Expanding Fixed Income Menus in DC Plans

Transcription

1 Expanding Fixed Income Menus in DC Plans White Paper September 2015 Not FDIC Insured May Lose Value No Bank Guarantee For Not financial FDIC Insured professional May Lose use Value only. Not Bank for inspection Guaranteeby, distribution or quotation to, the general public. INVESTMENT MANAGEMENT

2 Table of Contents Executive Summary 2 Introduction 3 World Market Portfolio Exposes Shortcomings of Narrow Focus 5 Fixed Income Options and Opportunity Abound 6 A Diversified Approach to Fixed Income Offers Many Potential Benefits 7 Toward Better Returns and Diversification 8 Conclusion 11 Executive Summary While defined contribution plans typically offer participants an array of equity investment options across styles, capitalizations and geographies, they seldom offer similar diversity within their fixed income lineups. As such, plans fail to capture the wide variety of available fixed income opportunities and leave participants exposed to risks that could be diversified away. An ideal world market portfolio would always include foreign bonds, high yield bonds and senior loans, to name just a few of the asset classes generally overlooked by DC plans. The wide range of returns generated by debt instruments from year to year show that fixed income is not a homogeneous category and suggests the benefits of diversification. Historical returns show the significant advantages of supplementing a domestic investment grade debt portfolio with such complementary assets as high yield bonds, emerging market debt, global bonds and senior loans. To address the fixed income deficiencies in their plans, we believe plan sponsors should consider: Judiciously expanding standalone fixed income asset class options Adding an unconstrained fixed income strategy option Adopting a multi-tiered white-label menu structure Inspecting the fixed income exposures in target date offerings 2 Expanding Fixed Income Menus in DC Plans

3 Introduction Defined contribution plans typically adopt a multi-fund, multi-style approach for their equity options in order to provide participants with discrete, complementary investment portfolios that in the aggregate would come close to representing a worldwide equity opportunity set. This approach to menu design offers several advantages; for example, it: Offers exposure to a wide range of investment opportunities Gives participants the flexibility to allocate assets consistent with risk/return profiles Facilitates well-controlled diversification and deliberate active risk-taking Permits replacing fund options as necessary without disturbing other investments Has been embraced by fiduciaries as a comfortable norm That said, most DC plan sponsors have been reluctant to adopt a similar array of options for their fixed income lineups, perhaps assuming participants lack an understanding of peripheral fixed income asset classes. Typically, DC menus include just one intermediate bond fund invested almost exclusively in investment grade U.S. debt with token allocations to high yield bonds, emerging market debt and other sectors; separate money market and stable value funds typically are also offered. While simplicity is achieved, this limited approach is suboptimal for a variety of reasons: DC plan participants are denied the opportunity to manage risk and diversify their exposures via multiple fixed income strategies (as they likely do in their other investment portfolios), leaving them potentially overexposed to certain risks in what may be their most crucial source of retirement funds. Beyond forgoing diversification opportunities, the typically limited fixed income scope of most DC plans fails to capture the wide variety of return opportunities available in today s diverse global bond market. The typical plan structure seemingly accommodates irrational fears while disregarding legitimate risks. For example, though high yield bonds may be derided as too risky for the average plan participant, virtually all equities are more volatile. Meanwhile, participants facing the very real risk of rising interest rates are unable to hedge against it through such vehicles as short-term bonds, Ginnie Mae securities and/or senior loans. Given diminishing access to defined benefit plans, the need for protection and diversification in a DC plan becomes even more critical. September

4 The potential opportunity cost of focusing exclusively on the domestic investment grade bond sectors is represented in Figure 1. Even without identifying all of the sectors and asset classes on the chart, the potential benefit of looking beyond the U.S. Aggregate Index is obvious and substantial. Figure 1. Fixed Income Offers a World of Opportunities Beyond U.S. Aggregate Bonds Global Fixed Income Return and Risk, Ten Years Ended March 31, % 10 High Yield Annualized Return (%) U.S. Aggregate EMD 2 0 Cash % Annualized Risk (%) Source: Voya Investment Management, FactSet Note: Cash = annualized yield on the three-month U.S. Treasury Bill; High Yield = Barclays U.S. Corporate Index; EMD = JP Morgan EMBI+ Market Bond Index; U.S. Aggregate = Barclays U.S. Aggregate Bond Index. All indices are unmanaged and an investor cannot invest directly in an index. Index returns do not include fees or expenses. Past performance is no guarantee of future results. 4 Expanding Fixed Income Menus in DC Plans

