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November 2020

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Plan Talk: Assessing Fixed Income Options in Retirement Plan Lineups

In the latest episode of Plan Talk, Retirement Director Ben Rizzuto and Fixed Income Product Specialist Jessica Leoncini discuss current plan menu designs and investment trends in defined contribution (DC) plans. Referencing the findings from a survey Janus Henderson recently conducted with the Plan Sponsor Council of America, they explain how the lack of adequate fixed income options in many DC plans could affect participants’ ability to retire comfortably – particularly with global interest rates at historic lows.

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Ben Rizzuto: Welcome to Plan Talk from Janus Henderson Investors. I’m Ben Rizzuto. Today we’re going to talk about some recent research specific to investments within retirement plans and how the current and future markets may affect the participants who use those investments. Now to do this, I am again joined by my colleague, Jessica Leoncini, who is the head of North America and Fixed Income Product Specialist here at Janus Henderson. And not only is Jessica an avid runner and reader, but she is the person here at Janus Henderson that I go to whenever I have a question about fixed income. So Jessica, thanks for joining me today.

Jessica Leoncini: Thanks for having me, Ben. Thanks for the great intro.

Rizzuto: So to get us started, recently we at Janus Henderson worked with the Plan Sponsor Council of America to conduct a survey of plan sponsors and plan advisors regarding current plan menu designs and investment trends with a specific focus on fixed income. There were several things that came from this survey but the main idea we found was that equity funds outweigh fixed income funds three to one in plan core menus. Now, we at Janus Henderson have had this hypothesis for some time. But honestly, it was nice to see that this was actually happening in real life, that being the plan sponsors seemed to be starting their plan menus with equity using several style boxes, then they move to international equity, then they round things out with just a few fixed income funds.

Now for those of you who work with retirement plans, you may be used to seeing quarter lineups that look like this, but I think anytime we see a ratio like this, it should at least make us take a step back and ask some questions. Is that the ratio that we should have? Is there something else that we should be doing, and are the options we’re providing the participants adequate? Now from that research, we found that across all the plans in the survey, there were on average 3.7 fixed income funds that were offered to plan participants. Most often, they were a stable value fund, a bond index fund, a money market fund and possibly an intermediate core bond fund. So Jessica, you’re the fixed income expert. Looking at all these options, I first want to kind of talk about how the current market conditions might affect these funds. So could you first kind of review with us where things stand for the U.S. economy when it comes to interest rates and inflation?

Leoncini: Absolutely, and I think that’s an important place to get started. So thinking about how the Federal Reserve cut rates, cut interest rates to zero earlier this year, and Chairman [Jerome] Powell has stated that he is not even thinking about raising rates, as well as the fact that many global central banks have rates at zero as well, this policy is really designed to help stimulate the economy given all of the volatility and everything we saw post March. It’s designed to allow consumers and corporations easier access to capital and financing. But what it also does is it reduces the rates that you’re earning on savings and in fixed income investments. In fact, if you look across the developed world, many countries are not just at zero, but are actually offering negative rates on two-year bonds, on five-year bonds, even out to 10-year bonds.

The other thing I think is important to consider right now is inflation. This is not something that investors have really thought about or had front and center for quite some time, but the Federal Reserve in addition to cutting rates has also shifted their policy and now they’re targeting an average 2% inflation rate. Now, there are many factors that will play into whether we do see inflation pick up or not, but this is still a very important shift because it means that it’s possible for inflation to run higher than 2% for a period of time before the Fed would take action. And I think this is something really important to consider, particularly within retirement plans, considering that impact of inflation. So your two dynamics that you’re dealing with in today’s economy are very low rates and the potential for inflation rates to run higher with a little bit of a shift in Fed policy.

Rizzuto: Yes, in thinking about that, I saw something just this morning that said, I think, the 10-year Treasury here in the United States is around 77 basis points. Correct me if I’m wrong, but if you think about it, that won’t even cover inflation for anyone out there. So you know, given that and given what you just talked about Jess, if we think about those four types of funds that are generally in a retirement plan, how is this environment going to affect them going forward?

Leoncini: You know, thinking about a money market fund, a bond index and intermediate core, a stable value, the one key implication across all of these is low rates. Money markets in particular tend to be one of your safest options within a retirement plan. But if you think back to post 2008 in another time period when the Fed cut rates to zero to help stimulate the economy, looking at the effect that had on money markets, from 2010 until 2015, your median money market fund returned between zero and four basis points a year. So that’s 0% to 0.04%. Very, very low, certainly not helping with savings rate, with keeping up with inflation.

