The market volatility of 2011 and expectations of continued turbulence in years to come has left many defined contribution (DC) plan sponsors and investment managers rethinking the best way to help employees meet their retirement goals. New product types now emerging in DC plans may lead the way for more secure retirement income for employees.
During the first half of 2011, the markets were looking sanguine, as was the prospect for growth around the world; equities were up and interest rates were stable. But with the arrival of summer and the second half of the year, things took a turn for the worse. In August, Standard & Poor's downgraded its rating of U.S. long-term sovereign debt from AAA+ to AA+. Next came a budget impasse in Congress over the raising of the U.S. debt ceiling, followed by the still brewing sovereign debt crisis in Europe.
The events conspired to erase much of the gains made in the first half of the year. "The past year was a volatile one in the financial markets, causing much fear and confusion about how to best protect and grow retirement assets," said Paul Zemsky, CFA, Chief Investment Officer, Multi-Asset Strategies, ING Investment Management U.S. "Investors in DC plans were tested in terms of their staying power and their ability to deal with the volatility."
The push by plan sponsors over the last few years to initiate auto enrollment and auto escalation plans has taken some pressure off participants designing retirement plans for themselves. Asset managers are also easing the pressure by designing new products to provide better long-term income solutions that offer guarantees against outside market risk.
The move in the industry toward increased participation in target-date funds was triggered when the Department of Labor implemented the Pension Protection Act in 2006. The Act gave fiduciary protection to companies that agreed to offer auto enrollment and auto escalation plans alongside an appropriate Qualified Default Investment Alternative (QDIA) selected by the fiduciary of the plan.
While all balanced funds including target-risk funds meet the QDIA standard, target-date funds have been elevated as a preferred qualified investment for such plans. This 2006 change also prompted an untimely shift away from stable value options, exposing many investors to the volatility and losses associated with the financial market meltdown in 2008.
Managing market volatility throughout an employee's investment horizon calls for diversifying assets.
For that reason, more asset managers are looking to invest a percentage of client portfolios in non-traditional investments for DC plans. Options include Treasury Inflation- Protected Securities (TIPS), commodities, real estate investment trusts (REITS), and gold. Emerging market securities can also help investors gain the diversification they need. "You have to look at how much risk a person can take and then you need to manage within that risk limit, by selecting assets that maximize diversification," said Stacy Schaus, Executive Vice President and DC Practice Leader at PIMCO. That way, employees get as much return as possible, given their risk budget.
Inflation hedging is another consideration when building a portfolio. "An important factor participants must remember when designing a plan for retirement is that they are not just building dollars, they are building inflation-adjusted purchasing power," explained Schaus. "They are accumulating money to buy the products and services they need, so inflation responsiveness is critical." Many DC plans are missing this component, Schaus noted. "Many target-date funds that we have seen in the market have little inflation hedging. Target-date strategies need to include assets that help participants both build and preserve purchasing power – with that goal in mind, real assets are critical," she said.
Defined contribution plan sponsors and investment strategists will no doubt continue to face stark challenges as they strive for higher returns for plan participants. They are going to have to navigate more volatility in the markets and uncertain economic conditions around the world.
But things are looking up. Investors are finally starting to enjoy some decent returns and rewards for the risks they have taken. "We think investors will be well rewarded in the U.S. equity markets, primarily from large cap dividend paying stocks and from stocks of companies that have less economic sensitivity," said Steve Medina, Co-head of Global Asset Allocation, Senior Managing Director and Senior Portfolio Manager, Portfolio Solutions Group at John Hancock Asset Management.
Asset managers are likely to look more toward global growth opportunities, including the economies of Brazil and China. Growth in these huge consumer markets could offer returns in the double digits. "If we know that in the U.S. the opportunities are not as promising as some of those abroad, then we will look to see how we can make sure that participants' portfolios are best managed to both help hedge the risk, but at same time deliver the right amount of returns," said Stacy Schaus, Executive Vice President and DC Practice Leader, PIMCO. Medina added that these markets pose higher levels of volatility, so exposures should be managed carefully, preferably inside a fully diversified, professionally managed target-date or target-risk fund.
The main focus of a defined contribution plan is to help participants save and grow the assets they need to reach their retirement goals. But after that goal is reached, there is still the long road ahead, called the retirement years. Plan participants need to think about those years well in advance and plan accordingly. "The volatility in the markets in 2008 caused lots of plan participants to become extremely concerned about what could happen to their nest egg in the last five to ten year before retirement," said Bob Boyda, Co-head of Global Asset Allocation, Senior Managing Director & Senior Portfolio Manager, Portfolio Solutions Group at John Hancock Asset Management. In response, many asset managers, over the last four to five years have been presenting plan sponsors with a through-retirement plan concept, designed to maximize wealth accumulation.
As plan participants are getting ready to cash out of their retirement portfolios, they often move to an all bond and all cash asset allocation, prior to their retirement date. But once they do retire, they are very often left to take on the longevity planning for their assets on their own. They have to make investment and savings decisions outside of their 401K plans.
Exposure to alternative investments in a defined contribution retirement portfolios can be beneficial for both hedging against risk and increasing returns for participants in a down market. But figuring out how much exposure the portfolio can take and what types of alternative investments to choose is more complicated. "It’s not just important to have exposure to alternatives in a retirement portfolio, but you have to think about how you weight them," said David Gluch, Head of US Product Management at Invesco.
When using a traditional asset allocation method, portfolios are weighted by expected return. "The average investor needs about an 8% return, and equities tend to provide that return, giving investors a long-term liability stream, said Gluch. "Most portfolios are weighted with a biased to equities, which is great when equities are in favor, but when equities are not in favor there is a negative consequence," he said.
Glutch remarked that at Invesco "instead of weighting a portfolio based on expected return, we often weight it on risk contribution, so that we equally weight risk contribution across all the major asset classes." He added that "by doing so, we can make sure a portfolio is not based on one asset class, which is riskier." A typical portfolio often holds a combination of equities, fixed income and commodity-based products. Gold is one type of commodity, which most investors are typically underexposed to, but there has been growing interest in it of late.
