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Retirement Perspectives

Sector concentrations and investment processes may blur the distinction. Understanding the potential overlap is essential.

Defined contribution retirement plan menus must continue to evolve in line with the changing concerns and demographics of plan participants, as millions of baby boomers approach the end of their careers and retire each year. Investment menu options must, then, focus on the anxieties of participants who are saving for retirement as well as those of current retirees who need income.

As this background continues to change, one factor has become increasingly important: the consideration for diversification. On average, retirement plan menus consist of roughly 16 funds. Of those, typically 14 are equity options and two are fixed income. In the majority of defined contribution investment menus, an intermediate-term bond and stable-value strategy are the primary fixed-income options available to participants.

So, where is the diversification among fixed-income options? Therein lays the opportunity for a single, diversified, multi-sector fixed-income strategy to offer clients exposure to all sectors of fixed income. But how do you make the decision on which strategy to utilize? Below are four questions that can help inform the conversation among defined contribution investment committees about investment menu diversification regarding the multi-sector category. 

1. Is your multi-sector strategy truly diversified?

A closer look at the Morningstar multi-sector bond category reveals that there are 94 different mutual funds (when screened for multiple share classes) with significant variances in duration, sector weights, and credit qualities. The differentiation in styles and exposures is striking:

  • 338 funds, totaling $200.18 billion in assets
  • 94 funds in the category when screening for multiple share classes of the same fund
  • Average effective duration for funds in the category ranges from 1.2–11.2 years
  • Corporate bond allocations range from 0–99.5%
  • Non-investment-grade bond allocations range from 0–94.5%
  • Asset-backed security allocations range from 0–96.6%
  • ‘AAA’ rated securities range from 0–67.2%

Together, these statistics should prompt plan sponsors, advisors, and consultants to ask themselves: “Is the multi-sector strategy I’m implementing truly multi-sector?” It is essential to recognize that the sector concentrations and processes used by investment managers may, by disguise, effectively turn a multi-sector bond fund into a corporate bond fund, a securitized debt fund, or a high-yield fund.

2. How stable is the duration of the multi-sector option?

A particular feature of the multi-sector category is that it allows managers latitude to pursue whatever they see as the greatest investment opportunity. As a result, the average effective duration of a multi-sector bond fund may fluctuate significantly. This, though, can be problematic for defined contribution plans, as stable-value managers may enforce covenants related to the duration of other fixed-income options in the investment menu. It is not uncommon for some multi-sector bond funds to see their average effective duration drift below three years.

3. What evaluation method is appropriate for this category?

When plan sponsors select strategies for their investment menu, many of them (with the help of their advisors and consultants) will primarily use screening models based on any number of metrics prescribed in their investment policy statement. Much of the rationale for a decision often comes down to performance rankings among the peer group. Unfortunately, the wide range of styles and exposures in the multi-sector category means that peer-group rankings do not provide the full story of how a particular strategy may perform over a full market cycle. It is important, then, to consider how investment managers report portfolio holdings. Managers may report holdings based on actual position percentages or duration-weighted percentages, which may further complicate the discussion, particularly when addressing the next question.

4. How significant is the overlap with other fixed-income investment options?

When adding or changing a multi-sector strategy in a retirement plan, it is necessary to understand how the new strategy will work with the rest of your investment choices; this is of particular importance when considering an intermediate-term bond investment option.

One of the most common reasons for utilizing a multi-sector strategy is to complement an intermediate-bond allocation. But are these strategies all that different? A quick review of the Morningstar intermediate-term bond options reveals the following:

  • Average effective duration for funds in the category ranges from 2.3–7.3 years
  • Corporate bond allocations range from 0–95%
  • Asset-backed security allocations range from 0–47.9%
  • Non-investment-grade allocations range from 0–66.7%

Understanding the potential overlap in sector allocations is critical, especially when there are shifts within the fixed-income market. There are numerous performance-related issues that should be taken into account, including economic trends, credit cycles, interest-rate moves, and risk-on/risk-off environments. In light of these considerations, plan sponsors should be sure that their fixed-income allocations are strategically aligned with the crucial goal of diversification.

The multi-sector category continues to gain significant traction in 401(k) menu designs for a variety reasons. First, it provides plan participants with access to multiple sectors of fixed income through a single-plan investment option, allowing asset managers to provide immediate diversification as well as the ability to potentially generate higher returns than a pure intermediate-bond allocation. In addition, the flexibility of a multi-sector strategy may provide  downside protection and stability when certain sectors of fixed income move in and out of favor. Finally, a multi-sector strategy can relieve an advisor of the possibly daunting decision of where to position his or her clients in fixed income as the market changes.

Evaluating investment choices in the multi-sector category is another matter. Given the options available, advisors and consultants should take additional steps to better understand how their selection will affect the rest of their investment lineup. Evaluation should involve more than simply looking at performance numbers and rankings over key time periods. After all, this is an opportunity to add a strategy that most likely will benefit the participants over the long term. When deciding which strategy to implement, we believe it beneficial to consider the four above questions as a framework for an advisor’s discussion with the plan’s investment committee.

With so many participants now moving past the accumulation phase in their 401(k), it may be time to pursue an actually diversified multi-sector income strategy to bolster clients’ cash flow during retirement. The current demographics—with a large pool of retirees staying within their employer-sponsored plans—help to underscore a fiduciary responsibility to provide a prudent alternative to participants who may be leery of the equity market.  Ultimately, the need for a more appealing income stream presents, as we’ve mentioned, an important opportunity for advisors and consultants to consider a multi-sector fixed-income strategy that can bolster their investment lineup.

 

This article has been prepared exclusively for use by analysts, institutional investors and their consultants, registered investment advisors, broker-dealers, and sponsors of plans with a minimum of 100 participants. It is not intended for, and should not be used with, small plan sponsors, plan participants, or the public.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

A Note about Risk:  All investments involve risks, including possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Stocks are subject to greater risk and market volatility, while bonds are subject to greater risk of default and interest rate volatility. Diversification does not guarantee a profit or protect against loss in declining markets.

All investments involve risks, including possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Stocks are subject to greater risk and market volatility, while bonds are subject to greater risk of default and interest rate volatility. Diversification does not guarantee a profit or protect against loss in declining markets.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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