The cost-advantaged bond indexing strategies that sponsors are clearly favoring may be challenged in an era of rising interest rates, and mounting uncertainty in global economies, says Christine Stokes, managing director, head of DCIO Strategy for Nuveen.

“When it comes to bonds in TDFs, most allocations are tied to Barclays,” said Stokes, referring to the Bloomberg Barclays U.S. Aggregate Bond Index, or “the Agg” in asset management parlance.

“In some ways that strategy makes sense. But we're also seeing a lot of plan fiduciaries that aren't monitoring the underlying exposures in the Agg,” she said.

The Agg index is comprised of thousands of bonds and includes the largest issuers of government and private debt.

But the index has a high and growing concentration in U.S. Treasuries—38 percent today, compared to 25 percent a decade ago.

U.S. and other government-issued Treasuries can be sensitive to rising interest rates, explained Stokes. Moreover, the index does not include high-yield corporate debt or emerging market debt, two sectors that have historically fared well in periods of rising interest rates.

Balancing fiduciary risk and participant outcomes

Lower-cost TDFs have been a hedge against plan sponsor fiduciary risk. A spate of excessive fee lawsuits against sponsors of defined contribution plans was accelerated after new fee-disclosure rules came into place in 2013, noted Stokes.

That trend synchronized with the post-financial-crisis economic recovery, and a period of historically low interest rates that spurred a bull market in equities, now in its 10th year.

“It was safe for a sponsor to say 'well I'm just benchmarking' a TDF strategy,” said Stokes.

Modest GDP growth during much of the bull market was dubbed the “new normal.” For most of the run-up in equities, interest rates were hovering around zero.

Going forward, the new normal may be the abnormal. Before the pressure equity markets suffered in the fourth quarter of last year, consensus speculation assumed the Federal Reserve would resume its path of normalization and continue to hike rates.

At the most recent meeting of the Federal Open Market Committee, interest rates were held steady after 11th hour speculation they might actually be lowered.

“After the last Fed meeting, I don't think we can say anything is certain—in fact, I think what we can say is the interest rate climate is uncertain,” said Stokes. “In periods of uncertainty, we need to understand how fixed income is intended to work in different market climates so investment menus can be aligned appropriately for participant outcomes. And we need to make sure we're not on autopilot when it comes to TDFs.”

In the context of participant outcomes, industry's multi-year focus on fees could be challenged under the new uncertainty.

“A focus on fees can only get us so far,” said Stokes. “Saying benchmarking is the right way without looking at plan demographics and market cycles is incomplete. If you are prioritizing litigation risk, then that argument may hold true. But under ERISA, a fiduciary's focus is to do what's best for a participant. If the focus is on participant outcomes, then benchmarking bond allocations to an index may not be the safest approach.”

4-part test for a TDF's bond strategy

In seven periods over a 9-year span beginning in 2009 that saw the 10-year Treasury yield rise by 75 basis points or more, total returns for high-yield U.S. debt averaged 6.93 percent, and emerging market debt averaged 0.38 percent. U.S. government debt, U.S. investment grade debt, TIPS, and international debt each posted negative returns.

TDFs relying on the Agg would have been hurt, particularly the vintages close to or at retirement, which can hold up to 70 percent of assets in fixed income and cash.

“There's always risk, but the role of fixed-income is to mitigate risk,” said Stokes. “A lot of plan fiduciaries are comfortable evaluating equity sector risk. We want to provide tools to help evaluate fixed-income risk.”

That evaluation can begin with a four-framework assessment, said Stokes. Beyond diversifying outside the limits of an indexed strategy and considering interest-rate sensitivity, sponsors should consider how TDF bond allocations fare in up and down markets, and consider the skill and experience of portfolio managers.

Within the TDF universe, there's wide dispersion on how fund managers manage risk as vintages approach retirement age.

Beyond equity and fixed income splits, the duration of bond allocations has wide variance, said Stokes. In a rising interest-rate climate, portfolios with shorter duration may prove beneficial for near-retirees, who can ill-afford to suffer lackluster returns on fixed income.

“There are glide path managers that take very different approaches to risk management near or through retirement,” said Stokes. “That can have an influence on duration and other fixed income characteristics. Near retirees will feel the fluctuation much more, and won't be able to recover if they're invested in bonds with longer duration.”

Nuveen manages TDFs with active and passive bond strategies. The firm encourages all fiduciaries to conduct a thorough peer review, said Stokes. But the introduction of more uncertainty warrants a deeper review of TDF offerings to optimize participants' savings outcomes.

“It underscores the critical importance of an ongoing fiduciary review of all investments,” said Stokes.

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