DC fixed income: The world has changed. It's time to catch up

Sep 14, 2015 / by Anne Ackerley

In December 2008, the Fed Funds rate dropped to 0.25%, and ever since investors have been waiting for rates to go up. Some people have watched rates so intently that they have neglected other potential headwinds for the fixed income market, including supply, volatility, credit quality, political and regulatory changes, and much more. Considering the multiple roles that fixed income plays in Defined Contribution, does it make sense to fixate on one source of uncertainty?

The obvious answer is no. What's less obvious is how DC plan sponsors should respond to a fixed income environment that is more complicated than anything we have seen in decades. Unfortunately, 30 years of strong bond fund returns have become encoded into the structure of DC plans, leaving us with standalone fixed income menu options that rarely stray beyond the Barclays Agg. If the world has changed – and we believe it has – DC fixed income menus need to change as well. The question is how.

New world, new approach

While declining interest rates were driving strong bond fund returns, another trend was shaping today's DC menus – the trend toward streamlined menus. These trends reinforced each other. With limited shelf space and strong fixed income returns providing the safety, diversification and return that participants had come to expect from their bond funds, few plan sponsors saw any reason to expand their fixed income selection. They were free to focus elsewhere, particularly on their second- and third-tier equity fund choices.

If rates do rise, or any of the other headwinds we mentioned challenge returns, today's bond fund choices may fall short of participant expectations – a particular concern for participants in or near retirement relying on consistent bond fund returns as the foundation for retirement income. Bond exposure within a multi-asset solution, such as a target date fund, are intended to provide equity diversification and is discussed elsewhere. As I see it, plan sponsors have three choices:

  1. Keep the current bond fund 'as is' and double up on education
    A plan sponsor may be able to justify making no change to its bond fund menu by doubling up on participant communications efforts to ensure that participants understand that the fixed income choices that seemed safe in the past may not be safe in the future. The problem is that while some participants will get that message, many will not. And many who do get the message will wonder what to do as an alternative.
  2. Expand the universe of fixed income menu options
    On the face of it, it makes sense to offer a broader menu of fixed income funds. Funds can be introduced to address a wider range of credit quality, geographic regions, strategies, and so on. For participants with the knowledge to make intelligent selections, this might be a welcome development. But most participants lack the in-depth investment knowledge needed to choose wisely. For many, adding choice will add confusion.
  3. Reinvent the bond fund with a multi-strategy structure
    The third choice is to not simply to prepare for immediate headwinds, but for the long haul and the new, highly uncertain reality. This can be done through a multi-strategy structure that incorporates a mixture of fixed income strategies and allows plan sponsors to allocate among them as circumstances dictate. The overall investment objective would be to provide appropriate risk adjusted returns, rather than simply tracking the Barclays Agg.

A white-labeled multi-manager fund acknowledges that both DC and the fixed income market have evolved, and that a new structure needs to replace the old. It’s about shaping the next generation of fixed income options across the DC landscape.

The case for multi-strategy fixed income

Creating a multi-strategy fund structure has the potential to meet two critical needs: Positioning the fund for returns in multiple markets, while also maintaining the clarity that participants want. Here's how it could achieve both of these goals.

In a multi-strategy solution, the plan's custodian typically holds multiple investment strategies, often managed by different investment managers. Managers can be selected based on complementary strengths and diversified for expected sources of risk and return, or pegged to various bond indexes, such as the Barclays Agg as well as other global benchmarks. The plan can adjust the mix of strategies quickly in times of market stress with an overall goal of seeking returns in a risk-controlled way. Depending on how the structure is implemented, the operational complexity of making changes – even including the hiring and firing of managers – can be reduced and the participant reporting requirements on specific changes can be minor.

Plan sponsors can "white-label" such a structure on the investment menu and give it a generic name. When we step back and ask what participants want from a bond fund, the likely answer is some combination of safety, return and diversification. They also want simplicity – a single choice. A white-labeled bond fund provides a single choice that is a potentially appropriate for a range of fixed income environments. That will help plan sponsors keep investment menus streamlined.

Combining approaches within white labeled funds is not simply a response to a short-term headwind. It is a way of structuring fixed income exposure for the long term, so that it continues to align with participant expectations in selecting the fund. Interest rate moves, credit concerns, regional headwinds and more can addressed within the fund.

A white-labeled multi-strategy fund acknowledges that both DC and the fixed income market have evolved, and that a new structure needs to replace the old. It's about shaping the next generation of fixed income options across the defined contribution landscape.

Anne Ackerley
Managing Director, Head of BlackRock's U.S. and Canada Defined Contribution Group
Anne F. Ackerley, Managing Director, is head of BlackRock's U.S. & Canada Defined Contribution (USDC) Group. She is responsible for the development and ...