A bond index fund will be subject to similar dynamics, certainly not as extreme as a money market fund, but consider right now, your main index for the broad bond market is the Bloomberg Barclays U.S. Aggregate Bond Index. The yield on the Aggregate Bond Index right now is just over 1% — it’s its lowest, near its lowest in history. And the index is heavily weighted toward government securities, which as we said are very low yielding right now. So these funds are still very, very important components within a plan lineup. Traditionally, these are some of the best diversifiers [with] equity. They were certainly some of the only bright spots back in March and they really deliver on what a lot of participants and a lot of investors expect from fixed income. But given how low yields are today, these options may not be enough within a plan lineup.

Rizzuto: So if those were the things that we used to diversify our portfolios with, it seems like we need to think about other things. Now, would this environment affect other types of fixed income products the same way? You know, I think the high yield is around 5-1/2% these days. How does this environment affect different types of funds?

Leoncini: Yes, at its most basic level you have two key risks within fixed income: You have interest rate risk and you have credit risk. Certainly, there are many other variations, but to keep it simple, those are your two key risks. All of the options we’ve talked about until now are heavily skewed toward rate risk. Looking at a category like high yield, high yield is predominantly credit risk and it will have a higher correlation to equities. So high yield can really help diversify a fixed income portfolio. It will act differently than a money market or a bond index. But if a plan participant doesn’t understand the underlying risks, he or she may be in for a negative surprise in a time period like March when equities sell off and they were expecting their bonds to perform well.

This is a really important factor to consider because if you look at past data, investors consistently underperform average fund returns. And what we found is this is exacerbated in difficult markets and it’s even more exacerbated in riskier asset classes. So for example, we looked at 2018 and the average investor underperformed the core bond category by 70 basis points, but they underperformed the high yield category by 1.5% And consider [that] this is just one category, just one year. Imagine compounding that across a variety of asset classes and across years. So it’s critical to make sure that there are, you know, there’s consideration of the risk factors in some of these asset classes. There may be a better way to include some of these higher yielding options and have a more expansive view of the bond market. Thinking about diversified options such as a multi-sector bond fund or a world bond fund, you know, these types of strategies may offer higher yields than the lower yields that we were talking about earlier. And as a result, they may have the potential for higher returns. And these more diversified options could be a way to include higher yielding assets but with less volatility than a dedicated high yield fund. These types of funds may act as a good complement to some of those more traditional fixed income funds we talked about earlier, and they may be a good way to help participants stay on track with a fund that’s more in line with their expectations than some of the volatility you may experience in a standalone high yield fund.

To give you a quick anecdote, thinking about the world bond option that I mentioned, you know, a very astute advisor that I spoke with recently, we were talking about the fact that most plans include an international equity option. They’re very prevalent, but only 7% include a world bond option. And the advisor asked me why this is, and my thought is that because it’s more complex, and it takes more due diligence. It’s harder to try to evaluate some of these types of strategies. And I think the other important factor is we’ve seen a meaningful shift in fixed income post 2008. So thinking all the way back to 2008, you were earning a 4% yield on the Aggregate Bond Index, which again, is yielding 1% today and you had a duration less than four years.

Today, that 1% yield, you’re taking on six years of duration so your risk-reward profile has changed dramatically since 2008. So while I think that core and core plus are absolutely a key component of a plan lineup, I don’t think it’s as easy as it was back then in stopping there. I think, you know, you may need to evaluate including additional options given that participant bases tend to be diverse across a lot of demographics and, you know, a core, core plus may not be that one-stop-shop to help everybody meet their needs anymore.

Rizzuto: Great, and I think, you know, that backdrop, I think is important to kind of get us into another subject, and that is, you know, how is this of course going to affect plan participants? Because at the end of the day, the retirement plan at least should be there to help participants allocate towards and save for their retirements. But we need to think about, again, the types of investments that they have available to them and how they are going to allocate to those investments. Now, there’s no one easy way to understand how participants choose the funds that they do within their 401(k) accounts. Each participant population is going to be a little bit different. But you know, I’ve seen research that says participants will allocate more of their assets to funds that have names starting with letters at the beginning of the alphabet, for example, versus those at the end of the alphabet. So this would mean, for example, that the Aardvark fund would see larger allocations than the Zygomatic fund simply because it’s going to show up sooner in the list.

