Execs wary, but experts urge long-term outlook

Amid a rise in short-term inflation — the July consumer price index was 5.4% higher than the corresponding period last year — the defined contribution industry's response could best be described as inquisitive and wary but not apprehensive.

"The questions come up in the context of due diligence meetings with sponsors and consultants," said Steven McKay, the Boston-based head of DCIO at Putnam Investments, Boston. "There's plenty of conversation. They ask for our views on managing target-date funds or investment strategies."

Plan sponsors' attitudes — so far — are forged, in part, by uncertainty over whether the recent rise in inflation is transitory or a harbinger of something longer lasting. However, DC experts point out that the past 12 months aren't a replay of the mid-1970s, an equity bull market has served as an inflation proxy for many investors and target-date funds have baked in risk mitigation and inflation protection for many DC plan participants.

"With plans currently offering best-in-class target-date fund solutions, they have already addressed long-term inflation protection," said William Ryan, the Chicago-based partner and head of North America defined contribution multiasset solutions for Aon PLC."I am confident that as long as we continue to see 60% and growing of all new money going into investments like target-date funds we are helping set up participants for success."

He encouraged sponsors to plan ahead. "While inflation is currently top of mind, we should be evaluating a plan’s go-forward investments and advice solutions to ensure they are addressing both long-term inflation and the next cycle of unanticipated inflation,” Mr. Ryan said.

“There’s definitely a lot of interest” about inflation among sponsors, added James Martielli, the Malvern, Pa.-based head of investment solutions within Vanguard Group Inc.’s institutional investor group. “It’s at the top of the investment reviews. There’s a lot of talk and conversation, but we haven’t seen action” in adding funds to investment lineups.

DC consultants and strategists said the most likely participants to ask questions about inflation aren’t investors in target-date funds.

“When we work with participants in target-date funds, we’re not having that conversation,” said Edward McIlveen, principal and chief investment officer at Francis Investment Council LLC, Brookfield, Wis. Inflation is a topic with older investors, those who are five to 10 years from retirement and those who are more active, tactical investors.

These discussions focus on participants asking if they need to “tweak their portfolios,” he said. “There’s no sense of urgency as in a crisis.”

Target-date fund participants have “an implicit trust factor” that their portfolios are designed to combat inflation and reduce risk, added David O’Meara, the New York-based director of investments for Willis Towers Watson PLC.

He recommends that sponsors review the structure of the target-date funds that they offer. As for investment lineups outside of target-date funds, he advocates a “robust” core lineup that contains some inflation-protection options.

However, “let’s not be reactive to the current market environment,” said Mr. O’Meara, cautioning sponsors about providing too many options or investments that are too narrowly focused. Participants could be overwhelmed by choices or fail to understand how stand-alone options fit into their overall investment strategy, he said.

Citing Treasury inflation-protected securities or a real estate investment trust fund as examples, he said “some participants can incorporate them into their total portfolio,” but others may not understand the potential risks.

And when sponsors add a stand-alone option — whether it’s inflation-related or not — participants don’t act quickly. “When they receive information on a new fund, very few will go onto the portal in a week, or a month or a year,” he said.

Inertia, he added, is a common characteristic of DC plan participants.

So is insufficient financial literacy, said Christopher Ceder, a New York-based retirement strategist at Goldman Sachs Group Inc.

“How well do they understand how to use these options?” he said. “There’s a lack of awareness. And even if you are aware, do you know how to use them? It becomes more of an issue for sponsors to educate participants.”

As for his firm’s DC clients, “we haven’t got a ton of inquiries” from sponsors or advisers, Mr. Ceder said.

DC experts say planning for inflation protection requires a long-term outlook, adding that making quick shifts due to market events can be challenging to sponsors and providers, and hazardous to individual investors.

Take commodities for example. During the first quarter of 2021, the Bloomberg Commodity index had the second-highest return among 10 asset groups, according to a Vanguard report that used data from Vanguard, Bloomberg Barclays and Morningstar Inc. During the second quarter, the commodities index was the best performer.

