1. Go custom
The decision to implement a custom target-date option is perhaps the most important one related to DC investment design. Unique plan demographics are
often a key motivation. Other compelling reasons include increased control and the potential for improved participant outcomes. A custom approach
allows for the implementation of a best-in-class structure, which may include a broader array of diversifying asset classes, category-leading asset
managers and potentially lower fees through the thoughtful allocation of active management dollars.
External support continues to build. Providing guidance to fiduciaries of 401(k) and similar employee-directed retirement plans, the Department of Labor suggests that plan sponsors consider custom solutions. And nearly 80% of consultants
responding to PIMCO’s 2015 Defined Contribution Consulting Support and Trends Survey supported the implementation of a custom target-date fund. The survey polled 58 U.S. consulting firms representing over 8,500 clients with DC assets in excess of $3.2 trillion.
Lastly, going custom is more accessible than ever. Recordkeeping, custody and trust capabilities have advanced significantly, as has the number of
experienced consultants able to walk clients through the process. Over
three-quarters of the consultants we surveyed support custom strategies, with $500 million commonly cited as a minimum threshold for assets under management. Plans under $500 million can access semi-custom glide path solutions
through their recordkeeper, gaining many of the benefits of fully custom approaches.
2. Employ active management
Investment risks are ever-present, and today’s are extensive. In this environment, active strategies may help mitigate risks and uncover value in global fixed income markets.
Market data have long supported the view that active fixed income management has the potential to deliver value well in excess of fees, while passive
management necessarily delivers returns equal to index returns minus fees. Indeed, Morningstar’s Intermediate-Term Bond Manager data shows that for
annualized returns over the 10 years ending 31 December, median and 25th percentile active managers outperformed not only their indexes, but importantly the median passive manager, by 29 basis
points (bps) and 75 bps (net of fees), respectively. Active managers have delivered meaningful value to participants historically, and may be better
equipped to manage risks prospectively, particularly should interest rates rise (see Figure 1).
Plan sponsors are understandably keen to keep plan expenses low. However, as the Morningstar data supports, low fee, passive strategies do not equal participant value. Active investment strategies may help plan participants realize their retirement
income goals, better control risk – and perhaps deflect heat from the growing fiduciary spotlight.
3. Augment core bonds with income
The start of the Fed’s hiking cycle in December was a momentous step in normalizing central bank policy. Yet we believe the implications for bond
portfolios are more nuanced and less threatening than most would imagine. This hiking cycle is likely to be the most gradual on record and have a lower
destination point than in prior cycles. The result: Rising rates could be advantageous as higher yields dominate
returns over time (see “Rising Rates: Dispelling the Myth
While the potential benefits of core bonds – income, capital preservation and equity diversification – are as valid as ever, there is a strong argument for augmenting core holdings
to address benchmark flaws, broaden the investment opportunity set and yes, potentially mitigate the impact of rising rates.
For example, multi-sector, income-focused strategies give managers the flexibility to invest globally and seek to maximize the production of consistent
income derived from
credit, mortgage, emerging markets and other higher-yielding sectors. Over half the consultants responding to PIMCO’s 2015 survey recommended adding a
global or multi-sector bond
option as a complement to an existing core bond exposure.
4. Add diversified inflation hedging
The lack of inflation around the world has contributed to significant declines in inflation expectations and a lack of urgency by DC sponsors to add
real asset exposures to plans. With inflation poised to pick up this year, now could be an opportune time to act. In fact, PIMCO expects U.S. inflation
to rise to 1.5% to 2.0% in 2016 while the market is pricing in less than 1%. After years of missing their inflation targets,
central bankers appear especially determined to achieve their price-target objectives.
Real assets provide a unique source of real returns that hold potential to build and preserve participant purchasing power. They also may provide
portfolio diversification benefits during inflationary periods, when stocks and bonds may suffer. Not surprisingly, over 90% of consultants
participating in our
2015 survey recommended using at least one inflation
hedging option. Plan sponsors should strongly consider
adding real asset options to their plans to help protect participants from potential inflation.
If offering participants only one real asset option, sponsors might consider a multi-asset approach that combines real asset categories including
Treasury Inflation-Protected Securities (TIPS), commodities and real estate investment trusts (REITs), among others.
5. Hedge international equities
Equities remain a cornerstone of DC portfolios and, in our view, are essential for delivering returns participants need to achieve their retirement
objectives. After years of strong equity returns supported by unprecedented monetary policy,
participants face broadly full valuations – especially in the U.S.
– strengthening the case for further diversification into non-U.S. equities.
For those invested in international equities on an unhedged currency basis, the recent depreciation of many currencies versus the U.S. dollar has
detracted significantly from portfolio returns while subjecting plan participants to significant volatility. Consider the MSCI EAFE Index (USD), which
captures large and mid cap stocks in developed markets outside the U.S. and Canada. In calendar year 2015, the U.S. dollar-hedged index returned 5.02%
versus -0.81% without hedging, with less volatility (measured by standard deviation). Over the past five years ending 31 December, the
hedged index had annualized returns of 7.75% with 12.05%
volatility compared with a 3.60% annualized return with
14.87% volatility without hedging.
Looking forward, this pattern may continue: PIMCO sees the potential for further U.S. dollar appreciation, albeit at a slower pace than the past 18
Today, few DC plans hedge currency exposure within their international equity allocations. This may be due to the limited availability of currency
hedged international equity funds (hedging is more common in bond portfolios) or perhaps the misperception that hedging is expensive. We believe plan
sponsors should review their international equity holdings and consider the value of diversifying existing unhedged exposures by adding a hedged
option, either as a standalone option or within a white label structure.
6. Review capital-preservation-focused options
SEC reforms of money market fund (MMF) rules take effect this October.
Fiduciaries have less than one year to prepare for these sweeping changes which, when combined with evolving technical and macroeconomic factors,
may make MMFs an unattractive capital preservation option for plan participants.
Among consultants participating in PIMCO’s 2015 survey, nearly all – 98% – said it is important for fiduciaries to review their use of MMFs in light of
pending regulation. In determining whether change is warranted, plan sponsors should assess the value offered by MMFs, the need for additional
disclosures to participants and the risk that their recordkeeper will face operational challenges.
Most MMF complexes have been reacting to these reforms by broadly switching their DC offerings to government MMFs
(G-MMFs), which can maintain a $1 net asset value and not be subject to fees or redemption gates. Unfortunately, this will likely increase demand for
government paper amid limited supply, keeping G-MMFs’ nominal yields low and real yields negative.
What are viable alternatives? Fortunately for plan sponsors, there are several attractive capital-preservation-focused alternatives that we recommend
for evaluation, including stable value, short-duration fixed income and white label (or custom) bond vehicles that combine these and other strategies.
The year ahead
As U.S. interest rates begin to normalize and inflation picks up, plan sponsors have an opportunity to refine their plan menus to improve retirement
outcomes. We think it’s an opportune time to evaluate active approaches, including custom target-date strategies, core strategies augmented by income,
real assets, hedged international equities and alternative capital preservation options.