What’s ahead for 401(k) plans — and the rest of the defined contribution industry — this year? The investing climate is already the most challenging we’ve seen since 2008. Equity markets around the globe have been very volatile, and there are more signs of stress in credit markets. Globally, geopolitical risks are on the rise and returns look harder to find. Disruptive forces from technology advancements also are changing the investment landscape.
At the same time, DC plans face increasing scrutiny from regulators and their own participants — even while fiduciary standards are still in flux. With so much uncertainty, it’s no small wonder that many sponsors in charge of workplace plans, as well as the employees counting on them for retirement, are uneasy.
Many plan sponsors and providers may need to rethink the direction they’ve been heading. What’s worked in the past may not work going forward. In recent years, the market has generated robust returns powered by historically low interest rates. But with earnings getting tougher to achieve going forward for a wide range of asset classes, it’s going to get harder to rely solely on strategies that simply track the markets. So, how can plan sponsors make sure their investment lineups are prepared for a new investment climate? And how can they help participants feel confident enough to keep saving?
Here’s our 2016 action plan:
Rethink the equity framework. The changing investment landscape means plan sponsors need to consider the implications for their equity portfolios. We believe today’s more challenging markets call for more diverse equity investment strategies, including both active and index. Expectations have shifted to lower overall growth and higher volatility. These new realities will create multiple opportunities in the market, but there will be greater dispersion of risks and opportunities. As such, manager skill will be an increasingly important driver of returns for the next five years. Plan sponsors should consider tilting toward alpha, and they should consider equity strategies ranging from alternatives designed to manage market shocks to data-driven fundamental and factor strategies designed to find differentiated alpha. Solely passive strategies may not meet investment objectives.
Refocus your bond fund lineup. Fixed income is getting more complicated. Many plan sponsors are viewing bonds as a source of risk today, and they want to make sure the strategies in their investment menu are continuing to serve their purpose. That means it’s important to understand what role bonds are playing in your 401(k) plan.
Within target date funds (TDFs), bond investments tracking the Barclays Aggregate Index — the most widely used barometer of the U.S. bond market — may continue to make the most sense. If equities see a steep sell-off, bonds that track the Barclays Agg are expected to continue to play their traditional role by offsetting some of the market shock and reducing the portfolio’s overall volatility.
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On the other hand, DC plans using bond funds as a standalone solution for participants seeking returns or income may want to look at options that diversify interest rate risk. With those goals in mind, different fixed income strategies may make sense, including multi-strategy solutions providing flexibility and potential for more robust returns.
Keep people invested. Now is the time to offer investment options that give participants the confidence to stay the course. One of the best strategies for doing so: automatically defaulting participants into a TDF from which they have to opt out, not in. TDFs typically invest more assets in equities earlier in employees’ careers, when they have more time to make up short-term losses. Then, the funds gradually shift assets into fixed income and cash-like vehicles as employees get closer to retirement. TDFs that manage investment risk appropriately have been shown in uncertain markets to give more participants confidence to stay the course — and to keep them from moving to cash amid market swings.
One important note: There can be big differences in the ways TDF families handle potential risks. In 2008 and 2009, the best and worst performing 2010 TDFs, as measured by Morningstar, showed a significant spread. It’s critical for plan sponsors and consultants to closely evaluate TDFs, along with other qualified default investment alternatives, based on their ability to generate returns and balance risk to keep participants investing consistently.
Revamp your plan design. Of course, the investment menu only matters when participants are saving enough. Plan sponsors trying to drive higher contribution rates among employees should also consider new plan design strategies. The most basic ways to build better retirement outcomes are to get workers contributing earlier, at higher rates, and sticking with it amid choppy markets. By using scientific modeling to measure participants’ retirement readiness, sponsors and advisors can better understand what changes have the most potential now to achieve improvements down the road. The possibilities include automating increases in contribution rates, reenrollment into current default investments, and adding tools that show people more clearly what their savings today may generate in income later.
As an industry, let’s resolve to share more such strategies — from the big decisions about how best to invest in unpredictable times, to small experiments designed to keep participants saving that really work — and channel all those efforts into building better retirement outcomes.
