Take Action: Six Ideas for DC Plan Sponsors in 2016

Macro inflection points create an opportunity to improve participant outcome potential.

This year really is different. The Federal Reserve is hiking rates for the first time in nine years. Inflation is making a comeback, however modest. For defined contribution (DC) plan sponsors, these inflection points create an opportunity to potentially improve participant outcomes.

In partnership with our DC clients and their advisors and consultants, we suggest six investment themes to guide plan sponsors in navigating the challenges ahead:

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 months.

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.

The Author

Richard Fulford

Account Manager, Head of U.S. Retirement

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Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. Commoditie s contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-lin ked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Money Mar ket funds are not insured or guaranteed by FDIC or any other government agency and although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investors should consult their investment professional prior to making an investment decision.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved.

Morningstar’s Intermediate Term Bond category includes 160 funds that focus on corporate, government, foreign or other issues with an average duration of greater than or equal to 3.5 years but less than or equal to six years, or an average effective maturity of more than four years but less than 10 years.

It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.