DC plans: Three timely themes that probably aren’t going away anytime soon

In the wake of an eventful 2021, 2022 has been equally action-packed so far, if not more so. Rising levels of inflation, heightened market volatility, geopolitical turmoil, and the still-ongoing COVID pandemic are just some of the challenges that have defined the first few months of the year. The good news: With elevated uncertainty may come underappreciated opportunities for investors, including defined contribution (DC) plans.

Against this backdrop, plan sponsors continue to seek out new investment ideas and strategies to help participants navigate today’s risk-laden landscape, while also positioning them to exploit investable market opportunities and pursue their retirement goals with confidence. With that said, here are three big themes that are not only top of mind for many investors right now, but are also likely to have staying power in the months ahead. We believe plan sponsors should put particular focus on all three for the balance of 2022 and perhaps beyond.

1. Defending against the bogeyman: Inflation

After lying dormant for much of the past 30 years, global inflation is clearly back. How might the growing threat of higher (and potentially “stickier”) inflation impact plan participants’ ability to achieve a comfortable retirement?

For starters, longevity risk (i.e., the risk of participants outliving their retirement assets) is a key issue to be aware of, especially with average life expectancies having increased from previous generations. DC plan sponsors should consider the insidious and very real risk that inflation may pose to their participants’ plan assets – and thus, to their retirement security – over a period of years. Even modestly higher rates of inflation can lead to meaningful erosion of a portfolio’s purchasing power over time, further raising the longevity risk facing retirees.

The potential drag on portfolio return potential is evident in the equity market, where persistent inflation can exert pressure on market valuations, as shown in Figure 1. The chart plots the market’s trailing price/earnings (P/E) ratio (vertical axis) against trailing three-year headline inflation (horizontal axis), divided into five periods distinguished by differing degrees of inflation volatility. Key takeaways include:

1. Higher levels of inflation, regardless of its volatility, tend to be associated with lower equity market valuations.
2. Similarly, environments characterized by more volatile inflation also generally imply lower equity market valuations.
3. Bottom line: Both the inflation level and the volatility of said inflation can erode a portfolio’s expected long-term returns – a kind of “double whammy.”

The continued rise of inflation should prompt plan sponsors to reevaluate their core investment menus for adequate inflation-hedging solutions. A multi-asset approach that includes TIPS, real estate, gold, and other commodities may make sense as a portfolio defense against inflation’s potentially harmful effects on many stocks and nominal-yield bonds. In our view, the simplicity of an investment strategy that “bundles” these types of assets together may appeal to many plan participants from an account-management standpoint.

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2. Growth vs value equity: What now?

Does value-style equity investing now present a multiyear opportunity for investors, following a 10+-year bull run by its growth-stock brethren that saw such funds garner a mounting share of DC plan assets? While it may yet be too soon to declare an enduring market “regime change” from growth to value, we believe there are reasons to be optimistic about the sustainability of value’s outperformance prospects. And that could have implications for DC plan investment lineups and for end participants’ portfolio allocations.

Not only have we seen something of a revival in value stocks to lead off 2022, but it’s also worth noting that 2021 marked a strong year for value relative to growth. Even so, from a valuation perspective, we believe many value stocks have remained reasonably priced as compared to their growth counterparts: For example, we estimated the “cheapness” of US value stocks versus growth to be at its 98th percentile as of November 2021. Forward-looking valuation projections from some sources also appear to be attractive as of this writing. In addition the value style’s historical resiliency in past inflationary settings would seem to bolster the case for value these days (Figure 2).

Early 2022 has witnessed a sharp pullback across much of the US equity market, with large growth stocks generally experiencing more downside volatility than their value cousins. Whatever lies ahead for the two camps, we believe value can continue to serve as a strategic portfolio diversifier through a variety of economic and market regimes. We believe plan sponsors should encourage their participants to periodically revisit (and perhaps adjust) their exposures to the two equity styles. This may also be an important consideration for sponsors that “white label” their DC plan’s equity offerings.

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3. Fixed income: Is it time to rethink?

Fixed income investments are often a cornerstone allocation for many DC plan participants, especially those nearing retirement. However, given today’s challenges, we also think the expected role of a ”core” fixed income allocation needs to be different now than it’s traditionally been for participants in years past.

We’ve seen a downward trend in bond yields broadly amid fairly tame inflation for the better part of the last few decades, particularly in US credit, resulting in a potentially more muted return profile for core/capital preservation-oriented fixed income assets. While most yields remain relatively low by historical standards, some have begun to creep up lately in anticipation of stubborn inflation and likely interest-rate hikes by the US Federal Reserve (Fed) and other central banks. Taking all of this into account, plan sponsors might consider reassessing their fixed income offerings to help plan participants get the most from this bedrock asset class.

• Do more for the core: Core/core-plus options remain the centerpiece of most DC plans’ limited fixed income menus, but we frequently see their role being “overstretched” to try to meet too many investment objectives for participants. We believe it will be increasingly essential to support your core fixed income offerings with a potentially higher-returning allocation, such as high-yield bonds or maybe a rotational/diversified approach that seeks absolute returns from several fixed income sectors.
  
• Case for custom?: Unlike equity investments, plan participants may not always fully understand the role that each fixed income component is supposed to play in their overall allocation. As DC plans have continued to grow in size, there has been greater interest in developing more customized approaches, comprised of multiple underlying “building blocks” (Figure 3).  This way, plan sponsors can leverage specialist asset managers for each fixed income sleeve and deliver a diversified, white-label offering that can act as a “catch-all” for fixed income exposures.

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Final thoughts

Equipping DC plans with the tools to succeed over the long term often requires being able to adapt to ever-changing economic and market conditions. The suggestions provided here may be a good place to start in the current environment.

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