Along with that, I’ve seen research that says that participants gravitate towards funds that have the word income in the name. So there’s a number of different ways that folks may do this, but we don’t really know. Now one other way that I think is a little bit more concrete goes back to research that was conducted by Richard Thaler and Shlomo Bernartzi. Now, in their paper entitled Naïve Diversification Strategies in Defined Contribution Savings Plans, they show that participants may take a one over N approach, which would lead them to allocate evenly across all the funds in the plan lineup. Now in this study, this led to allocations that were 75% equity and 25% fixed income. They noted that this could lead to naive diversification choices, especially for those who are risk averse. And if you think about this, participants are going to get more risk averse as they age, which is why this fixed income conversation is so important. And we see that in Thaler’s research, you get allocations of 75/25, and if we look at the research that we conducted with the Plan Sponsor Council America, we see that three-to-one ratio of equity to fixed income and we would get the same result.

So overall, I think the most important thing from Thaler’s research is that investors will tend to choose investments based on the overall makeup of the funds in the plan. He actually noted that participants will choose mostly stocks in a plan predominantly offering stock funds and mostly bonds in a plan primarily featuring fixed income funds. This type of allocation is probably going to be okay for younger participants, but it may be too aggressive for older participants. Luckily, it does seem like participants will become more conservative with their allocations as they age but here, Jessica, I want to come back to you. What happens if I simply have those same three or four fixed income options at the beginning of my career as I do as my career moves forward and I become more conservative? You know, my allocation shifts more to fixed income as I get older, but what concerns would you have for a participant if they’re allocating and increasing amount to only a small number of fixed income options?

Leoncini: So assuming your equal weighting given the one over end approach, in the current environment, what that would translate to would be, say, one-third of your fixed income portfolio being in a money market fund returning zero, one-third of your fixed income portfolio being in a bond index fund yielding 1% and then the other one-third either in an intermediate core or stable value [fund] also offering very low yields. So my first concern here would be that these options are often very heavily tilted toward government securities. And looking at the 10-year Treasury, you mentioned where the 10-year Treasury is trading today, going back to March, it’s been in roughly a 50- to 80-basis-point range. That really gives you pretty little upside potential if you’re looking at a half a percent to 0.8% range over the past several months, particularly for participants that are closer to or entering into retirement that may be looking for a steadier income stream to help replace wages.

My second concern would be that some of these options may have pretty high correlations to each other. So participants may not be as diversified as they think they are. Just picking three different options may not necessarily be giving you the diversification that you’re expecting. I think there’s also precedent to take in consideration from the Fleming versus Rawlings case to make sure a plan has not only an adequate number of options, but also to ensure that these options are appropriately diversified. So I think looking at where yields are is a primary concern for today. But also thinking about the fact that some of these allocations may not be giving participants the diversification that they think they may be getting.

Rizzuto: Yes, and that Fleming versus Rawlings case is one that I think we’ve talked about on the podcast before. That’s a 401(k) lawsuit where you see this failure to diversify allegation come up because as you mentioned, there weren’t enough fixed income options and equity options were very highly correlated to each other. But you know, I think the other thing that comes to mind here is if we’re going to expand the options that are available to participants and really, if we’re even going to start to talk about this with plan sponsors and investment committees, we need to educate them. And that’s something else that came out of this research was that there’s a definite need for education. I mean you talked about, you know, kind of the inverse nature of bonds. And that can be, to put it simply, mind bending for some people. So how can we go about educating folks a little bit better when it comes to these products?

Leoncini: This is so important Ben, and something that I’m very passionate about. So for fixed income, start with understanding your expectations as well as your participants’ expectations for fixed income. Are you looking to fixed income to preserve capital when equity markets sell off in a time period like March earlier this year? Are you looking for fixed income to provide uncorrelated returns? Are you looking for them to generate a reasonable level of income for you? Maybe you’re looking to them as a hedge against inflation. I think starting with this and understanding what you’re really looking for and what your participants are expecting is a really good starting point.

Now, what makes this a little bit more complicated is I think everything’s a little bit easier on the equity side of the house. You know, there’s an equity style box that most abide by in terms of diversifying across growth core value, large cap, mid cap, small cap. There really isn’t comparable guidance for fixed income. Plus, there’s a lot more complexity and types of products, there’s a lot more gray area between types of strategies – even if you can nail down a category you’re looking for – the way individual managers are adding value can be very, very different.

