DC Plan Sponsors Should Get Comfortable With Market Volatility

There will always be unpredictable times, and just as participants are told to take a long-term view, so should plan sponsors when selecting and monitoring investments.

The market saw extremely heightened volatility last year. Over the past 30 years, half of highest volatility days were in 2020, notes Jeremy Stempien, principal, portfolio manager and strategist for QMA, a PGIM company.

“Volatility is still heightened, but it’s down substantially from Q1 2020,” he says. “It will take some time for volatility to get back to historical ranges, so it’s likely to continue in 2021, but we should see reduced volatility by the end of the year.”

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Christine Stokes, head of institutional and retirement learning and development at Nuveen, says Nuveen believes volatility will be lower on average over the course of this year. She points out there were recently two completely unrelated spikes in volatility: One was sparked by the GameStop incident and the second was brought on by concerns about rising interest rates. “We will see spikes like this over the course of the year, but, on average, there will be better growth, which will translate to higher earnings, and the Fed will hold the line,” Stokes says.

Stempien says that from a defined contribution (DC) plan participant viewpoint, volatility can be a risk, but it can also be a benefit. He explains that it is a risk for older participants who have less time to recover—it could cost them a year of retirement income. But younger participants can be benefit from dollar-cost averaging, as they can buy when the markets are low.

It is important for plan sponsors to have conversations with plan participants about market volatility, Stokes says. “Volatility and uncertain markets can cause panic and emotional investing moves. Participants can forget about their long-term time horizons,” she says. “Plan sponsors are on the front line of that, so it is important to educate employees about how to think about it and what steps to take.”

Stokes adds that this education should be provided regardless of whether there is current market volatility.

In periods of volatility, the key is for plan sponsors and participants to remember the long-term time horizon of most investors, Stokes says. Staying invested and depending on professional investment management is important. “When we think of last year, the market bottomed out on March 23, and some individuals pulled out of market. However, professional money managers used that as an opportunity to rebalance, so they were able to take advantage of buying low and able to take advantage of the upside of the market in subsequent months,” she explains. “Those who moved out of investments didn’t see these advantages.”

Fiduciaries who are doing their due diligence on investments might already be going through a deep dive on asset managers’ capabilities. Stokes says plan sponsors can incorporate this research in times of market volatility by understanding asset managers’ views of the market. “Anytime sponsors are reviewing asset managers, they need to understand the time horizon for investment strategies and how they manage up and down markets,” she suggests. “What are their expectations for their investment strategies’ performance during those times? Does historical performance align with what they are expecting? Do expectations come to fruition? Look at periods of volatility and how the investments performed. If they didn’t perform the way the investment manager expected, why not?”

Stempien also says it is important for plan sponsors to take a long-term approach. They should make sure they are offering an appropriate level of risk, especially in default investments. “That is most important if most participants are in the default investment option,” he says. “Plan sponsors should look at the long-term success of their default investments and shouldn’t make snap changes based on short-term views.”

Stempien adds that when participants start to tactically shift their own portfolios, they almost always fail to maximize returns; the data shows they are almost always better off in a diversified portfolio, such as a target-date fund (TDF).

TDFs that adjust risk as participants get older help those closest to retirement. Stempien says sponsors should educate participants about the investments they have and steer them toward the default. “The more they do so, the better off participants will be,” he says.

To choose the appropriate TDF for their plan, plan sponsors should look at the risk in TDFs for those closest to retirement. “Deciding whether they are more concerned with downside risk or with having the best performance near retirement will lead them to choose the most appropriate TDF,” Stempien says.

He adds that the conversation about volatility can lead to a discussion about retirement income. “Volatility increases older participants’ risk of running out of money before they die, and this makes a case for plan sponsors to consider adding guaranteed retirement income products,” he says.

Regardless of the market environment, on an ongoing basis, plan sponsors should have a good understanding of what the investments in their DC plan lineup might do in bull and bear markets, says Stempien. “If plan sponsors are only assessing this during periods of volatility, it is too late,” he says. “This should be an exercise plan sponsors are continually working through to understand the repercussions of plan investments. This often means working with an investment manager or adviser who does this evaluation.”

Stokes says she wouldn’t recommend changing DC plan investment lineups specifically for volatility purposes. However, she notes, as the new administration gets started, there are new fiscal policy and growth objectives. She says it’s a good time to look at how investment managers and their partners are thinking of their strategies in the new environment. Plan sponsors should be comfortable with how they are managing investments.

There are a variety of investments plan sponsors have access to, so Stempien suggests they think about different tiers within their DC plan investment menus. “Some investments are more protective during high volatility, while some are not,” he explains. “Plan sponsors can design a diversified menu for standalone options, with defensive strategies and market participation strategies to capture the market upside and limit the downside.”

Stempien adds that participants would need to be educated about how to use the investments and that deciding to add these types of investments when volatility is already high is too late.

Plan sponsors should have confidence that they have service providers they can partner with in times of volatility. “Lean on investment managers and lean on recordkeepers for support in sending the right messages to participants,” Stokes says.