More than $4.5 trillion of defined contribution assets are held by participants over the age of 50, the period when fixed income exposure becomes more prevalent in retirement portfolios. Jessica Leoncini, Head of Fixed Income Product Specialists, joins Retirement Director Ben Rizzuto in a discussion on what plan sponsors should consider when designing the fixed income portions of their plan menus.
Fixing the Fixed Income Options in Defined Contribution Plans - Ben Rizzuto and Jessica Leoncini
- When building the fixed income portion of their plan menus, plan sponsors should consider both interest rate risk and credit risk.
- The menu of fixed income options within many plan menus could be either too simple or too complex to effectively and efficiently address those risks.
- Plan sponsors should review and rationalize their approach to building a fixed income lineup that considers participants’ expectations at each stage of their retirement journey.
Ben Rizzuto: Welcome to Plan Talk from Janus Henderson Investors. I’m Ben Rizzuto. More than $4.5 trillion in defined contribution assets are held by participants over the age of 50. Along with that, this is the period of life when exposure to fixed income assets becomes more prevalent as asset allocations become more and more conservative. In thinking about the sheer amount of retirement dollars that are allocated to fixed income funds, as well as the current market environment, low interest rates and the number of changes that we’re seeing within plans, we thought it would be important to provide some ideas or ways that advisors and plan sponsors can look at the fixed income portion of their plan lineup. And to do that, I’m joined by one of my colleagues here at Janus Henderson, Jessica Leoncini, who is Head of Fixed Income Product Specialists here at Janus Henderson. Jessica, thank you for being with me today.
Jessica Leoncini: Thanks for having me, Ben.
Rizzuto: Great. Now, before we get into the nuts and bolts of our discussion today, I think it’s always important to dig in a little bit and understand you as a person. So with that, I always ask people who are on the podcast what’s your favorite book and why, and is there anything else important that we should know about Jessica Leoncini?
Leoncini: Favorite book is a really hard question. I do a lot of reading, but I have to say, and I especially like books that showcase the human spirit and just the incredible ability of the human mind and the human body. So a couple that I’ve read recently would be “Ashley’s War,” which is about an extraordinary team of female soldiers that served alongside U.S. Army Special Operations and then Diana Nyad’s book, “Find A Way,” that was about her journey to swim from Cuba to Florida. So both just hugely inspirational books.
Rizzuto: Great, great recommendations there. And definitely for plan sponsors, we always need a little bit of extra spirit when it comes to our duties, when it comes to being fiduciaries. So yeah, if you’re looking for a couple of books, those are a couple of good ones. Now, thinking about, you know, Diana Nyad’s journey from, that swim from Cuba to Florida, I think it’s really apropos of the discussion we’re having today in that when we look at a plan menu, there are changes that occur in the currents, the market, and plan sponsors need to be able to take advantage of those or at least deal with those in order to put participants in the best place possible. So if we take that idea, and we think about the markets and fixed income in general, Jessica, you know, what are the issues that plan sponsors need to think about when they think about the fixed income portion of their plan menu?
Leoncini: Sure, I think when you’re looking at fixed income, there’s really two key risks within that market, right? You have rate risk on one side and you have credit risk on the other side, and it’s really important to navigate both of these risks. So looking at rate risk on one side, you know, fixed income will be impacted when rates rise, and by design, fixed income has a pretty big exposure to interest rates. That’s a big reason behind why it’s a good diversifier to the equity risk within your portfolio. So it’s important to maintain some of that exposure to rates or to duration, but any rapid movements or unexpected movements in interest rates could really have a detrimental effect on fixed income portfolios.
On the other side, the second key risk to manage is credit risk. So this is the component of your fixed income portfolio that will have a higher correlation to equities. And given all of the concern about rate risk over the past several years with the Fed hiking interest rates, I think some plans may have unknowingly traded rate risk for credit risk. So both of these risks are really important to navigate, and I think when you’re exploring them, it’s important to know the fund or the manager that you’re using to be able to navigate these. So a good manager will need to balance both of those risks. And good proxies to look at for this would be the Bloomberg Barclays Aggregate Bond Index to look at the potential impact of rates. That index will be highly rate sensitive just given the amount of Treasuries within that and the duration component of that index.
