Plan Sponsors Must Prioritize Market Risks

November 12, 2012 ( Reinvestment rate risk is one of the greatest risks for long-term investors in the current market.

Reinvestment rate risk is the risk of investing at low rates of return, thereby failing to achieve total returns over the investment timeframe. Many times, investors do not feel the impact of this risk until the damage is done and their investment goals are out of reach, according to asset management firm Manning & Napier.

In the current market environment, reinvestment rate risk is more widespread and exists in both stocks and bonds. Manning & Napier said they favor stocks over bonds given current yields and the greater likelihood that interest rates should increase. Especially when nearing retirement, a bond-heavy portfolio is risky, Mary Moglia-Cannon, senior analyst in Manning & Napier’s investment review group, told PLANSPONSOR

Sources at Manning & Napier said they realize investors have low tolerance for volatility because of the financial crisis, causing them to shift into traditionally defensive securities like government bonds and defensive equity market sectors. However, investors should keep in mind that seeking protection from volatility through traditionally safe investments can cause them to lose sight of their originally intended long-term financial goal, and now they are much less likely to reach it. Seeking safety from volatility through these defensive sectors and asset classes could expose investors to capital risk, given higher-than-average valuations for certain bonds and defensive equity market sectors, such as utilities and some dividend-paying stocks.

“Volatility alone is not a risk,” Moglia-Cannon said, adding that it is different from capital risk. Volatility is represented by both up and down movements in stock prices and is normal for long-term investors in the stock market. Capital risk, on the other hand, is the risk of permanent price declines and is a downward correction in prices.

Manning & Napier sources said they do not believe capital risk is a concern for the broad stock market in the current market because valuations remain attractive and sentiment indicators remain weak and low. Given these conditions, the company does not believe all stocks are positioned to move materially lower and remain there indefinitely.

Plan sponsors and advisers must prioritize which risks are most important to navigate—whether it is reinvestment, capital or inflation risk, Moglia-Cannon said. They should consider whether the plan managers are dealing with the risks that need to be addressed in order to help participants meet their retirement goals.

Attractively priced longer-duration equity investments—especially those with secular tailwinds—can help mitigate risk, Moglia-Cannon said, and diversification alone is insufficient in managing risk. She suggests active managers who understand how to tackle varied risks in the current market.