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After an extremely trying 2020, many defined contribution (DC) plan sponsors and consultants are hopeful that 2021 will bring more opportunities than challenges. From an investment standpoint, here are three key areas that may be worth focusing on in the new year.
1. Take stock of equity exposures
Equity market performance is cyclical by nature, but what’s striking is how long-lived and pronounced recent cycles have been. Technology and other growth-oriented stocks have handily beaten their value-sector counterparts over the past decade. Similarly, large-cap stocks as a group have outperformed smaller-cap companies in recent years, while US equities have trounced overseas issues (Figure 1).
When might these performance patterns reverse? No one can say for sure of course, but if the market’s history is any guide, we believe they ultimately will at some point. For example, equity investors who claim value-style investing is “dead” should bear in mind that value stocks have typically led the way in decades that followed a 10-year period of growth-stock outperformance.
In the meantime, plan sponsors can take steps to help plan participants manage their equity exposures and be ready for an unpredictable future, whatever it might hold:
Target-date funds (TDFs)
- To help participants position for eventual shifts in market leadership, plan sponsors should ensure that TDFs have not become too overweight the outperforming areas of the market (e.g., US growth and large-cap equities).
- Plan sponsors should examine and evaluate their TDFs’ rebalancing policies to help keep participant allocations on track in the wake of recent market performance trends. (See “Helping DC plan participants keep their balance.”)
Core plan menus
- Plan sponsors should strive to give participants access to all areas of the equity market, including those that have underperformed lately.
- Provide ongoing investment education, particularly for participants who may have fallen into the potentially dangerous habit of “chasing winners.”
- To help participants maintain a healthy mix of growth and value stocks, consider utilizing managers that are more “core equity” in their approach.
- Alternatively, give thought to a multi-manager structure where the plan sponsor manages the allocations to growth/value, large/small, etc.
2. Fixate on fixed income
We believe fixed income should be a cornerstone allocation for most DC plan participants. However, today’s uncertain environment has pushed yields to all-time lows around the world. As a result, traditional money market funds and stable value products, while providing safety of principal, may not deliver enough return to even stay ahead of inflation, let alone pursue a comfortable retirement.
In addition, whereas plan participants often have multiple equity investment options from which to choose, fixed income options have tended to be fewer and not as well understood by participants. For instance, global fixed income is seldom available as a stand-alone choice within DC plans. So, given these issues, how should plan sponsors structure their fixed income offering(s) to best serve participants?
We see two practical approaches, which we can explore in more detail upon request:
Core bond or “core-plus” strategy
- A single-manager, core bond or core-plus strategy may work well if it is broadly diversified across fixed income sectors — high-quality bonds as well as more niche areas of the market, like high yield and emerging markets debt — and not overly dependent on any one sector for return generation.
Custom, multi-manager solution
- As DC plans have grown in size, plan sponsors have increasingly been open to adopting a more customized approach in the form of a multi-manager solution that supplies appropriate underlying diversification by combining best-in-class specialist managers. As shown in Figure 2, a few targeted fixed income building blocks may be all it takes.
A final word about those money market funds and stable value products: They can still play a role for many participants, but we believe it’s important to have one that prioritizes capital preservation via a steady net asset value (NAV).
3. Beware the silent thief: Inflation
The fiscal and monetary policy responses to the COVID-19 crisis by governments worldwide have been extraordinary, but are not without potential longer-term risks. For example, while global inflation has been largely muted for a number of years now (Figure 3), there is mounting concern that the massive stimulus measures put in place this year have ratcheted up the risk of rising inflation going forward.
How should DC plan sponsors react to renewed inflation risk, if at all? Again, participant education can go a long way. Participants shouldn’t underestimate the long-run threat that inflation might pose to their retirement goals and security. That’s because, over a period of many years, even modestly higher rates of inflation can slowly corrode the purchasing power of an investor’s retirement assets.
Beyond that, we suggest that sponsors check their plans’ TDF allocations for the presence of commonly used inflation-hedging assets, such as Treasury Inflation-Protected Securities (TIPS), real estate, gold and other commodities, and specific inflation-sensitive equities. These types of assets can help defend a portfolio against looming inflation that may be detrimental to many stocks and nominal-yield bonds.
We also believe a core menu choice that bundles together various inflation-hedging investments, like those listed above, can be an effective diversifying asset for plan participants who may manage their own retirement accounts from the core options.