So the risk and reward profile within the same category can be very different across different products. So one thing that we have helped frame out here at Janus Henderson is a starting point to consider that we’ve called our framework of five. So this interview is certainly not the number of fixed income options that should be in every plan, but something to think about framing out where to start. So the first option we consider is a money market or stable value strategy which we know a lot of plans include. The second is a short-term bond or low duration strategy. The third is a core or core plus fund. The fourth is the one that I highlighted earlier, either a multi-sector fund or dollar-hedged world bond fund, and then the fifth would be something to protect against inflation.

Thinking about the education, especially, looking at the potential to include something in that multi-sector world bond category, another interesting finding that we had in the research that we conducted was the inconsistency between what advisors and plan sponsors stated was important to them versus the factors that they said they were evaluating. So 90% of survey respondents stated that quality was critical to them in fixed income. They noted that it was either essential or preferred, which makes sense given the expectations for fixed income. But interestingly, factors such as correlation to equities, maximum drawdown and sector allocations ranked pretty low in terms of factors that were considered important. And this was really surprising to us because we think that all of those factors I mentioned – correlation, drawdown, sector allocations – are factors that we consider critical in evaluating quality. So I think that really underscores the importance for education.

So I think it’s important to understand how best to evaluate fixed income options to make sure they’re meeting up to those expectations that you’ve identified you’re looking for. I think asset management partners can be a great reference here. And I know here at Janus Henderson, we put together a toolkit to identify a couple of actionable ideas for potential inclusion in an investment policy statement. So looking at those factors like correlation to equities, standard deviation, max drawdown. Another one I would add is maybe consider looking at discrete time periods. You can really hide a lot of volatility in a three- or five-year number. Those are still very important dates to look at, but I would suggest looking at 2015. Look at the year when high yield sold off pretty dramatically. Look at 2018, the most recent full year when equities sold off. Look at March of this year. Look at what you consider these worst-case scenarios. They may be able to help you gauge whether you’re comfortable with the potential risk profile and whether or not you think they’re appropriate for your participant base.

Rizzuto: Yes, and those you know, those worst-case scenarios that they sometimes occur more frequently than we would hope. So I think that is an important consideration for plan sponsors to make. You know, another thing that you brought up, you brought up this framework of five and many plan sponsors or advisors may think of that and think about a plan menu and say, “Well, that’s going to be too many options for participants.” And that has been the thinking for some time. But one piece of research that I would point to came out of Morningstar. It’s a paper called Bigger Is Better and they showed that plans, as you move from in their study, 10 funds up to 30 funds, it actually helped participants create more efficient portfolios. Now, of course, these are the participants that are selecting portfolios on their own or they have the help of an advisor to help them do that. But there is evidence that increasing the number of options may actually help folks create more efficient portfolios. And our hope, of course, would be that these portfolios are able to stand the test of time and be able to get through these worst-case scenarios to keep folks on track for retirement.

You know, speaking of advisors, Jess, you have the pleasure of talking with advisors a lot from your position. You’ve had a lot of conversations with some of the advisors that we work with regarding retirement plans and investment menus. What’s come out of those conversations that you found interesting?

Leoncini: There have been a couple of interesting themes that have come up in these conversations, and I’ve had a lot of conversations, in particular, in partnership with our Portfolio Construction and Strategy Team in helping to really dissect the risk in plan lineups. So a couple of things that have come out, first, one really interesting factor that we’ve seen is a lot of advisors have been unaware of the correlations across some of their fixed income options. So one thing that we’ve looked at is some plans tend to have a core fund and a core plus fund. But going back and looking historically over the past 10 years, if you look at the average core and core plus fund, standard deviation is about the same, max drawdown is about the same, and correlation between those two asset classes on average is 1.0. So there are certainly exceptions within each category, but if you’re picking an average fund in each category, chances are they’re pretty heavily correlated to each other. So we’ve seen that in terms of a lineup having a lot of funds that are really highly correlated to each other and providing similar exposures. Thinking back to what we highlighted on money markets and bond index funds and intermediate core strategies having a an overweight to government securities.

On the other side, we’ve seen options that have had a higher correlation to equities than were expected. So particularly thinking of some of these single sector type funds like a high yield option or even looking at a core plus strategy, I think one of the important things that have come out of this is not all fixed income is created equal. There are some core managers that have more risk than core plus. There are core plus managers that have hidden risk factors with returns being driven by allocations in high yield or emerging markets. So I think the looking at correlations to both fixed income options and across a plan has been something that’s been pretty enlightening.

