Fixing the 40 in Defined Contribution Plans

By: Brett Minnick

The historical baseline for what an investor considers a diversified portfolio is often referred to as the 60/40: 60 percent of an investor’s assets invested in equities and 40 percent in fixed income. The 60 is generally global exposure, proxied by the MSCI ACWI Index, and the 40 by the Bloomberg Aggregate Bond Index. While this portfolio has generated satisfactory risk/return metrics in the past, there are a number of challenges that investors face moving forward.

Let’s consider those challenges and what actions investors can take to mitigate the deterioration of the risk/return profile that the 60/40 faces. In the equity portion of the 60/40, threats to risk-adjusted returns come in many shapes and sizes. Geopolitical risks create uncertainty among specific regions and key exports, none more apparent in this moment than eastern European oil. Stretched valuations lead investors to question whether or not stock prices have room to grow.

Equity factors are important, but it is our belief that considerations for change should focus on the fixed income portion of the portfolio. We have all felt the effects of inflation in recent months, and it seems the term ‘transitory’ was retired as quickly as it was created. Persistent inflation could lead to lower real returns (returns after the effects of inflation), which would hit the more conservative bond market much harder than equities. Another consideration for fixed income investors is the potential for rate increases. Rates increasing, coupled with higher-than-usual inflation, could not only diminish the value of the underlying bonds in a portfolio but could also reduce the purchasing power investors have once they redeem their bonds.

Knowing all of this, we want to use two hypothetical scenarios to demonstrate the options that investors might consider. The first, the risk-averse investor, is looking to maintain the amount of risk they are exposed to, even if it means sacrificing returns. The second, the return generator, is looking to maintain their expected return with the understanding that risk may increase. Both investors will have to take a different route but have options available to meet their objectives.

The Risk-Averse Investor

The risk-averse investor’s primary goal is to preserve capital, and therefore must be comfortable exchanging return for risk mitigation. In a defined contribution retirement plan, this will most likely be found in a stable value product. A stable value fund is a defensive fixed income portfolio at its core, while the underlying holdings are insured to protect the investor against negative fixed income conditions. Essentially, a stable value fund is designed to “smooth” the underlying short-term bond portfolio.

In a rising rate environment, a broad market core fixed income manager will typically struggle due to its increased exposure to interest rate risk. That risk, also known as duration, has ranged from 6.5 to 7 years for the Bloomberg Aggregate Bond Index in 2022. This means that a 1% increase in rates will result in a percentage decrease of 6.5 to 7 percent on the index as a whole. On the other hand, a stable value product has a much shorter duration. As of 12/31/21, large stable value provider Galliard had an effective duration of 2.74 years.

Not only does stable value have a shorter duration than core fixed income, but participants also benefit from the contract structure of the products. Stable value contracts, issued by banks and insurance companies, allow for these funds to value their underlying investment at “book value” as opposed to “market value.” This allows stable value providers to offer a crediting rate to investors that resets periodically, as opposed to participants being exposed to the ups and downs of the market. In short, a stable value fund may not outperform in bull bond markets, but it does provide an investor with protection in bear markets.

The Return Seeker

The return seeker’s primary goal is to retain their expected return, with the understanding that their risk may increase. Within a defined contribution plan, this comes in the form of short duration or opportunistic fixed income managers. These managers typically have the ability to allocate to areas of the fixed income market that others may not. This includes, but is not limited to, a wide variety of government bonds, agency and non-agency securitized debt, and issuances across the corporate structure.

As measured by Bloomberg, there have been seven instances of a rising rate environment since 1970. Of the seven, there have been five periods in which short duration products (measured by the Bloomberg 1-3 yr Govt/Credit Index) have outperformed the Bloomberg Aggregate Bond Index. The shorter a portfolio’s duration, the less likely it is to be negatively impacted by increasing interest rates.

Investment in these products does come with risk. Investors may be exchanging duration risk for credit risk. Credit risk is the probability of loss resulting from a borrower’s inability to repay or meet their contractual obligations. Only the participant, and potentially a trusted adviser, have the ability to determine whether or not the potential increase in return warrants the additional risk brought on.

Gone are the days where a 60/40 portfolio provides investors with adequate risk and returns. There are many potential actions that participants can take to reevaluate the 40. It starts with an evaluation of the goal of their portfolios and the determination whether they fall into the risk-averse category, the return-seeking category, or somewhere in the middle. The risk-averse investor may consider an allocation to stable value and the return seeker may consider an allocation to a short duration product.