retiring at roughly age 65, we have four decades, and so although we have a strategic allocation in that glide path, as the market performance waxes and wanes throughout that period, so do risks. So, we have the opportunity to tilt and move away from that glide path, not so much that it changes the overall profile of the portfolio but enough to take advantage of opportunities and steer clear of risk when prudent. We have the ability to add incremental risk-adjusted returns. Some managers will take advantage of this tactical ability, and some will set that glide path and remain constant and true to that throughout all the preretirement years. It’s the manager’s choice.

Q:  What is your investment process?

We take a full life cycle investing approach; we have a higher allocation to higher return and higher risk assets, but we always remain diversified. In the target fund, we start with the higher equity allocation in the early years and then, progressively over time, shift away from some of the higher risk assets as we approach the client’s retirement date and shift more into fixed-income assets. At the same time, however, we’re also trying to give investors exposure to some other lower correlation assets that might reduce risk over time. For example, some sort of alternative investments we have incorporated into our portfolios as well to reduce portfolio risk over the portfolio’s full lifecycle as well as potentially adding incremental returns.

Q:  What asset classes do you invest in, and how granular is your investment process?

We invest across the spectrum equities and fixed income, and we’ve also begun to include alternative investments as well. We invest globally, both on the equity and fixed income sides. In addition, we have the ability to access different styles and capitalization sizes within equity markets. We have specific fund allocations dedicated to each of those sub-asset classes. We invest in roughly 20 funds from about 50 in our universe. Historically, in the past few years, the low end is about 14 or 15, and the high-end is in the low 20s. Given the breadth of our fund options within Franklin Templeton, we can also give investors exposure to some fairly different asset classes that we feel can add significant value to the portfolio. For example, we have the Franklin Biotechnology Discovery Fund that’s a very special offering. On the non-U.S. side, we can give investors exposure not just to emerging markets but also to frontier markets through a fund like the Templeton Frontier Markets Fund. On the fixed-income side, we have access to funds across a number of different sectors including high yield, bank loans, global bonds, emerging market debt, and several low duration strategies. In addition to that, we also have the capability to use ETFs in our portfolios up to an allocation of 20 percent of the portfolio. ETFs serve two purposes, first, they allow us to make quick tactical adjustments to the portfolios without disrupting our underlying fund investments, so for example, if we want to increase equity allocation by 5 percent, we can do that very quickly and easily with ETFs, or if we wanted to reduce our equity allocation we can do that as well. Second, we can use ETFs to gain exposure to any particular market segment where we have a desire to invest but do not have internal funds available.

Q:  Does your asset mix extend to commodities, currencies, and domestic or global real assets?

Yes we do. In fact, in the case of real estate, we do have a position, the Franklin Real Estate Securities Fund, in the portfolio which does invest in a variety of REIT instruments. In terms of commodities, we do have exposure to commodities through the Franklin Pelagos Commodities Strategy Fund.

Q:  How do you manage glide path?

Ours is a continuous process. If you look at the actual glide path it’s non-linear, or parabolic, and we adjust the strategic allocation on an annual basis. As the investor ages, we will adjust the allocation to equity and fixed income and to other assets annually. In addition to that, we have a tactical range of plus or minus 10 percent, towards or away from equities or fixed income depending our views of opportunities or risks in the marketplace. In order to understand whether we have added any value through tactical tilts or manager/fund selection we compare our portfolio implementation against that glide path asset allocation across the spectrum to understand our sources of value add. For instance, in 2013, we were overweight in equities pretty much all year, and that served us well. Secondarily, we added value in selecting the right managers within our investable universe. Those are the levers at the broad management level we can pull into the portfolio. So our portfolio attribution process helps inform us as to value add against what we set out to do i.e. that glide path In addition, clients will judge us against other target date funds that we compete against, so we do have to stay mindful of peer group performance as well. In terms of target returns and risks, when we build out the glide path we use our forward-looking return expectations and risk numbers, so there’s always an expected overall portfolio return, but this isn’t something we expect to hit on a month-to-month or quarter-to-quarter basis because these are long-term portfolios. Over time, we are hitting those objectives. At the same time as we manage the portfolio, we do make changes to the portfolio, but we’re always mindful of overall portfolio risks and ensure we don’t get too far out in those terms.

Q:  How do you evaluate the effectiveness of your glide path?

