After a year of exceptional returns in 2019, gathering headwinds could hinder retirement plan returns in 2020 and beyond, according to Retirement Outlook 2020 from MFS Investment Management.
“We estimate that a hypothetical portfolio of 60% equities and 40% bonds will have a 10-year annualized return of approximately 3.6% [over the next 10 years] as compared with a return of 7.2% over the past 10 years,” say report authors Jon Barry, senior retirement strategist, and Jessica Sclafani, DC strategist, at MFS in Boston.
Barry says this is an educated estimate based on research. On the equity side, “We feel good about sales growth and dividends, but we don’t feel as good about corporate margins and profits and just valuations in general,” he says. “Stocks are trading at a very high price-to earnings ratio, and we don’t see that as sustainable. With the trade wars, and as unemployment remains low and wage growth cuts into margins, companies will be restrained.”
As for fixed income, Barry says, “Rates are historically low, and we don’t see anything in the near term that will make rates move higher in a meaningful way. Starting yields are a good predictor of where returns will be. Treasuries are yielding around 2%, and it’s not unreasonable to expect the same,” he says. “Central banks in the U.S. and around the world have extended a lot of resources available to keep the positive cycle going. We question how much they have left to do to keep it going.”
The report notes that defined contribution (DC) plan sponsors made substantial allocations to passive investment strategies over the past decade, mostly due to costs concerns. But, it says, “The new year presents an opportunity for sponsors to revisit their allocations to active investment strategies, which could offer additional returns in a low-growth environment and provide some level of risk management when the current cycle comes to an end. These characteristics of active management will be particularly crucial for participants approaching retirement, who are vulnerable to sequence of returns risk.”
As participants approach retirement, common wisdom is to move to more conservative investments, but considering the low interest rate environment’s effects on fixed income investment vehicles, Barry and Sclafani suggest plan sponsors also revisit participants’ fixed income investments, including both core options on the DC plan investment menu and fixed income allocations in qualified default investment alternatives (QDIAs) such as target-date funds (TDFs).
Sclafani notes that traditional U.S.-based core (and core plus) fixed income funds have been the most prevalent in DC plans. “We think because of the low-rate environment and other reasons, plan sponsors should broaden and diversify access to fixed income investments in their core investment menus as well as TDFs,” she says.
To broaden and diversify access, Sclafani suggests plan sponsors should consider global bond and global opportunistic funds. “Participants approaching retirement are generally increasing their fixed income exposure, but they are also increasing their exposure to interest rate risk. If all of their fixed income investments are in core or core plus vehicles, that exaggerates their interest rate risk. If they diversify with global opportunistic strategies, they will get a different interest rate exposure from a geographic perspective,” she says.
Barry says that having a good short duration bond fund in a portfolio is important. “Look at high-yield bonds and emerging market debt for potentially higher yields, not just for those nearing retirement, but for all participants,” he adds. He warns that these investments also come at a higher risk so plan sponsors should very thoughtfully add them into the investment lineup. Barry also suggests considering Treasury Inflation-Protected Securities (TIPS) for inflation protection.
“We’re not advocating that sponsors necessarily add these investments as standalones on the investment menu,” Sclafani says. “Consider mixing them into other strategies, such as a white label fund or TDF.”
Sclafani mentions a survey MFS fielded in the first quarter of 2019 of approximately 1,000 DC plan participants who were approaching retirement. While a majority of the participants identified the need to increase their focus on fixed income as they age, only about 20% answered that they were likely to add to their fixed income investments.
According to the MFS Retirement Outlook 2020 report, “We view this disconnect as an opportunity for sponsors to support participants approaching retirement by packaging their fixed income for them.” Sclafani says this includes white label funds and TDFs, as she mentioned. “The obvious construct is in the plan’s QDIA. We encourage plan sponsors to review their TDFs and take a deep dive into the fixed income allocation—not just the level of fixed income allocations along the glidepath, but the components of the fixed income allocations,” she says.
The percentage of DC plan sponsors with a policy for retaining the assets of terminated and retired participants in their plans has increased steadily since 2015, according to the Callan 2020 DC Trends Survey. Sclafani says this is true particularly in the mega plan market. And, to help participants with decumulation strategies, more DC plan sponsors are including income solutions in their plans. A survey from Willis Towers Watson found that among those that offer a lifetime income solution, the most common is systematic withdrawals (80%), followed by lifetime education and planning tools (70%) and in-plan managed account services (44%). Only 17% offer an in-plan asset allocation option with a guaranteed minimum withdrawal or annuity component. Fifteen percent support out-of-plan annuities, and 15% offer in-plan deferred annuity investment options.
“Sometimes the industry equates retirement income solutions with annuities, and that is not the case,” Sclafani says. “To make a DC plan a retirement income vehicle, plan sponsors should review plan distribution options, consider offering managed account programs with financial wellness components, and make advice available to participants approaching retirement age. This is when participants are more engaged and looking for advice.”
A BlackRock analysis suggests that given some negative views of annuities, plan sponsors could consider in-plan income options that are not guaranteed.
“A lot of it comes down to providing education and tools,” Barry says. “Even for younger folks, if we’re looking at a lower-return environment, DC plan participants need to think about saving more or deferring retirement. Plan sponsors should make sure they have the tools or access to advice to model outcomes and to help participants think through their strategy for taking Social Security.”