5 World Market Portfolio Exposes Shortcomings of Narrow Focus Financial theory introduces the idea of a world market portfolio that represents an estimate of the market value of all assets available for investment and, more important, often serves as a starting point for strategic asset allocation decisions. Based on the aggregation of major market indexes, the world market portfolio describes both the worldwide opportunity set for investors and the theoretically ideal portfolio for a completely passive investor. The world market portfolio in Figure 2 includes several bond categories beyond U.S. investment grade bonds. Figure 2. World Market Portfolio Shows Global Opportunity Set for Investors Market Size Asset Class/Category % of Market ($ Trillions) U.S. Equity Non-U.S. Equity /Frontier Markets Equity Private Equity Real Estate U.S. Bonds Non-U.S. Bonds s Linked Bonds s s Money Market/Cash Equivalents Hedge Funds/Alternatives Total Source: Hewitt EnnisKnupp, Global Invested Capital Market, June 2014 Data as of June 30, 2014 In the real world, the opportunity set actually available to most investors is much more limited than suggested by the world market portfolio. Nevertheless, for directional purposes, it is clear that the fixed income components represent a set of asset allocation standards that deserve consideration. We can see from the data in Figure 2 that about 50% of the world s investments are in bonds and cash equivalents, but only 30% of those are in U.S. investment grade bonds with 65% in foreign bonds, high yield, emerging markets and senior (bank) loans. Since the bond market is clearly more diverse than many might assume, investors could obviously benefit from broader diversification and more thoughtful risk-taking. September

6 Fixed Income Options and Opportunity Abound Now let s consider Figure 3, which shows the range of fixed income returns across sectors over the last ten years. Over the period depicted, the average difference between the top-performing and bottom-performing bond category was 17.3%. Meanwhile, the ten-year average return on intermediate term bonds was just 4.7%. If broader exposure across the fixed income universe permitted DC participants to capture just one-sixth of the full range of historical returns which statistical norms suggest should be possible about two-thirds of the time the total return on their fixed income investments could be raised to 7.58% annually, a 60% increase over the intermediate term bond average and enough to produce a 20% gain in their accumulated account balance after 20 years. In addition, the constantly changing market leadership in Figure 3 demonstrates the futility of gaming diversification that is, trying to outsmart the markets by abandoning diversified positions in an effort to sidestep impending risks or to crowd into an area of strong returns, usually after the fact. Such reactive behavior tends to depress returns over the long term. On the other hand, effective diversification takes strategic long-term positions across a range of investments to improve the chances of enhancing total returns while managing downside risk. Figure 3. Broad Array of Fixed Income Returns Suggests the Benefits of Diversification Morningstar Bond Categories, Annual Returns Long Short Long Short Short Long Long Short Long Short Long Short Long Short Long Short Short Long Long Short Range of returns (%): Source: Morningstar, Voya Investment Management All indices are unmanaged and an investor cannot invest directly in an index. Index returns do not include fees or expenses. Past performance is no guarantee of future results. 6 Expanding Fixed Income Menus in DC Plans

7 A Diversified Approach to Fixed Income Offers Many Potential Benefits Examination of what could have been possible in the past is another way to confirm the efficacy of a broadly diversified approach to fixed income. Consider Figure 4, which shows the returns for various combinations of fixed income assets over the period from 1997 to The portfolios that include domestic investment grade bonds (as represented by the U.S. Aggregate) plus equal proportions of high yield bonds, emerging market debt, global aggregate bonds and senior loans completely dominated returns generated by a portfolio comprised only of U.S. high-grade debt. In fact, some of the portfolios notably those with senior loans and global bonds delivered both higher returns and lower risk, likely a result of the added diversification benefits. And keep in mind that this is not a conveniently chosen time period; if risk relates to return in a rational way, most reasonably long periods would produce similar results. Figure 4. Broadly Diversified Portfolios Significantly Outperformed Those With Only U.S. Aggregate Bonds Annualized Return (%) 8% 7 6 U.S. Agg. + HY + SL + GA + EMD U.S. Agg. + HY U.S. Agg. + HY + SL U.S. Agg. + HY + SL + GA U.S. Aggregate plus Spread Sector Assets U.S. Aggregate % Annualized Risk (%) Source: FactSet, Voya Investment Management Note: HY = Barclays U.S. Corporate Index; SL = S&P/LSTA Leveraged Loan Index; GA = Barclays Global Aggregate Bond Index; EMD = JP Morgan EMBI+ Market Bond Index; U.S. AGG = Barclays U.S. Aggregate Bond Index. Each line represents historical returns of equal weighted combinations of the indicated sectors at various risk levels. All indices are unmanaged and an investor cannot invest directly in an index. Index returns do not include fees or expenses. Past performance is no guarantee of future results. September