And then as a proxy for credit risk, you can look at the Bloomberg Barclays High Yield Corporate Bond Index, so that will be largely driven by credit risk. So if you look at time periods of stress for both of those indices, something like a 2008 certainly will stress high yield. That will be a lot of credit risk. But even more recent time periods, knowing that a lot of funds haven’t been around since 2008, you can look at 2015 or 2018 as good examples of, you know, what you might expect from a credit risk scenario.
On the other side, if you’re looking at interest rate risk, the Agg 2013 is a good example for that or even more recently, the fourth quarter of 2016, where you saw an unexpected and rapid movement in rates. So I think those are some good things to look at when you’re exploring fixed income options and the two types of risk that you really need to watch out for.
Rizzuto: Got it, got it. So if I’m an advisor, the three things that I think to bring up to my investment committee is, let’s think about rate risk, credit risk and then understand how our manager’s going to be affected by both of those. Is that fair to say?
Rizzuto: Great. So you know, I’m lucky enough to get to travel around the country and meet with a lot of advisors and plan sponsors. And one of the things that I’ve seen when it comes to the fixed income portion of plan menus is one of two things. One, they’re either very simple in that they have a money market fund, maybe a stable value fund and then an intermediate-term bond fund. That’s the simple case. On the other hand, there are those plans that have all sorts of fixed income options. So not only the ones that I just mentioned, but there’s high yield, there may be some sort of income fund, a TIPS fund, emerging market debt. You know, they’ve really cast a wide net when it comes to the fixed income offerings that they’re offering their participants.
And in both cases, and based on what you just mentioned, it seems like investment committees would do well to take some time, especially now, to review and maybe rationalize that portion of the plan menu. So based on that and based on the current environment, if I’m a plan sponsor who has either a very simple fixed income menu or a more complex menu, what should I be thinking about? And maybe better yet, what should I be most concerned about?
Leoncini: Yeah, absolutely. So I think from the standpoint of a plan sponsor, in general a big goal is participant experience, right? You want your participants to have that upside return to help them meet their retirement goals, but you also want to help limit that downside that they experience. Both, I think, are absolutely critical to staying on track for retirement.
So one thing that may be an interesting option in either situation, in either scenario that you suggested, Ben, is a multi-sector bond portfolio. So a multi-sector bond fund typically spans that space between a traditional core bond fund and more of a moderate allocation strategy. This is a relatively new asset class. Most of these strategies launched post-2008 as a way to more actively navigate those two key risks that we talked about earlier. Given that we’ve been in a low rate environment for some time, that certainly creates some challenges to participants in reaching their retirement goals and creating the returns that they need.
One thing to be careful of when you’re looking here is there are a multitude of approaches, so this asset class is designed to take advantage of a lot of those asset classes, typically outside of the purview of a core bond strategy. So think of things like high yield, some areas of the securitized markets, but they typically won’t take on as much risk as a high-yield fund. So you have a lot of this flexibility to a larger degree than core, but it won’t be as concentrated as some of those single-sector type funds.
So I think the benefit for a simple menu is you expand that a little bit more and give those options to help your participants take on perhaps a little bit more risk but help reach those return goals. And the benefit for a more complex menu is that may give you the ability to kind of pare that down a little bit and offer fewer options for participants and help them avoid some of those funds that they may be selecting based on strong recent performance but, like a high-yield fund, but may not be in line with what they’re looking for for their retirement goals.
Rizzuto: Got it. So it almost reminds me of “The Three Little Bears” story, right? You’ve got too cold, you’ve got too hot, and maybe we find something in the middle that is just the right temperature to again, as you mentioned, provide participants with a good experience, not too high on the ups, not too low on the downs.
