Plan Sponsor Investment Considerations for Second Half of 2019

Defined benefit (DB) and defined contribution (DC) plan sponsors are expected to have to navigate a more volatile market environment in the second half of the year.

The first half of the year was excellent for investor returns, with the S&P 500 up 18.5%, developed country equities up 15%, and emerging markets up 11%, says David Kelly, chief global strategist for J.P. Morgan Asset Management in New York City. “This was well above the expectations we had coming into the year, especially after the severe market correction in the 4th quarter of 2018,” he adds.

Ed Farrington, executive vice president of retirement strategies at Natixis Investment Managers in Boston, speaking from the perspective of a retirement plan investor, says any time there are double-digit returns, it is a positive. If exposed to equities, retirement plan participants are really pleased because their balances have gone up.

However, the outlook for the second half of the year is not as good. Kelly says, “Looking forward, we are modest in our expectations.” He explains that stocks are starting from an expensive price to earnings (PE) ratio—stock prices are at about 17 times expected earnings. And, bonds aren’t cheap either, and the 10-year Treasury bond only pays 2% below inflation. “Because of that, plan sponsors and participants need to dampen down expectations of returns going forward,” he says.

A fear of both economists and investors is that the country is headed into another recession. Allianz Life’s Quarterly Market Perceptions Study found 48% of Americans fear a major recession, and 47% fear a major market crash. Only 31% of Americans say they are comfortable with market conditions and are ready to invest. In addition, nearly three-quarters (72%) say it’s important to protect retirement savings.

During a video conference, Liz Ann Sonders, chief investment strategist, Charles Schwab & Co., Inc., said, “With 100% certainty, we will get a recession. Trade is the most important needle mover to timing.” She said if the U.S. is on that path, the peak will be in the first quarter of 2020. She said the trade war will offset business confidence gained by corporate tax cuts, and absent a comprehensive trade deal, businesses will not be reignited. She also cited an inverted yield curve as a sign of an impending recession.

However, other economists are not as certain about a recession. Farrington says the trade war tariffs and the slowing of global economic growth are increasing fears that a recession could happen, but Natixis’ chief strategist says there’s a 30% chance.

In an Investment Strategy Overview, Christopher Hyzy, chief investment officer at Merrill, a Bank of America company, says market watchers believe the U.S. is the late stages of the business cycle with a rising probability of a recession. However, he says “We believe there have been a series of ‘mini waves,’ and we are in the early to mid-stages of the fourth mini wave since the Great Recession. Our view is largely based on current economic conditions, many of which are not typical of a cycle’s late stages historically.”

While Farrington says Natixis believes there will be positive returns in the next six months, still, there are “storm clouds on the horizon that may cause some trepidation.” Robert C. Doll, chief equity strategist and senior portfolio manager at Nuveen, in “Bob Doll’s 10 Predictions for 2019: 2Q update,” says, “We are in unbelievable cross currents with investors trying to figure things out.”

During the Schwab video conference, Brett Wander, CFA, chief investment officer of fixed income, Charles Schwab Investment Management, Inc., said the Federal Reserve will meet at the end of July, and the last thing it wants to do is have market pricing one thing and do something else. “In 80 out of 80 meetings, the Fed has done what the market is doing, so a rate cut is possible,” he said, adding that he expects three by the end of the year. For this reason, Wander said using fixed income to offset risk in equities may not be what investors want to do.

But, Kathy Jones, chief fixed income strategist, Schwab Center for Financial Research, said if the stock market goes into a correction, Treasuries are investors’ best bet. They should have some duration but also be high quality.

Farrington says retirement plan sponsors and advisers know there’s always a bump in road. “Sometimes it’s not something we hear in the news every day that causes volatility, it’s something not on the radar screen,” he says.

Hyzy offers some examples in his Investment Strategy Overview. A potential drop in business confidence could lead to lower job growth and, ultimately, lower consumer confidence and spending. If consumer spending pulls back, then the need for liquidity may rise. He adds that at that point any areas with very high exposure to illiquid assets or an excessive need for financing could have liquidity issues.

Another item of risk not widely discussed Hyzy offers is the “weight” of deflation. “Deflationary risks, in many cases, are more difficult to turn around than inflationary risks. This is where companies have less pricing power, which could lead to anemic financial institutions around the world, a drop in lending velocity, a sharp rise in savings, productive capital exiting the broader economy, and the potential for a negative feedback loop—a self-reinforcing system—so to speak, with these factors potentially driving a further reduction in inflation,” he says.

Actions for DB and DC plan sponsors

Kelly says defined benefit (DB) plan sponsors are constrained by their own investment policy to match liabilities. The problem is when interest rates fall, liabilities are expensive, and the presumption of lower interest rates makes the problem more serious. “The major thing DB plans can do is increase exposure to international equities. They are cheaper than U.S. stocks—selling at about 79% of the PE ratio—and they will give better returns because of that. Beyond that, DB plans have to be realistic about returns being low going forward—U.S. stocks around 3% and U.S. bonds around 2%. If that doesn’t give DB plan sponsors a chance of matching liabilities, they have to think about putting more money into the fund,” he says.

Every DB plan is unique, Farrington says. The funded status of the plan will often determine the investment mix that’s appropriate. “The ideal scenario is the plan is fully funded and can look at a more conservative investment approach to maintain that. However, globally, there are many markets where the bond yield is negative. The extremely low-rate environment [which increases plan liabilities] forces DB investors to look at investments that are not bonds,” he says.

Doll suggests portfolios include companies that benefit from the economic cycle and show they are reinvesting in their business. He also suggests looking into companies with extras to offer, such as a new product with the ability to raise prices. In contrast to Kelly, he suggests investing in companies with most of their business in the U.S., and to be underweight in international companies.

For defined contribution (DC) plan sponsors, communications is the place to focus. “The message should never be to time the market for DC participants,” Kelly says. “Constantly switching investments hurts people.”

However, Kelly does suggest that plan sponsors should point out to participants that if they have a lot of money in stable value and cash, they are paying more now. And, since the Fed is expected to cut interest rates, participants shouldn’t regard cash as a long-term investment.

“What’s critical is we live in a world of short termism and new cycles defined in 12 or 24 hour chunks of time” Farrington says. “But a retirement plan is for the long-term, so participants need to be reminded that their time horizon is defined in decades,”

He also suggests that plan sponsors remind participants that the choices are very artfully put into the plan’s investment menu—so much goes into making the choices. Participants should be told the investments were chosen for their best interest and they should let short-term results derail their strategies.

“History is a great friend when it comes to communicating to plan participants,” Farrington adds. “I often remind myself that my job keeps me focused on the stock markets, but most people are focused on their own jobs. He says it is important to communicate historical lessons to DC plan participants. A great one comes from the 2008-09 financial crisis. “Some DC plan balances went down 35% to 40%, and participants may have panicked and moved to safer strategies when, in fact, the next year markets went up significantly,” he says. “Especially equities will experience ups and downs, but history tells us the return trade-off is favorable. Historical lessons help people stay patient.”

One final note Farrington makes is that where both performance and demand are starting to find common ground is in environmental, social and governance (ESG) investments. “We’ve seen a growing demand from plan participants for more ESG, and at the very same time, there is an emerging body of evidence that companies with strong ESG profiles are stronger and more stable,” he says. “When [DB and DC] plan sponsors think about the volatility expected in the second half of the year, ESG is a consideration due to its strong investment profile in uncertain markets. Participants may be on to something.”