8 Figure 5 shows the correlation of five major bond categories global bonds, domestic high yield, Ginnie Mae securities, emerging market bonds and senior loans relative to the Barclays U.S. Aggregate Index for the 15 years ended June 30, Over that period, these five sectors have an average correlation to the broad index of just GNMA is an exception to low correlation objective, which, though it behaves much like the U.S. Aggregate, it carries generally lower duration risk, a meaningful advantage when interest rates rise. Even if we acknowledge that summary statistics ignore the wide variation in correlation between any two asset classes from time to time, they still suggest quantitatively how diversification may help lower volatility in a portfolio, which can help mitigate the impact of rising rates and other risks. Figure 5. A Portfolio of Low-Correlation Assets Can Reduce Volatility and Improve Return Correlation Matrix, 15 years ended June 30, 2015 Barclays U.S. Aggregate Barclays U.S. Aggregate 1.00 Barclays Global Aggregate Barclays High Yield Barclays GNMA Index JPMorgan EMBI+ S&P/LSTA Leveraged Loan Barclays Global Aggregate Barclays High Yield Barclays GNMA Index JPMorgan EMBI+ (0.03) S&P/LSTA Leveraged Loan Source: Barclays, FactSet, Voya Investment Management. All indices are unmanaged and an investor cannot invest directly in an index. Index returns do not include fees or expenses. Past performance is no guarantee of future results. Toward Better Returns and Diversification Though most DC plans have been remiss in offering a robust, diversified lineup of fixed income investment options, there are steps they can take to unleash the powerful benefits mentioned above on behalf of their participants. Expand fixed income options to obtain diversification comparable to equities. While trends have favored streamlining investment menus in recent years to assist participant decision-making, thoughtful expansion of menus should be considered to allow participants broader diversification in their fixed income allocations. As more participants approach retirement age and the accompanying drawdown of assets, the fixed income menu plays an even more critical role. High yield, global fixed income, agency mortgages, senior loans and other asset classbased funds are making their way into DC plan menus. These options allow not only the potential for higher yields but also greater diversification and risk control. Plan sponsors should be sure that stand-alone add-ons are genuinely discrete and supplemental to the existing lineup and are not so idiosyncratic as to defy understanding by the average participant. On balance, the key is to be selective in the number of new options offered in order to avoid overlap and confusion and to ensure there is adequate education and communication to help participants understand the risks and make suitable allocations to unfamiliar assets such as high yield bonds. 8 Expanding Fixed Income Menus in DC Plans

9 Consider an unconstrained bond strategy exposed to various fixed income sectors and sources of return. A less sweeping way to address the lack of diversification is to consider adding an unconstrained bond strategy to the DC lineup an approach that would address the issues outlined above without adding individual options for each and every fixed income asset class. An unconstrained bond strategy allows an investment manager considerable discretion to take advantage of the full spectrum of investment opportunities and manage risk through various market environments. Such strategies typically are not benchmarked to a conventional index such as the Barclays U.S. Aggregate Index, more likely using an absolute return objective, often relative to LIBOR (London Interbank Offered Rate), to measure performance. Absent the benchmark constraints, the manager is freely able to allocate to sectors, regions and credit qualities as appropriate and to maintain a duration profile consistent with interest rate expectations. Given this added freedom, it is important for plan sponsors to engage the right fund manager for their plan, as not all unconstrained strategies are necessarily appropriate. Recognizing that participants often see fixed income as a more stable investment, an ideal manager choice is one that does not truly take unconstrained risk but instead utilizes a clearly defined risk budget to achieve a moderate long-term return objective, producing reasonably stable returns with a focus on capital preservation and downside protection. Plan sponsors should also seek managers with the skills to fully utilize the discretion available to them. Some unconstrained managers, for example, might habitually avoid interest rate risk and instead over-allocate to credit risk, which can lead to high correlations with equities. A more desirable approach for a DC plan would involve actively managing a mix of sector, credit and duration risks as market conditions change to deliver a strategy with low correlations to both global interest rates and equity markets. Some plan sponsors might even find that a suitably constrained unconstrained strategy, focused on stable returns and capital preservation, could be more appropriate for DC participants than a typical intermediate bond fund. Expand fixed income options through a white label menu structure. To simplify plan participation, engage more participants and even improve diversification, many DC plan sponsors are considering a move to tiered menus with white-label investment options. Essentially, white labeling combines multiple funds, investment styles and/or asset sub-classes into groups and gives them broad, descriptive labels, thereby reducing the number of investment choices confronting participants while continuing to offer access to a robust and diverse set of investment exposures. With white labeling, plans can move from a vast array of core products for example, in Figure 6, five bond options and nine equity options to an abridged menu of white-label options grouped either by asset class or investment objective. For DC plans with a limited or underdeveloped fixed income lineup, white labeling can provide access to multiple underlying fixed income assets under a single U.S. Fixed Income or Global Fixed Income white label, for example. White labeling can also include multiple underlying managers, each potentially offering a different investment approach. September

