As retirement plan participants begin nearing retirement
age, the risk-averse investor’s primary goal becomes capital preservation. That
can mean exchanging return for risk mitigation, usually by reducing the
allocation to stocks and adding to bonds.
However, a lot is happening in the bond market now, most
notably inflation at a 40-year high, pushing real yields to record low levels.
Surging inflation means a decrease in purchasing power but also led to the
first Fed rate hike since 2018.
In a rising rate environment, a broad market core fixed
income manager will typically struggle due to increased exposure to interest
rate risk. That risk, also known as duration, has ranged from 6.5 to 7 years
for the Bloomberg Aggregate Bond Index in 2022. This means that a 1% rate
increase will result in a percentage decrease of 6.5 to 7 percent in the index.
Safety in a defined contribution retirement plan may be
found in a stable value product due to a much shorter duration than the core
bond market. Many maintain a duration of approximately 2.5 to 3.0. At its core,
a stable value fund is a defensive fixed income portfolio, while the underlying
holdings are insured to protect the investor against negative fixed income
conditions.
In the current low interest, high inflation environment,
investors need to combat inflation’s eroding impact on portfolios while also
generating income. The challenge for bond funds is that they own bonds that are
worth less if all the new bonds offer higher yields. That’s why the prices of
bonds are down, and their returns are diminishing. Corporates, Treasuries,
mortgages, long term, short term, international – you name it, they are all red
this year.
Inflation-Fighting Assets
Common anti-inflation assets include commodities and natural
resources, real estate, and Treasury Inflation Protected Securities. These
asset classes come with challenges when looking to implement them in defined
contribution plans, particularly for the risk-averse bond investor looking for
inflation protection, as described above.
Commodities include grain, precious metals,
electricity, oil, beef, orange juice, and natural gas, as well as foreign
currencies and other financial instruments. Commodities and inflation have a
unique relationship, where commodities are an indicator of inflation to come.
As the price of a commodity rises, so does the price of the products that the
commodity is used to produce.
That relationship also carries some volatility. Commodities
are dependent on demand and supply factors, and a slight change in supply due
to geopolitical tensions or conflicts can adversely affect prices.
Exposure to rising commodity prices as a hedge against
inflation or for capital appreciation is a challenge for defined contribution
plan investors. Access may come through direct investment or through commodity
futures. Direct investment outside a defined contribution plan may work well
for smaller investments in precious metals, but it quickly becomes impractical
in most other types. A fund-based approach may be used by a defined
contribution plan using commodity futures but can carry significant volatility
and can be negatively impacted by the cumbersome need to roll into new futures
contracts as existing contracts near expiration.
Natural resource investing includes anything mined or
collected in raw form. Natural resources may go through further processing –
say, cutting a tree into 4x4s, 2x10s, 2x4s, and so on – or simply be cleaned up,
packaged, and sold (a barrel of oil or a bottle of water). Natural resources
can act as stores of value, especially during rising inflation or currency
depreciation.
Access to natural resources can be through direct
investment, as with commodities, but this approach is impractical for most
investors, mainly defined contribution plans. Access for defined contribution
plans may come through the natural resources equity sector, which includes the
extraction of metals, coal, metallic ore, sand, gravel, and oil shale. It may
also include logging and drilling for oil and gas.
Unfortunately, when it comes to inflation fighting, natural
resource funds don’t always behave the same way as the natural resource itself.
The notion that a natural resource company shares behave differently from the
underlying commodity may seem puzzling. Why wouldn’t the price of, say, copper
be the largest factor in the price movements of a copper producer?
There are fundamental differences between these two asset
classes that cause their price levels to move independently. Most notably,
company-specific factors will influence an organization’s stock price, but not
the price of the underlying commodity. While stock prices will change to
reflect company-specific changes in dividend policy, corporate governance, or
earnings potential, there’s no reason to expect that this will have any impact
on the associated commodity.
Other challenges for investing through equities include the
regulatory environment for natural resource stocks and the tendency for equity
prices to move together as an asset class. Many natural resource-related
companies are aware of their commodity exposure and may actively hedge away
this risk using forward price agreements or other instruments. While this
doesn’t wholly immunize these companies from the price impacts of the
underlying natural resource, it diminishes the relationship between a company’s
profitability—and, indirectly, its share price—and the price of the underlying
commodity.
This disconnect between natural resource prices and the
performance of natural resource company stocks causes inefficient exposure when
used in defined contribution plans through natural resource mutual funds.
Real estate investments – offices, apartment
buildings, warehouses, retail centers, medical facilities, data centers, cell
towers, infrastructure, and hotels, as a class – have traditionally had the
characteristic of performing well in an inflationary environment. The assets
have several benefits during periods of high inflation, including appreciation
as property values keep pace with inflation, fewer real estate development
projects due to rising labor, material, machinery, and other costs, and
increasing rents.
Implementation into a defined contribution plan continues to
be a challenge for this asset class. Like other inflation-fighting asset
classes, direct access to real estate – owning actual properties – is the most
effective and least volatile. Still, in the daily-traded, liquid environment of
defined contribution plans, direct ownership is difficult.
Defined contributions plans may implement real estate access
through investments like Real Estate Investment Trust (REIT) funds. REITs are
companies that own and operate income-producing real estate. However, there are
drawbacks. As stocks of companies, not direct real estate, the performance of
REITs tends to be much more volatile than direct real estate. REITs are also
sensitive to rising interest rates.
REITs also have a high correlation to the broad stock
market. From 1972 to 2018, REITs have had a slightly higher average total
annual return than the U.S. Total Stock Market (11.4% vs. 10.3%), but also a
higher average standard deviation (16.9% vs. 15.5%).
Treasury inflation-protected securities (TIPS), a
type of U.S. Treasury bond, are indexed to inflation to explicitly protect
investors from its impact. TIPS adjust the amount investors receive based on
changes in the consumer price index. Twice a year, TIPS payout at a fixed rate.
The principal value of TIPS changes based on the inflation rate, and so the
rate of return includes the adjusted principal. This means that investors get
paid more as inflation rises.
Despite the inflation protection, an overall rise in
interest rates will still feed through to the TIPS market, putting downward
pressure on prices. In addition to the changing expectations for inflation, the
Fed’s stepping back from the quantitative easing is removing a massive source
of demand that had pushed yields down.
We have and are going through a period when the investment
environment has changed, and expectations are that returns on multi‑asset
portfolios are likely to be lower than they have been in the past.
Investors still actively in the workforce have greater
choices. The first—and likely least attractive—is to simply save more.
Investors can save more or delay retirement, which in effect will decrease the
level of wealth required in retirement.
The second option is to focus on increasing exposure to
growth-seeking assets through more equity or higher-returning segments of the
fixed income market. This approach can boost long-term portfolio return
potential by increasing the level of market risk within a portfolio either
through adjusting the balance of assets between equity and fixed income or
adjusting within asset classes.
A third option to address lower return expectations is to
adjust spending in retirement. Research on retirees’ spending habits reveals
that retirees tend to adjust their spending to their income.
Still, getting investments right is critical. Moving into a
period of lower expectations for returns reduces the margin for error.
Retirement plan investors may consider the following to increase their chances
of success:
Understanding that successful retirement outcomes
necessitate a long-term investment perspective.
Diversifying across both equities and fixed income to pursue
excess returns.
Focusing on investment options that have the potential to
perform well in a variety of market environments.
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