As U.S. interest rates begin to normalize and inflation picks up, defined contribution (DC) plan sponsors have an opportunity to refine their plan investment menus to improve retirement outcomes, according to PIMCO.
In a Viewpoint article, Richard Fulford, executive vice president and head of U.S. Retirement at PIMCO, suggests plan sponsors evaluate active approaches, including custom target-date strategies, core strategies augmented by income, real assets, hedged international equities and alternative capital preservation options.
“Of the six ideas proposed, only the first, going custom, requires a meaningful revamp of the plan, or more accurately, the target date option,” Fulford tells PLANSPONSOR. “The remaining asset class-specific enhancements can be easily implemented by adding a new strategy or by replacing an existing strategy, whether in the core lineup or within a custom target-date or white label structure. We believe that these practical enhancements have the potential to result in a meaningful improvement to risk-adjusted investment returns for plan participants over time.”
In the article, Fulford says unique plan demographics are often a key motivation for using custom target-date funds. 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.
Going custom is more accessible than ever, Fulford says, because recordkeeping, custody and trust capabilities have advanced significantly, and there are more experienced consultants able to walk clients through the process.
In this market environment, active strategies may help mitigate risks and uncover value in global fixed-income markets, Fulford also suggests. He cites Morningstar’s Intermediate-Term Bond Manager data, which shows that for annualized returns over the 10 years ending December 31, 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,” he writes.NEXT: Augmenting core bond strategies and adding inflation hedging
According to Fulford, the Fed's interest rate 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.
“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 potentially mitigate the impact of rising rates,” he says. Fulford notes 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.
In addition, Fulford contends there have been 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,” he writes. “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.”
Fulford suggests that if plan sponsors offer participants only one real asset option, they may 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.NEXT: Hedge international equities and review capital-preservation investment options
Fulford says equities remain a cornerstone of DC portfolios and, in PIMCO’s view, are essential for delivering returns participants need to achieve their retirement objectives. But, 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.
PIMCO sees the potential for further U.S. dollar appreciation, albeit at a slower pace than the past 18 months. Fulford notes that few DC plans hedge currency exposure within their international equity allocations, but suggests they 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.
SEC reforms of money market fund (MMF) rules take effect this October. Fulford points out that this means plan fiduciaries have less than one year to prepare for sweeping changes which, when combined with evolving technical and macroeconomic factors, may make MMFs an unattractive capital preservation option for plan participants.
According to the Viewpoint article, 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. But Fulford says this will likely increase demand for government paper amid limited supply, keeping G-MMFs’ nominal yields low and real yields negative.
There are several attractive capital-preservation-focused alternatives that PIMCO recommends for evaluation, including stable value, short-duration fixed income and white label (or custom) bond vehicles that combine these and other strategies.
“We recommend that plan sponsors consider these investment ‘ideas’ in the context of their overall plan objectives and constrains and under the advice of their investment consultant or adviser,” Fulford tells PLANSPONSOR.The Viewpoint article can be viewed here.
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