Ever since the Federal Open Market Committee dropped the federal funds rate range to zero to 0.25% in 2008, investors have been waiting for rates to go up. Following the latest committee meeting Sept. 17, investors are still waiting.
Some people have watched rates so intently they have neglected other potential headwinds for the fixed-income market, including supply, volatility, credit quality, political and regulatory changes, and much more. Considering the multiple roles that fixed income plays in defined contribution plans, does it make sense to fixate on one source of uncertainty?
The obvious answer is no. What's less obvious is how defined contribution plan sponsors should respond to a fixed-income environment that is more complicated than anything we have seen in decades. Unfortunately, 30 years of strong bond fund returns have become encoded into the structure of defined contribution plans, leaving us with fixed-income menu options that rarely stray beyond the Barclays Aggregate index. If the world has changed — and I believe it has — defined contribution fixed-income menus may need to change as well. The question is how.
While declining interest rates were driving strong bond fund returns, another trend was shaping today's defined contribution plan menus — the trend toward streamlined menus. These trends reinforced each other. With limited shelf space and strong fixed-income returns providing the safety, diversification and return that participants had come to expect from their bond funds, few plan sponsors saw any reason to expand their fixed-income selection. They were free to focus elsewhere, particularly on their second- and third-tier equity fund choices.
If rates do rise, or any of the other headwinds we mentioned challenge returns, today's bond fund choices might fall short of participant expectations — a particular concern for participants in or near retirement relying on consistent bond fund returns as the foundation for retirement income. As we see it, plan sponsors have three potential choices:
nKeep the status quo, double up on education. A plan sponsor might be able to justify making no change to its bond fund menu by doubling up on participant communications efforts to ensure participants understand the fixed-income choices that seemed safe in the past might not be safe in the future. The problem is that while some participants will get that message, many may not. And many who do get the message might wonder what to do as an alternative.
nExpand fixed-income menu. On the face of it, it might make sense to offer a broader menu of fixed-income funds. Funds can be introduced to address a wider range of credit quality, geographic regions, strategies and so on. For participants with the knowledge to make intelligent selections, this might be a welcome development. But most participants may lack the in-depth investment knowledge needed to choose wisely. For many, adding choice may add confusion.
nReinvent the bond fund with a multimanager structure. The third choice is to not simply prepare for immediate headwinds, but for the long haul and the new, highly uncertain reality. This can be done through a multimanager structure that incorporates a mixture of fixed-income strategies and allows plan sponsors to allocate among them as circumstances dictate. The overall investment objective of the fixed-income strategies could be to provide appropriate risk adjusted returns, rather than simply tracking the Barclays Aggregate index.
Creating a multimanager fund structure has the potential to meet two critical needs: Positioning the fund for returns in multiple markets, while also maintaining the clarity that participants want. Here's how it could achieve both of these goals.
In a multimanager solution, the plan's custodian typically holds multiple investment strategies, often managed by different investment managers. Managers can be selected based on complementary strengths and diversified for expected sources of risk and return, or pegged to various bond indexes, such as the Barclays Aggregate as well as other global benchmarks. The plan can adjust the mix of managers in times of market stress with an overall goal of seeking returns in a risk-controlled way. Depending on how the structure is implemented, the operational complexity of making changes — even including the hiring and firing of managers — can be reduced and the participant reporting requirements on specific changes can be minor.
Plan sponsors can white-label such a structure on the investment menu and give it a generic name. When we step back and ask what participants want from a bond fund, the likely answer is some combination of safety, return and diversification. They also want simplicity — a single choice. A white-labeled bond fund provides a single choice that is potentially appropriate for a range of fixed-income environments. That can help plan sponsors keep investment menus streamlined.
Combining approaches within white-labeled funds is not simply a response to a short-term headwind. It is a way of structuring fixed-income exposure for the long term, so that it can continue to align with participant expectations in selecting the fund. Interest-rate moves, credit concerns, regional headwinds and more can be addressed within the fund.
A white-labeled multimanager fund acknowledges that both defined contribution and the fixed-income market have evolved, and that a new structure may need to replace the old. It's about shaping the next generation of fixed-income options across the defined contribution landscape.
Plan sponsors hoping to address their fixed-income menu shouldn't wait for the Fed to make a move on interest rates. As recent history shows, action could be a long time coming.
Anne Ackerley is managing director and head of BlackRock Inc.'s U.S. and Canada defined contribution group, New York.