And I definitely want to get back to the participant experience, but other thing that I think is important right now, and it goes back to that simple plan menu, is this idea … or the intermediate-term bond fund. What are some of the issues or considerations to think about with that fund, which really is, in many cases, the linchpin or the central fund that plan sponsors think about when they start their fixed income plan menu?
Leoncini: Yeah, the core bonds base is a critical one. This is your traditional fixed income exposure. It’s for those diversification benefits, for capital preservation for that portion of your plan that will have a lower correlation to equities.
But what we see with this asset class is most core bond funds are benchmarked to the Aggregate Bond Index and post-crisis, what we’ve seen is duration of that index extend while the yield has actually come down. So you’re shifting that risk/reward profile towards higher risk and towards lower reward. So with these lower yields available within the market, just given policy in the macro environment that we’ve seen, you’re essentially taking on more of that interest rate risk.
I think these lower yields can have implications on your long-term alpha generation potential since yield is a big component to your total return and subsequently, that can have a negative impact on participants in their ability to meet their retirement goals if this is one of the key components of their portfolio.
Rizzuto: Got it. And not to mention all those market issues to think about, there have been some structural changes that plan sponsors and investment committees need to be thinking about when it comes to how intermediate-term bond funds are categorized, right?
Rizzuto: Okay. So if nothing else, I think if I’m an advisor out there, fixed income is definitely going to be an agenda item on… for that investment committee meeting, just based on those structural changes.
Leoncini: I would agree.
Rizzuto: Got it. So let’s move back to the very important participant experience and discuss how all of this may affect them. Now if we look back to a relatively volatile period at the end of 2018, we saw some data that said that overall, participant balances decreased by about $10,000. They went from $104,000 to $95,000, give or take. But what I thought was somewhat good to see is that despite all that market volatility during the fourth quarter of 2018, most investors did not react. Based on this Fidelity survey, only about 5.6% made mass transfers out. So Jessica, based on what you’re seeing, how might the current market environment affect participants?
Leoncini: So interest rates are low, and with the Fed essentially pivoting earlier this year and introducing the potential for a rate cut, many believe that rates will stay low. And I think whether the Fed hikes or stays where it is or cuts, this presents a challenge for market participants in generating those returns that they need. But on the other side, we are late in the credit cycle, so if you think about, you know, the potential for additional risk as every month we’re further away from the 2008 recession and we’re further into this expansion, I think it’s really important to balance that risk of low returns with the risk of potentially reaching for yield at the exact wrong time and added some of this unanticipated risk into your plan or into your portfolio.
So I think there’s also that risk of participants gravitating toward those strategies with the highest returns over the past several years. So I mentioned a high-yield fund. If you’re looking historically, it looks very attractive, but as we’re at the end of the, or towards the end of the credit cycle, that may not be the best fixed income option to hold up through a potential economic downturn if or when we see that in the future.
So there’s no shortage of media hype and noise around geopolitical risks, which I think are extremely difficult if not impossible to predict an outcome. So in this type of environment where rates are low, inflation is pretty muted, credit spreads are tight, these market jitters can become amplified, and it’s important to really stay mindful of your long-term goals and not let some of the short-term volatility derail those goals, which it sounds like participants were pretty good at kind of staying the course through some of this recent volatility.
One thing that we look at in terms of participant experience, Morningstar calculates what they call investor returns, so these essentially measure how your average investor fared and takes cash flows into account. One of the most important things we know that a participant can do to achieve their long-term retirement goals is to stay invested and not let these short-term volatility periods derail those goals. But from a behavioral standpoint as emotional beings, we’re inclined to buy funds that have had good past returns and potentially sell those that have underperformed recently, even though they may be what we really need in our portfolio. And we see this amplified in down markets. So looking at 2015 and 2018 in particular, we looked at the multi-sector bond category, and the average investor returns were 50% below that of the median peer. So if you take an average fund within the category, your average investor underperformed that by 50% just by poor timing of cash flows in either buying at the wrong time or selling at the wrong time.
Rizzuto: Just by being human, basically.