That’s something we addressed just a couple of years ago. We had a glide path in place when the funds launched in 2006. Then, we did a thorough review and determined there were things we could do to improve the effectiveness of the glide path. We previously had a linear glide path that was a so-called through-retirement glide path that continued to evolve beyond the retirement date. We did research on both investor behavior and glide path portfolio outcomes and determined that for us, a non-linear to retirement glide path was most appropriate and as a result, we made that change. We do review our glide path on a regular basis. There are additional modifications we might want to make that reflect the current state of the market as well as what the trends in the industry are and where the most appropriate glide path is for our funds and for our investors. The building of the glide path is really a mixture of art and science. First, there are certain philosophical views that we have in terms of to- versus through-retirement. It’s really a question of do you want to get people safely to their retirement date and assume they will work to determine what the most appropriate course of action is for them at that time, or is the target date fund viewed as something investors will keep in their portfolios as their anchor investment and will continue to use throughout their retirement years and potentially use as a vehicle for generating income. We tend to the former viewpoint: getting people safely to retirement. There’s a lot of uncertainty around individual investor needs when they get to their retirement date. We think it’s a good time for them to interact with their advisers to determine the best course of action for them. Since we’re not record keepers we haven’t seen this directly, but everything we’ve read on investor behavior in and around retirement is that the assets tend to leave target date funds in the first few years post retirement. So, we don’t believe we should constantly evolve an asset allocation in the five, ten, twenty years post-retirement if a big chunk of those assets will no longer be there. That’s what led us to the notion that a to-retirement glide path is most appropriate for us. Also, we know investor risk-tolerance isn’t necessarily a straight-line nor are portfolio investment values. They tend to grow exponentially as they get closer and closer to retirement due to compounding and contribution rates over time, so that led us to thinking of a non-straight-line glide path. We then took all of the assumptions and analyzed them quantitatively. We included a number of return-enhancing and risk-mitigating factors, i.e., what is the expected value of the portfolio at retirement, and do we want to maximize that value. We also looked at the probability that the investor’s portfolio will be depleted before the actuarial end of his or her expected lifetime and that we want to minimize that probability. Then, we also looked at things like the range of potential outcomes from that scenario analysis at retirement and, more important, what the bottom end of that range of potential outcomes is. You want to ensure that at retirement, the portfolio value is as high as possible. We want to bring people safely to retirement with a high degree of certainty and a portfolio that has a good chance of lasting throughout their retirement years. Through all of that quantitative analysis, we concluded that at least for us a to-retirement, non-linear, diversified, conservative glide path made the most sense for us.

Q:  What are your views on equity allocation?

Our equity allocation at retirement is slightly more than 30 percent. We feel that’s an appropriate reflection of the need to stay somewhat defensive as the investor approaches retirement so he doesn’t incur a severe shortfall prior to retirement due to a market event like the one in 2008 when a lot of investors were overly exposed to equities right before retirement, and they suffered losses they couldn’t recoup. At the same time, though, you must have sufficient exposure to assets that are going to grow longer term. Most people are living much longer in retirement now than they ever have and that trend will only continue. There’s a statistic I saw that for people who reach the age of 65, the life expectancy is older than 85. You’re looking at 20+ years in retirement for most people, and for their portfolios to sustain them through that period, they need some exposure to higher return and higher risk assets. It’s about striking a balance between being appropriately cautious as retirement nears, but at the same time, maintaining some equity exposure for investors so they’re ready for those retirement years.

Q:  What are your views on risks and how do you manage risk exposure in the fund?

Certainly, risk is paramount in any kind of investment context, and we are constantly mindful of risk. I would point out that at Franklin Templeton, it’s of such high importance that we have a separate risk group, called the Portfolio Analysis and Investment Risk team (PAIR) which is a separate unit that acts independent of the investment teams and provides thorough risk analysis and support to the various investment groups throughout the organization. We can analyze our portfolios from a number of different perspectives looking at not just the individual risk exposure within each of our funds but also looking at how the portfolios perform more broadly. We look, for instance, at how our portfolios and the risk exposures are relative to our benchmark and looking at our portfolios relative to what our peers are doing. Specifically, we want to identify where we’re taking risks and to make sure that where we are taking risk, it’s nothing that we’re uncomfortable with, and it’s consistent with our overall investment philosophy. We have a saying at the firm: You can manage risk, but you can’t manage return. We’re always cautious about understanding where the risks are coming from. One of the things we always do is ensure that we understand both what the effects are from both an absolute risk perspective as well as tracking error to the glide path, relative to the glide path allocations. So the investment team utilizes risk models to ensure that we do not take undue risks when managing portfolios and the PAIR team serves in an oversight capacity. The PAIR folks have three “R”s around risk that we must always abide by: risks must always be rational, recognized, and rewarded. What that means is that we must understand where the risks are coming from, and we have to ensure they make sense, and we will be adequately compensated for the risks we take on in our portfolios. I think the relevant example in our target funds today is that the single biggest active risk or active exposure in the portfolio is lower than the benchmark exposure to U.S. interest rates, and that’s the identification phase. One of our themes in fixed income during the past year has been to lower duration in fixed income. We think it makes sense, and historically, during the past year or so, it certainly paid off to be lower than benchmark. We think that’s going to be the case going forward. We ensure always that we understand things that make sense and that we’re compensated. As the PAIR team serves as an oversight function on our behalf; one of the nice features about how they can add value to our portfolios is if we’re looking to make a change in the portfolio or adding a new fund or making some sort of adjustment to the portfolio, we can ask the team to run a sensitivity analysis. How is this change going to affect the overall risk profile of the portfolio so before we even commit to a change in the portfolio, we can have a good feeling for how it will affect our risk exposure.

Q:  How do Franklin Templeton target date funds differ from the peer group?

Across Franklin, we have multiple investment teams with separate chief investment officers, separate styles, and very little overlap. So, when we’re trying to build multi-asset, class-diversified portfolios from an asset allocator’s perspective, Franklin provides unique building blocks for portfolios to get truly diversified funds. The depth and breadth of the underlying funds that we have to choose from within Franklin Templeton give us a tremendous advantage within the industry. The various independent management teams don’t have a whole lot of overlap so we can create truly diversified portfolios that give investors exposure to a wide range of asset classes and, in addition, the thorough asset class research process we offer. There is not anything that makes one set of target date funds entirely different from everybody else. Some folks embrace a to-retirement glide path and some folks have the through-retirement glide. We’re in the to- camp. Some folks are active, some folks are passive. We are in the active camp although we use passive investment ETFs in order to facilitate the active management of the portfolio. Some folks are tactical, some folks are not tactical; we’re on the tactical end. In general, when we’re compared to our peers, our target date funds tend to be more conservative and more diversified.