DC investing themes: Our big three for 2023

In the wake of an eventful 2022, 2023 has so far delivered yet another unique market environment for investors. Stubbornly higher inflation, heightened market volatility, unsettling geopolitical strife, and recent turmoil in the banking sector 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) plan sponsors and participants.

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 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 2023 and perhaps beyond.

1. Defending against the silent thief: Inflation

After lying dormant for much of the past three decades, global inflation has once again reared its ugly head in recent years. How might the reality of higher (and potentially “stickier”) inflation impact plan participants’ ability to pursue 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. Plan sponsors should consider the insidious and very real threat 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 meaningfully erode a portfolio’s purchasing power over time, further raising the risk facing retirees.

The potential drag on portfolio return potential is evident in both the equity and fixed income markets. With equities, persistent inflation can exert downward pressure on corporate earnings and market valuations, while rising rates often have a major impact on fixed income outcomes. In 2022, for example, the S&P 500 Index and the Barclays US Aggregate Bond Index fell 18.1% and 14.6%, respectively. In contrast, a blended multi-asset inflation index ended 2022 with a positive (4.9%) return. 

Figure 1 illustrates how participants would have fared by retiring at different points in history. It is important to note that when you retire, how risk assets (primarily stocks) perform in the ensuing years ultimately matters less than how high inflation is during your retirement years:

• Retiring in 1929 (the start of the Great Depression), you would have been hit with a massive equity market drawdown (-27% annualized from 1929 – 1932) and an annualized market return of only 3.2% for the next 30 years. On the plus side, inflation was historically low over this timeframe, blunting its impact on purchasing power and retirement asset growth. 
  
• Conversely, retiring amid the credit crunch of 1966, you would have benefited from a 10.7% annualized equity market return during a 30-year retirement, but those gains would have been eaten up by high inflation throughout. The result: You would have run out of money before the 1929 retiree would have. 
• Looking at more recent periods, 2000 (tech bubble) and 2008 (global financial crisis) would have been relatively good years to retire, as low inflation and solid equity market returns have led to more stable retirement account balances. Unfortunately, 2022 marked the largest equity drawdown that a 2000 or 2008 retiree has lived through (in both real and nominal terms). 

There are two mechanisms through which high inflation negatively impacts retirement assets: (1) it directly erodes asset returns and account balances by lowering spending power; and (2) the response to it is often higher interest rates, which tend to adversely affect both stock and bond allocations. This second point is what we observed last year, and why 2022 proved to be so costly in nominal terms.

Figure 1

We believe today’s outlook for continued higher inflation should prompt plan sponsors to reevaluate their core investment menus for adequate inflation-hedging solutions. For example, a multi-asset offering that includes TIPS, natural resource equities, gold, and other commodities may make sense as a portfolio defense against inflation’s harmful effects on many stocks and nominal-yield bonds. In our view, the simplicity of an investment approach that bundles these types of assets together may appeal to many plan participants from an account-management standpoint.

2. Growth vs value equity: The state of the debate

Does value-style equity investing now present a multiyear opportunity for investors? While 2022 saw value stocks demonstrate greater resilience than their growth-style brethren, it may yet be too soon to declare an enduring market “regime change” from growth to value. However, we believe there are reasons to be optimistic about the sustainability of value’s outperformance prospects. And that could have important implications for DC plan investment lineups and for end participants’ portfolio allocations.

Not only did value stocks experience something of a revival during parts of 2022, but it’s worth noting that 2021 also 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 2022. Forward-looking valuation projections from some sources also appear to be attractive as of this writing. In addition, the value style’s historical advantage in past inflationary settings would seem to further bolster the case for value stocks these days (Figure 2).

2022 witnessed a sharp pullback across much of the US equity market, with large-cap growth stocks generally suffering 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 suggest that plan sponsors encourage their participants to periodically revisit (and perhaps adjust) their exposures to the two equity styles. This may also be a relevant consideration for sponsors that “white label” their DC plan’s equity lineup.

Figure 2

3. Supporting the retiree participant tier

Many retirees face a steep challenge when planning for and funding their retirement. In our view, most of the currently available investment options often leave them prone to using expensive portfolio allocations that may not provide the necessary tools to preserve and grow capital through decades of retirement. Perhaps more importantly, the combination of lackluster retirement savings, “under-risked” income options within target-date portfolios, and insufficient protection against inflationary or volatile market environments has amplified the risk of many participants failing to generate the reliable stream of retirement income they may need.

Notably, we believe today’s retirees face three key risks, which most current plan investment options have yet to address to our satisfaction:

• Sequencing risk: Retiring in a down market and being forced to sell assets that may have lost significant value can have a profound negative impact on investors who are close to retirement.
  
• Longevity risk: As life expectancies continue to increase, most investors today should plan to spend at least 20 or more years in retirement and thus need to plan ahead accordingly to minimize the risk of potentially outliving their retirement asset base.
• Inflation risk: As discussed in more detail above, the specter of inflation remains a formidable threat to investors’ cost of living and retirement security over time, with the obvious implication that appropriate measures should be taken to combat it.

Portfolios that address these risks, while aiming to deliver attractive risk-adjusted total returns and consistent income (without depleting the capital base), may be better geared toward serving the retiree and near-retiree segments of your plan population. As Figure 3 shows, adding only a downside protection or mitigation option to a plan’s investment menu can be a first step toward increasing participants’ sustainable real withdrawal rates in retirement.

Figure 3

Participants only get one shot at a successful, fulfilling retirement, so we believe it’s worth putting the right investment pieces in place to help them achieve that goal.  

Final thoughts for plan sponsors

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