10 White labeling also offers simplicity for participants, enhanced portfolio construction and a streamlined and simplified process for investment changes and communications. Like any option in the DC plan, white label menus should be regularly reviewed and monitored. Figure 6. Sample White Label Approach to DC Plan Menu Design Tier One Tier Two Traditional Fund Menu White-Label Asset Class Menu Asset Class Target Date Funds Target Date Funds Target Date Funds U.S. Large-Cap Value U.S. Large-Cap Index U.S. Large-Cap Growth U.S. Small/Mid-Cap Value U.S. Large-Cap Equity White-Label Objectives Menu U.S. Small/Mid-Cap Core U.S. Small/Mid-Cap Equity Growth U.S. Small/Mid-Cap Growth Non-U.S. Value Non-U.S. Index Non-U.S. Growth Global REITs Global Bond Non-U.S. Equity Global Fixed Income Income Core Bond U.S. Fixed Income Core Bond Index Stable Value Stable Value Capital Preservation Tier Three Brokerage Window Brokerage Window Brokerage Window Source: Voya Investment Management Review target date/custom target date fixed income exposures. As a majority of DC plan participants are increasingly investing through the plan s target date or, to a lesser extent, risk-based option, it is important to examine the fixed income exposures contained in those strategies and verify that they adequately contribute to the goal of broad diversification. As participants approach retirement and the drawdown phase of their lifecycles, a smoother ride becomes even more critical. Plan sponsors should consider their target date strategy carefully to ensure there is adequate fixed income diversification to help weather market volatility should it arise. Fixed income allocations in target date plans are determined by the glide path trajectory. As participants approach and reach retirement age, fixed income will assume the majority allocation position in most plans. The critical question is whether available options are sufficient and suitable for those close to or at retirement age. If adequate fixed income diversification is not present in an off-the-shelf target date strategy, a custom target date strategy designed for specific employee demographics and investment objectives may lead to even greater employee satisfaction and retirement readiness. 10 Expanding Fixed Income Menus in DC Plans

11 Conclusion Defined contribution plans typically adopt a multi-fund, multi-style strategy for their equity investment options without offering similar diversity within their fixed income lineups. Not only does such a plan structure fail to capture a wide variety of available fixed income opportunities, it leaves participants exposed to risks that could be obviated though better diversification and may also lead to chronic portfolio underperformance. Historical returns for broadly diversified bonds plus equal proportions of high yield, emerging market debt, global aggregate bonds and senior loans significantly outperformed the Barclays U.S. Aggregate Bond Index in fact, some combinations delivered both higher returns and lower risk, which could surely benefit DC plan investors. For DC plan sponsors looking to address these deficiencies, we suggest: Judicious expansion of fixed income asset class options The possible addition of a thoughtful, unconstrained fixed income strategy The exploration of a white label menu structure incorporating multiple investment options Evaluation of the fixed income exposures within target date offerings. September

12 Investment Risks All investments in bonds are subject to market risks. Bonds have fixed principal and return if held to maturity, but may fluctuate in the interim. Generally, when interest rates rise, bond prices fall. Bonds with longer maturities tend to be more sensitive to changes in interest rates. All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. High Yield Securities, or junk bonds, are rated lower than investment-grade bonds because there is a greater possibility that the issuer may be unable to make interest and principal payments on those securities. As Interest Rates rise, bond prices may fall, reducing the value of the share price. Debt Securities with longer durations tend to be more sensitive to interest rate changes. High-yield bonds may be subject to more Liquidity Risk than, for example, investment-grade bonds. This may mean that investors seeking to sell their bonds will not receive a price that reflects the true value of the bonds (based on the bond s interest rate and creditworthiness of the company). s are also subject to Economic Risk which describes the vulnerability of a bond to changes in the economy. Diversification does not guarantee a profit or ensure against loss. Past performance is no guarantee of future results. Important Information This paper has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors. The opinions, views and information expressed in this presentation regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Portfolio holdings are fluid and are subject to daily change based on market conditions and other factors. Products and services are offered through Voya family of companies. Please visit us at for information regarding other products and services offered through Voya family of companies. Not all products are available in all states. This document or communication is being provided to you on the basis of your representation that you are a wholesale client (within the meaning of section 761G of the Act), and must not be provided to any other person without the written consent of Voya, which may be withheld in its absolute discretion. This material may not be reproduced in whole or in part in any form whatsoever without the prior written permission of Voya Investment Management Voya Investments Distributor, LLC 230 Park Ave, New York, NY All rights reserved. Not FDIC Insured May Lose Value No Bank Guarantee For financial professional use only. Not for inspection by, distribution or quotation to, the general public. BSWP-FIMENUS IM