The first in a series of articles exploring diversifying asset strategies, including fixed income, real assets, equities and capital preservation.
We’re often asked how many bond offerings should be on a defined contribution plan’s investment menu. The answer: It depends.
Defined contribution (DC) plan sponsors face a dual challenge: They must offer investment options consistent with the goals and demographics of plan members. They also must consider how the menu’s structure affects the way individuals select investments. Bond offerings must be evaluated individually and holistically to help participants build a well-structured portfolio that fully leverages fixed income’s potential to preserve principal, generate income and boost diversification.
What’s on the investment menu now? This is a critical first question in designing core bond offerings. Plenty of research finds too many undiversified choices can drive suboptimal
investment decisions or inaction.
Unfortunately, many lineups are bloated, particularly with equity choices. These lineups often are based on equity style boxes and may include strategies with value, growth and blended styles in small, medium and large market capitalization categories. All too often a menu with seven of 10 investment choices in the equity category provides “unintended advice” that may lead some participants to allocate 70% of their savings to equity offerings. This phenomenon is known as the “1/n heuristic” or “naïve diversification.” It may lead participants to select portfolios that are inappropriate for their time horizon and risk capacity.
Some plans take the opposite tack, ultrasimplifying menus to less than a handful of “risk pillars,” including cash, bonds, equities and possibly real assets.
What’s important in structuring a DC menu, whether lengthy or brief, is to offer a risk-balanced investment set. In the event that participants evenly divide their assets across the investment menu (i.e., 1/n), the result should provide a reasonably balanced portfolio. Many DC plans offer just one U.S.-centric bond choice. We suggest that plan sponsors consider adding more bond choices to balance their lineup (see Figure 1).
Balancing risk-diversifying choices
Capital preservation-focused strategies and core bond strategies are cornerstones – and often the sole diversifiers to equity – in many DC lineups. As plan sponsors consider balancing their lineups, we first suggest a thorough examination of existing diversifiers:
Capital preservation-focused strategies typically include money market funds, short-term funds and stable value strategies (which combine active bond strategies with insurance contracts to help assure principal and income).
For plans that offer stable value, potentially competing investment choices such as money market, short-term and low-duration bond strategies may be precluded. Stable value strategies not only offer capital preservation potential but also historically higher risk-adjusted returns than money market and low-duration strategies. In the U.S., only about half of all DC plans offer stable value funds, although for the largest plans with more than 5,000 participants the figure is 70%,according to the Plan Sponsor Council of America’s 2013 survey.
For menus that include a money market fund, we suggest fiduciaries consider adding a short-term or low-duration bond strategy, either as a replacement or complement. We believe it important for these replacements to have return potential, low volatility and small risk of negative single-day performance.
Many DC plans offer only a single bond strategy that is passively managed or tightly tethered to the Barclays U.S. Aggregate Index (BAGG). At PIMCO, we believe that passive BAGG-oriented allocations are no longer efficient in tapping the true value of bonds. Historically, the BAGG offered broad diversification among U.S. bond market sectors and typically had low volatility and low correlation to equities. But the growth of government debt has eroded these advantages: The BAGG and strategies benchmarked against it may fall short in the critical areas of return enhancement and risk-mitigation potential.
Consider the BAGG’s concentration risk. Because it is a market- capitalization-weighted index made up of U.S. investment grade bonds, the share of U.S. Treasuries in the index rose to a 10-year high of 36% at the end of 2013; this reflected the U.S. government’s continued debt issuance to finance its budget deficit. Moreover, yields on the index remain near historical lows because more than 70% of the index is composed of low-yielding government and mortgage-backed securities, according to Barclays. In short, overconcentration, coupled with low interest rates for a large portion of the index, suggests limited scope for capital appreciation and may increase the risk of losses when rates rise.
A better alternative, we believe, would be bond strategies that can actively manage risks, invest globally and enhance yield potential relative to the index. Active management offers several potential benefits critical to DC participants: Duration flexibility may reduce downside risk in a rising rate environment; broader investment guidelines may expand the opportunity set and increase return potential; and sector selection may improve diversification and reduce concentration risk in government-backed securities.