However, between 2011 and 2020, the commodities index placed last for five years and second to last for three years. The annualized return was -5% for the 10 years ended June 30.

Addressing the potential impact of inflation is “a tricky conversation,” said Ross Bremen, a partner at Boston-based investment consulting firm NEPC LLC, citing the performance of commodities. “You don’t want sponsors making decisions based on short-term market movements.”

Among NEPC’s 142 DC clients, one-third offer a stand-alone TIPS fund and 15% offer a REIT fund. “We haven’t seen a lot of movement over time” regarding sponsors offering these funds, Mr. Bremen said.

If sponsors want to change their lineups to offer more fixed income, “TIPS is a choice,” said Mr. Bremen, adding the warning that “TIPS isn’t a magic bullet.” TIPS fund returns aren’t guaranteed and the performance can be volatile, he said.

“Equities do a pretty good job of addressing inflation” for the investment lineups of DC sponsors, Mr. Bremen added. “When they see equities’ performance over time correlated with inflation, they don’t change.”

Although sponsors have added stand-alone inflation-protection investments, participants’ response remains muted.

Last year, 34% of Vanguard DC clients offered a stand-alone TIPS fund, according to the company’s annual survey. Among this group, only 3% of participants invested. Thirty-two percent of clients offered a REIT fund. Among this group, only 6% of participants invested.

The Vanguard report noted that the growth of target-date funds has encouraged participants to invest in fewer options. Last year, 60% of participants in Vanguard record-kept DC plans invested in only one fund. Among that group, 91% were in a single target-date fund.

Another 10% of participants were invested in two funds. For any other category — from three funds and more — the percentages of participants investing was in single digits.

The role of inflation protection in target-date funds is highlighted by Callan LLC’s tracking of 74 off-the-shelf products in which 73% contained a TIPS component, 54% had a REIT allocation and 28% had a commodities allocation. This Callan Target Date index covers mutual fund-based and collective investment trust-based target-date series.

“Overall, the message is that target-date funds have some degree of inflation sensitivity built in,” said James Veneruso, Callan’s senior vice president and defined contribution consultant based in Summit, N.J. “We haven’t seen much communication on inflation fears.”

Separate Callan research also explores the if-they-build-it-they-won’t-come aspect of sponsors’ offering stand-alone products. The quarterly Callan DC index found that 12% of plans in 2009 offered a stand-alone TIPS fund or a stand-alone real assets fund (a combination of TIPS, REITs and commodities), rising to 35% this year.

In March 2021, the percentage of assets in these stand-alone options was 1.2%. Since 2012, the peak allocation was 1.9% of assets in June 2016 for these options. “Inflation has been so benign over this time period, so the low utilization is not surprising,” Mr. Vene​ruso said. The index usually contains results from 120 sponsors, most of which are clients.

Still, some sponsors believe participants should have a broad choice for inflation-sensitive investments beyond target-date funds. Francis Investment Council, for example, recommends that clients provide several stand-alone options for participants. “We say you need inflation-sensitive assets in a diversified portfolio,” Mr. McIlveen said.

More than 90% of clients have a TIPS fund, emerging markets fund and a commodities fund as stand-alone options. These three offerings have been consistent among clients for the past 15 years, he said.

These options are part of lineups that range from 10 to 18 choices (a target-date series counts as one choice) among clients whose average DC assets are about $100 million but range from $10 million to $1.5 billion.

Excluding target-date fund assets, commodities funds account for about 3% of average plan assets, emerging markets equity funds account for 7% to 8% of assets and TIPS funds represent 5% to 6% of assets, Mr. McIlveen said.

In addition to the inflation-protection measures, sponsors and providers must do more to help participants avoid outliving their assets, Aon’s Mr. Ryan said.

“Where we as a DC industry could be better is in the design of advice solutions focused on the spending phase that help participants navigate how to adjust their in-retirement spending patterns for a one- to three-year time horizon so that they don’t negatively impact long-term spending abilities,” he said. “We need to keep pressing to innovate DC plans to offer retirement income-focused solutions.”