Leoncini: Exactly, just by following emotions. And I think this category is a place where it’s amplified as well given that, you know, the flexibility that managers in this category have and the ability to invest in so many different sectors, there’s so many different ways that these funds go about achieving their goals. So if you look at 2018 as an example, the difference between the best manager and the worst manager was 19%. That’s a huge difference, so you take on all of the differences that a manager can do and then layer on emotional behavior that may not work to your advantage, you know, there’s a lot of potential things that can go wrong. So I think doing due diligence on those managers and then helping, you know, find one that may have a little less volatility to give your participants that confidence to remain invested will be helpful.
Rizzuto: Got it. Those are great points, and I think, you know, many times on the podcast, we talk about participant education and making sure participants are engaged, but participant education only can go so far. Because as you noted, we are all, you know, silly apes at the end of the day, right?
Leoncini: We’re all human.
Rizzuto: Now one other thing you just mentioned is the idea of due diligence and, of course, another topic we always talk about on the podcast is fiduciary responsibility. So, you know, if I’m a plan sponsor, I guess a couple of things that I’m thinking about as we talk about this idea to either expand or contract the plan menu. And the way that I think about it is yes, if I’m a plan sponsor and I’m expanding my plan menu, sure, that does provide another fund that I have to do due diligence on. But the hope is that that provides for a better overall participant experience. If I’m coming the other way, if I’m contracting my plan menu, well, that’s one less fund that I have to worry about. And I think if nothing else, the thing to remember, whatever side of the coin you’re on as a plan sponsor, is that the plan we put out and the plan menu we put together needs to be done or needs to be put together in the best interest of the participants. And providing something that is too cold or too hot, as I said, isn’t in their best interest. So even though there may be a little bit more work, I think it is, again, in the best interest of the client.
Finally, one other thing we always talk about legal cases on the podcast. I can’t think of any legal cases that this brings to mind as far as providing one fund over another in the fixed income space. Again, I think it gets down to what’s in the best interest of the participant. So one last question for you, Jess, if I’m an advisor, and I’m meeting with an investment committee over the next few months, what is the one thing that I should be asking that committee regarding their fixed income or the fixed income portion of their menu?
Leoncini: So I would take a little bit of a two-pronged approach to this. I would ask, “What is your approach in building a fixed income lineup?” And then, “Do your options within that align with your participants’ expectations?” So I think it’s really important to know the purpose that each fund in your fixed income lineup serves. And here at Janus Henderson, we’ve developed a framework of five to help construct a menu that will offer options appropriate to participants in each stage of their retirement journey.
And then within those options, I think it’s important to select managers that provide a risk and return stream in line with your participants’ expectations. So fixed income is typically thought of as the safer assets within a portfolio, and I think that’s how a lot of participants treat them. So after picking the areas that you want to be invested, I think it’s important to do that due diligence and really find those managers that will be good within each of those buckets.
Rizzuto: Perfect. Yeah, and you mentioned approach and process. We know how important that is in the fiduciary responsibility of a plan sponsor. Whether that plan sponsor is a client or a prospect, I mean, that is one question that I would ask a plan sponsor is, “What is the process that you go through when selecting funds whether it’s equity or fixed income in your plan menu?” That’s a great way that an advisor can provide value. So overall, as we close up, I mean, I think the few things that I take from this conversation, and again, thank you, Jessica, for being part of the podcast today.
Leoncini: My pleasure.
Rizzuto: Three things: credit risk, interest rate risk and know your manager. Those are things that investment committees need to be thinking about. And in that, we get back to again, the simple things that we learned in kindergarten, the Three Little Bears, too cold, too hot, finding something that is just right. You know, and overall, fixed income is such an important piece of the retirement pie, so our hope is that this has given you some insight that you can take to plan sponsors that you work with. As always, we’ll continue to discuss these issues as well as the latest plan participant, legal and regulatory trends in our next episode. So if you haven’t subscribed, be sure to do so on the Janus Henderson radio podcast channel. Jessica, thank you again.
Leoncini: Thanks, Ben.
Rizzuto: Until next time, I’m Ben Rizzuto. This is Plan Talk.
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