We’ve had some conversations on active versus passive within fixed income. I know there is a very strong focus on fees. But remember, ERISA states that you just need to look for fees that are reasonable for the services being provided, not necessarily the lowest option. So consider where you can most efficiently go active and add those options within a plan. You know, benchmark construction tends to be pretty flawed within fixed income. The Aggregate Bond Index has a very limited subset of investable sectors and securities. Active managers just have a lot more flexibility to potentially add value.

Another thing that we’ve seen is standard metrics don’t necessarily work for all asset classes. So if you’re looking at an asset class like multi-sector bond, that category was essentially designed to give managers more flexibility above a core plus manager above the Aggregate Bond Index. So by definition, benchmark relative statistics will be less relevant, our squareds won’t make sense, tracking error won’t make sense. So there may be a need for further due diligence into some of those categories.

I think the three key takeaways to summarize from me would be looking to your fixed income options to be adequate, diversified and differentiated. So, adequate: make sure that they are doing what you expect them to do. Make sure you have enough of these options and make sure that they’re in line with your expectations. Diversified: make sure that you’re not just having all of these single sector options that can have more volatility. If you have precious few spots for fixed income within a lineup, make sure those funds are really earning their keep and working hard and giving diversified exposures, which may give your participants a better chance of meeting their goals. And then make sure they’re differentiated. Just because you have three different fixed income options in a plan doesn’t mean that they’re giving you different exposures. So really evaluate whether they’re giving you those different allocations that you’re looking for. So, adequate, diversified and differentiated I think are the three key takeaways from my side.

Rizzuto: I think that’s a great framework there because I know, as we talked about, fixed income can be difficult to understand. But you know, as advisors are sitting down with investment committees, I think those are some really great ideas to take to the table to help them wrap their arms around how investments work in a lot of different environments.

A couple things that I wanted to take from what you said Jess. You know, correlations, I think that’s a very interesting idea to think about for plans going forward. That’s something that came up in that Fleming versus Rawlings case. And as you noted, fixed income options can have very high correlations. Equity options can have very high correlations. So the question we really need to ask ourselves is, are we really providing participants with a diversified set of options? And if nothing else, it’s good to at least check. So if you want to work with Jessica and the Portfolio Construction Services Team that she mentioned, we can certainly do that to help you go through that due diligence process.

The other thing is standard metrics. I think this is a great way for advisors to add value because we can’t just use standard metrics for every plan we work with. We really need to provide a differentiated look at plan investments and this is one way to do it or at least a framework at least to do this from. Now you know, to finish up, the one thing I wanted to note here is we don’t know what interest rates are going to look like in the future. We don’t know what inflation will be or look like long term. But the main thing we need to remember is that these things are going to change, right. And because of this, it’s important to build, I think, flexibility and optionality into plan menus. And this is very similar to a conversation I have on the retirement planning side of the business when it comes to taxes. With that lens we use for tax, it’s usually a short-term lens. You know, Democrats and Republicans have different ideas about taxes, but policies are going to change, no matter who’s the president. So it’s really important to build flexibility into one’s financial plan and I think the same goes for retirement plans based on everything we’ve talked about today.

Options allow folks to develop more efficient portfolios and have different options available to them when they need it. You know, the retirement plan account is supposed to be for someone’s retirement. It’s supposed to provide someone with the ability to invest for the future. And the thing that we need to remember is that more and more plan sponsors feel responsible for their participants’ ability to retire comfortably. In fact, based on Bank of America’s 10th Annual Workplace Benefits Report, 62% of employers feel “extremely responsible” for their employees’ financial wellness today. That’s compared to just 13% back in 2013. So based on that, I feel plan sponsors need to ask themselves if offering just three or four fixed income options, based on everything we talked about today, is really going to meet that responsibility. It may be sufficient to meet the shorter-term needs of younger participants, but does it meet their mid- and long-term needs, especially as they age? It may not. And if nothing else, this should lead plan sponsors to at least ask themselves if what they’re offering does in fact meet those needs. So with that, Jessica, I’d like to thank you again for spending some time with me and providing some context to our listeners.

Leoncini: My pleasure. Thanks so much for having me.

Rizzuto: And for those of you out there, we hope that this has been helpful and maybe a way to better connect some of the dots when it comes to investments in plan menus and participants who are using them. Finally, remember that you can of course subscribe to this podcast and others from Janus Henderson via iTunes or Spotify. And if you’d like to continue the conversation, feel free to reach out to me or Jessica. We’d love to hear what you think or learn about what you’re experiencing in the marketplace. So until next time, I’m in Ben Rizzuto and this is Plan Talk from Janus Henderson Investors.

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