Fixed income is an essential component of every Defined Contribution plan’s lineup. It may help lower volatility, provide diversification to equities and potentially enhance the risk/return profile in participants’ portfolios. But fixed income investing, like all investing, comes with a multitude of risks that must be carefully managed.
Traditionally, many DC plans have relied primarily on strategies benchmarked to the Barclays U.S. Aggregate Bond Index as their primary fixed income offering. However, a limited fixed income offering, coupled with a challenging — and changing — fixed income landscape (notably the potential for rising interest rates coupled with a low yield environment within traditionally offered fixed income benchmarked solutions), is driving the need to rethink a DC plan’s approach to fixed income solutions. With bond investments comprising 12% of 401(k) plan balances, the potential impact on participant investment outcomes may be significant.1
Participants face many risks in a retirement plan from simply outliving their savings, to losing assets in a market downturn, to experiencing the eroding effects of inflation. For fixed income portfolios in DC plans, three risks in particular affect participants: participant user risk, interest rate risk and market risk.
How can you be sure that you are implementing the right fixed income approach in a DC plan? By addressing these risks with the appropriate international or global fixed income investment options, and continually re-evaluating the lineup.
PARTICIPANT USER RISK
Not enough choice, not enough knowledge.
Participant user risk is characterized by limited investment knowledge. Many participants do not understand the role of fixed income within a portfolio, the implications of interest rate fluctuations or how fixed income risk differs from equity risk. In addition, fixed income is typically under-represented in the DC plan compared to equities. This results in portfolios that may be under-diversified and not aligned with their risk preferences and tolerances.
CONSIDER THIS: In the absence of offering more fixed income solutions, provide the right mix of fixed income options to help participants diversify across countries, sectors and durations. Expand education efforts to help participants better understand the role of fixed income in their portfolio.
INTEREST RATE RISK
What’s on the horizon?
As the economic landscape continues to shift, the risk of rising interest rates looms as a challenge investors will inevitably face. Real yields on Treasury bonds may lag behind nominal yields (the actual fixed interest rate of the bond) depending on the prevailing interest rates. Interest rates and bond prices are inversely related: as interest rates rise on newly issued bonds, the market value of already issued bonds will fall. As a result, participants with large fixed income allocations may be exposed to interest rate risk and declining asset values.
CONSIDER THIS: If offering an array of fixed income solutions, including an international option, educate participants on the need to diversify within their fixed income holdings and to rebalance their broader portfolio yearly, or in response to changing conditions.
Preparing for all kinds of weather.
Market risk is the risk that the value of an investment will decrease over a given time period because of economic changes or other events that have an impact on the market. Asset allocation and diversification can help protect against market risk since different portions of the market tend to perform or underperform at different times. As mentioned, risk can be exacerbated in DC plans that rely primarily on fixed income strategies benchmarked against the Barclays U.S. Aggregate Index. As such, participant user risk is compounded by the limited choice of fixed income solutions that are primarily U.S.-benchmarked. Without access to broader fixed income markets, a participant’s portfolio may experience higher levels of volatility.
CONSIDER THIS: Offer solutions across country, sector, quality and duration to help participants properly diversify to potentially gain better fixed income returns. Taking a more global approach to providing fixed income solutions within the DC lineup can help reduce market risks and volatility by providing access to diverse interest rate and yield environments. Diversification across bond types is also important because over-reliance on single-sector bond portfolios may lead to excessive volatility. With better asset allocation and the right investment solutions to properly diversify, participants may experience less volatility and overall enhanced returns.
BALANCING THE DC PLAN’S FIXED INCOME LINEUP
Depending on the goals of the plan, every plan sponsor and investment committee member will have a unique philosophy and approach to providing fixed income solutions within their DC lineup. It’s important to avoid overlap and redundancy when expanding the opportunity set. It’s critical to consider how participants will react to more choice, how effectively they will be able to allocate and diversify within this expanded menu, and the capacity of the plan to add more investments. The approaches outlined here may be helpful in determining and implementing the right course
Begin your fixed income transformation now.
1. Review the plan’s investment menu.
- How many fixed income options are in the lineup?
- Do they provide proper diversification for addressing risk?
2. Run a benchmarking report.
- Retirement plan advisors can run benchmarking reports for plan sponsors.
- Compare the plan’s fixed income options with plans of similar sizes and industries.
3. Implement a two-pronged educational campaign.
- Target all participants to help convey a general understanding of the basics of fixed income. Specifically target employees nearing retirement.
CONSIDER THIS: Start re-evaluating the DC plan now to determine if it provides a globally diversified portfolio and the right number of fixed income options for participants. The benefits of doing so include reducing risk, simplifying choice, and helping participants achieve the secure futures they deserve.