One of these days, the Federal Reserve will start tapering its bond-buying, reducing the flow of easy money. And one of these days, interest rates will advance and inflation will rise.
Defined contribution plan executives, however, aren't necessarily waiting for one of these days. Researchers and DC consultants say executives at many plans have discussed changes — and some have adjusted investment options — in anticipation of higher interest rates and inflation.
Among choices being reviewed or implemented:
- investing in shorter-duration bonds;
- adding international/global bonds;
- reconsidering passively managed domestic bond funds;
- increasing offerings of Treasury inflation-protection securities and multiasset funds that include tips; and
- looking at unconstrained bond strategies.
“We're facing a challenging environment for fixed income,” said Christopher Lyon, a partner at Rocaton Investment Advisors LLC, Norwalk, Conn. “For the conservative investor, there's no place to hide.”
DC plans aren't lurching to the changing headlines of Wall Street speculation about when the Fed will start tapering. Or to the Securities and Exchange Commission's proposed changes in the structure of money market funds. Or to the spike in interest rates this spring.
“Change happens very slowly in the defined contribution space,” said Sue Walton, a director of Towers Watson Investment Services Inc., based in Chicago.
And just because DC plans diversify fixed-income investment options, that doesn't mean participants will use the options, said Winfield Evens, a partner at Aon Hewitt, Lincolnshire, Ill.
Mr. Evens pointed to research by Aon Hewitt that tracks participant transfers in 401(k) plans for which Aon Hewitt is the record keeper. At the end of 2008, as the economy and stock markets were diving, Aon Hewitt found 19.6% of participants made one or more transfers. That rate has declined steadily each year through 2012 — the latest data available — to 14.5%.
Still, DC plans have increased their offerings of so-called specialty bond funds. In 2009, other Aon Hewitt research shows, 22% of plans offered specialty bond funds — such as global bond, high-yield bond and Treasury inflation-protected securities. The percentage grew to 29% in 2011 and to 39% so far this year. “We're seeing more interest by sponsors in diversifying asset classes to take advantage of inflation expectations,” said Mr. Evens. This research is based on data from approximately 400 DC plans, most of which aren't Aon Hewitt clients.
However, participants' allocations to these funds have grown modestly to 4% so far this year, from 2% in 2009 and 3% in 2011.
Callan Associates Inc. also has detected an increase in DC plans offering fixed-income funds designed to diversify bond portfolios, according to its quarterly survey of approximately 80 plans that it calls the Callan DC index.
“Sponsors are clearly concerned about inflation, but we're not seeing the same sensitivity by participants,” said Lori Lucas, the Chicago-based executive vice president and defined contribution practice leader.
For example, Callan found one-third of plans offered real return/TIPS portfolios as of June 30, up from 5.7% on March 31, 2006, when Callan first published the survey results. Yet those portfolios accounted for only 0.44% of participants' allocations as of June 30.
Ms. Lucas said Callan clients are more likely to offer TIPS funds than a real-return fund or multiasset fund to deal with inflation expectations. However, TIPS funds have become more expensive, she said.
Other client strategies, she said, include seeking bond funds with reduced durations and offering a so-called core-plus fund, which adds some international debt, high-yield bonds, corporate debt and emerging market debt to core bond holdings.
“The fixed-income fund is an anchor in defined contribution plans,” she said. “Core-plus provides some latitude.”
Donald Stone, managing partner and CIO at Plan Sponsor Advisors, Chicago, said clients “have an appetite for shorter duration for intermediate bond funds.” This strategy could move the duration to the 2.8- to 3.2-year range from 3.8- to 4-year range.
“Some sponsors are concerned about passive bond funds,” he said. “If rates go up, they say they could really get hammered.”
Mendel Melzer, chief investment officer at The Newport Group, Heathrow, Fla., said his firm's defined contribution plan clients are looking at diversifying their portfolios with global bonds and unconstrained bonds, which aren't tied to a benchmark and would allow managers to short bonds.
His firm recommends that a diversified fixed-income portfolio designed to cope with a rising interest-rate environment should include a 30% to 35% mixture of global, unconstrained and emerging markets bonds, as well as floating-rate debt. TIPS should have been part of the portfolio already, he said.
Some clients of investment consultant Arnerich Massena Inc., Portland, Ore., are adding TIPS funds, emphasizing shorter durations, said Vincent Galindo, an adviser. Others are using diversified multiasset funds — combining TIPS, commodities, real estate investment trusts and floating rate debt.
Recently, a “handful” of clients have added or are thinking about adding money market funds, anticipating interest rates will rise soon, he added.
“Anecdotally, we're hearing from sponsors about whether they should add a money market fund,” said Mr. Lyon of Rocaton Investment Advisors. “Some of this is due to participant confusion about stable value funds.”
Some clients are looking at diversification through opportunistic bond funds that could include such investments as emerging markets debt and unconstrained bonds in the U.S. “They have significantly more latitude and much less benchmark focus than the typical core or core-plus bond fund,” he said.
Despite DC plans' attempts to adjust their investment menus, research by Vanguard Group Inc., Malvern, Pa., confirms participants don't change their 401(k) allocations very much or very fast.
At year-end 2012, participants in 401(k) plans for which Vanguard is record keeper allocated 7% to bond funds — the same as of Aug. 31, 2013, said Jean Young, senior research analyst for the Vanguard Center for Retirement Research. The combined allocations to money market and stable value slipped to 10% from 11%.
“One of the things about 401(k) investing is that when participants make a decision, inertia is a huge friend and a huge foe,” Ms. Young said. “Very few participants trade even during extreme circumstances.”
This article originally appeared in the September 30, 2013 print issue as, "Plan options tweaked as execs prep for rising interest rates and inflation".