What Do Participants Really Want from Their Bond Fund?

March 18, 2014 (PLANSPONSOR.com) - Why do retirement plan participants choose bond funds?

Some may understand how bonds can function in a diversified portfolio, while others may turn to them believing that bonds are somehow supposed to be “safer” for retirement. Whatever their reason, it’s almost certain most individuals don’t think about their core bond fund the way investment professionals do.

This disconnect is a point worth reinforcing—especially now, with a shifting fixed income landscape.  An investment professional measures a core bond fund by how closely it matches its benchmark, typically the Barclays US Aggregate Bond Index.  However, participants measure whether it has gained or lost value, or produced sufficient income.

We need to put the participants’ perspective—specifically, their goals in making a selection—at the heart of building defined contribution (DC) plan menus. If participants are looking to a plan’s core bond fund for safety, return, or retirement income, then we may need to rethink our fixed income options in order to help them meet their purpose.

What’s more, it makes sense for plan sponsors to re-examine the goal and nature of the fixed income option now before we see even more dramatic turns in the fixed income markets.

Shifting Ground: Looking Ahead for Fixed Income

The fixed income environment is changing in ways that might undermine what participants hope to achieve through their core bond fund investment.

For the past three decades, conditions have been nearly perfect for core bond funds benchmarked to the Barclays Aggregate Bond Index. Since 1980, rates have drifted steadily lower from their post-World War II high, driving bond prices higher and boosting core bond fund total returns. But in recent years, rates have been at historic lows. There is a growing consensus that, at some point, they will start moving in the other direction.

In May and June 2013, when interest rates rose and the Barclays Aggregate fell 3.5%, we saw powerful evidence of how interest rate movements can impact fund returns. The Index did rebound from the jolt, but the question has become not whether rates will rise, but how—steadily, quickly, or with sudden shifts back and forth. Different scenarios provide different challenges. Depending on their convictions about what's ahead, portfolio managers are looking down the road and considering where returns are to be found.

Done in a careful, intelligent way, a manager may be able to find returns in a rising rate environment by employing an approach that introduces greater flexibility regarding duration, credit quality, and sectors.

Yet switching to a strategy that adds some exposure to high yield, foreign or emerging market debt does not entirely solve the problem. Many such strategies are still benchmarked to the Barclays Agg, and much of their return is still explained by the Index.


Importantly, adding asset classes in an attempt to compensate for the declining return potential of the benchmark could miss the point. When it comes to DC plans specifically, the core bond fund story shouldn't necessarily be about returns—but risk as well.

Safety First: The Purpose-Driven Menu

Despite all of the recent change in the fixed income landscape, participants, especially those near or in retirement, still view their bond allocation as primarily a source of safety and income. Indeed, one survey found 65% of DC participants do not understand they can lose money in a bond fund. 

Thirty years of robust core bond fund returns may have skewed even intelligent investors' perceptions about the risk of fixed income investments. Participant expectations about bond funds create a potential fiduciary concern for plan sponsors in a rising interest rate environment. Simply put, participants do not understand the risk (and likely reduced returns) with fixed income, while plan sponsors and their investment managers are expected to know better.

Given participants’ expectations, managing risk should be first and foremost in plan sponsors' minds when responding to the changing fixed income environment. With the new risks that participants potentially face, the “same old core bond fund" approach simply will not deliver what participants want. 

To adapt to these changes, plan sponsors can employ a more flexible fixed income approach than in the past.  More specifically, they should reconsider whether their participants are best served by a fixed income fund benchmarked to the Barclays Agg, or by a fund with a specific risk-and-return mandate.

Decoupling from the Agg may allow for a wider opportunity set, comprising asset classes, credit qualities and geographies that sponsors may not have considered in the past.  Rigorous risk management, coupled with dynamic portfolio construction that adjusts the portfolio's risk exposures, can help improve return and, more importantly, mitigate risk.

There are far more moving parts involved than with a core bond fund that simply follows a benchmark.  Yet, a variety of approaches are available to plans of varying sizes to achieve access to blended strategies that diversify risks while improving return prospects.

Ultimately, the important thing to recognize is that change is happening. Simply standing still can't be an option.  Plan sponsors should act before rates start moving, and put a plan into place that can truly provide both the risk management as well as the potential returns that participants seek.


Chip Castille, Head, BlackRock US Retirement Group 


NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.