Without doubt, passive bond management typically offers lower expense ratios than active strategies. Nonetheless, reduced returns and exposure to rising rates may hit participants with significantly higher “hidden costs.” In contrast, active core bond managers have shown the ability to manage risk and increase alpha relative to the BAGG over time and during most market downturns. Passive intermediate-term bond strategies underperformed more than 75% of active core and core plus strategies over the past five and 10 years (see Figure 2).
Some plan sponsors may offer both active and passive core bond options. We believe that offering both creates unnecessary communication and selection complexity for participants. When it comes to core bonds, we suggest the fiduciary offer access only to skilled active managers.
Selecting diversifying bond strategies
Figure 3 shows a list of potential diversifying fixed income strategies that DC plan sponsors could consider adding to their lineup.
In choosing these strategies, plan sponsors need to consider a variety of factors:
Might bond strategies provide access to securities with higher return and yield potential than passive BAGG-bounded strategies?
To answer these questions, we suggest evaluating the return potential of current plan offerings. Although yield-to-maturity (YTM) is an incomplete measure of the return potential of bond strategies, it may be used as a good first step to compare the BAGG with diversifying bond strategies — it explains 85-90% of returns over reasonably long horizons. As of 31 December 2013, the BAGG’s YTM was 2.4%. This compared poorly with an equally weighted index blend of the Barclays Global Credit Index, the BofA Merrill Lynch Global High Yield BB-B Rated Constrained Index and the JPMorgan EMBI Global Index (YTM of 4.8%). See Figure 4.
Volatility and correlations:
Is your offering appropriate from a volatility perspective? Does it offer diversification via lower correlations relative to other choices?
Managing volatility to offer a “smooth ride” to DC participants may reduce fear and flight (i.e., shifting assets out of a strategy) in rougher markets. Strategies with less volatility and lower correlation with both equities and other asset classes already on the menu may add value. We suggest fiduciaries compare estimated volatilities and correlations to those of the S&P 500.
Plans may consider offering a low-duration strategy. These may reduce estimated volatility by about 60% to 1.8% from 4.1% for the BAGG (both at year-end 2013). Another approach could be a foreign U.S. dollar-hedged bond strategy that may offer lower volatility and other potential risk-mitigation benefits. Our analysis suggests that both low duration and foreign U.S. dollar-hedged bond strategies may reduce estimated equity correlations.
Does the bond choice mitigate downside risk? What type of loss may participants experience in various market environments?
Although there are many ways to measure potential loss, we suggest evaluating risk exposure by assessing Value-at-Risk (VaR) at a 95% confidence level (VaR estimates the minimum expected loss at a desired level of significance over 12 months) or similar appropriate downside risk measures. Plans may realize the greatest opportunity to reduce downside risk by adding low duration and foreign U.S. dollar-hedged strategies. At the end of 2013, the BAGG had a VaR (at 95%) of 4.6%, while the comparable figure was just 1.2% for low duration and 4.0% for foreign U.S. dollar-hedged bond strategies.
U.S. rate exposure:
Is your bond strategy sufficiently diversified to reduce exposure to U.S. interest rate risks? We propose you consider nominal duration, both overall and U.S.-specific. Based on our index analysis, low duration and the blended index of global credit, high yield and EM bond strategies all offer lower duration-risk potential than the BAGG.
A balanced approach
The challenges of strengthening bond lineups in DC plans can be complex, but needn’t be overwhelming. We suggest looking first at the current mix of investment options and ways to improve it. This may lead sponsors to replace suboptimal solutions, possibly money market funds and passively managed core bond strategies. It also may prompt sponsors to offer more choices, either as stand-alone core menu offerings or blended within a custom core strategy. As you consider your core, we suggest that fiduciaries model the potential effects of adding or combining solutions.
In the end, there may be no correct answer to the question of how many offerings should be on a DC plan’s investment menu. It depends. But if sponsors can offer a range of options consistent with the needs of plan participants – and present them in a way that reduces the risk of naïve diversification – it may go a long way towards helping employees achieve their retirement-savings goals.