focus on the result
At a high level, the problem boils down to managing duration. Asset allocation vehicles such as target date funds — which can be viewed as a version of a 60/40 portfolio with an asset mix that changes over time — tend to emphasize equities for younger investors and invest less in long-duration fixed income securities, which is a downside is an asset class often associated with meeting retirement savings needs.
As investors approach retirement age, target date funds reduce equity exposure and increase fixed income investments, which means they lengthen duration. Tyler Thorn, multi-sector portfolio manager at PGIM Fixed Income, said he believes this is the opposite of how duration should be managed.
“If you think about what your spending goals are when you’re young, you have a lot of spending very far in the future, so your investing goal requires a lot of duration,” Thorn said. “But as retirement approaches, the duration associated with these spending outflows is getting shorter, which means you should have less exposure to duration.”
The duration of a traditional target date fund is going in the wrong direction, he added. “Rather than starting low and increasing with age, it should start high and decrease with age. To rework the 60/40 construct, you need to correct this duration mismatch.”
Another element that comes into play when it comes to duration is the traditional view that equates it with additional interest rate risk, he noted. However, PGIM Fixed Income research has shown that adding duration can not only reduce interest rate risk for investors saving to meet future spending needs, but can also improve performance. This is due to the historical consistency of positive term premia – the excess return over cash based on a bond’s duration – and credit risk premia – factors for which fixed income investors are compensated, e.g. e.g. rating downgrades or liquidity events, among others.
Correct the mismatch
Portfolio construction clearly needs to change to address the duration mismatch between 60/40 portfolios and investors’ projected retirement spending. Using target date means as a framework, McCartan suggested these steps:
Start younger investors with increased allocations to equities and duration, ie more exposure to equities and longer duration of fixed income. Money managers could achieve the latter by using a longer duration fixed income benchmark.
Use futures contracts to get desired equity exposure instead of buying cash stocks. This low-cost move could free up cash to invest in credit instruments, which — for active money managers — tend to offer better alpha opportunities than stocks.
Shift the focus to reducing equity exposure and duration as the investor nears retirement. Both changing the benchmark and reconfiguring the duration mix of the fixed income allocation can reduce overall duration exposure.
The need to overhaul the 60/40 portfolio and the underappreciated role of duration have additional implications for DC plan sponsors and pension managers. By adjusting their strategic investment mindset and rethinking their plan offerings, they can better achieve their plan goals, Thorn said.
DC Plan sponsors must keep the investor’s retirement spending needs in mind when designing target date funds and retirement income strategies. “While performance sponsors have always been concerned with balancing portfolio life with future liabilities in the form of plan distributions, DC sponsors have not had to because their participants are responsible for their own investment decisions.”
However, Thorn noted, “DC sponsors have a tremendous impact on participants’ outcomes, not only because they decide plan design and select investment options, but also how they guide their participants about retirement planning in general and their plan’s options in particular enlighten . If sponsors don’t think the plan should exist to meet individual retirement spending needs, participants probably won’t think about it either.”
Thorn says revising the 60/40 allocation to address risk premia could also open up new opportunities for fixed income managers with robust credit capabilities. The emphasis on the terms premium and credit premium favors managers who have portfolio expertise across the credit spectrum and strong research staff who can add value through sector allocation and security selection.