P&I: In the current environment, what are some benefits of assets like Treasury inflation-protected securities, commodities and real estate investment trusts to mitigate inflation risk?
THOOFT: We include a variety of real assets and alternatives in our target-date solutions, more than most of our competition. We have exposure to TIPS and REITs, inflation infrastructure exposures and diversifying alternatives, such as a long/short currency strategy. We invest in several real assets and [include them in] a package that we use as part of our glidepath. The proportion and profile of those assets change and become more significant as you go down the glidepath, but they also become more conservative in the types of exposures we use that target inflation protection. For example, there are more TIPS relative to equity-like real assets in the near-retirement portfolios versus those that are further out. Inflation is a risk for our clients in managing for retirement, whether that was 10 years ago or today.
BALAKRISHNAN: For long-term investors, equities provide better inflation-adjusted returns and far-dated funds have a sizable allocation to equities. In the near-dated funds, there is a sizable portion of nominal bonds which do not do well during inflationary environments. TIPS can provide direct inflation protection in those funds. Usually, in a high-inflation environment like the current one, central banks will act to counter inflation by raising rates. Commodities and REITs are sensitive to rising rates and, hence, that makes them volatile over the full cycle. TIPS have a duration component that makes it sensitive to rates as well, but that can be controlled by combining TIPS with stable value. At MissonSquare, we believe that a combination of TIPS and stable value can provide better inflation protection in near-dated funds. In an environment where inflation is the primary driver for both equity and bond market downturns, stable value can preserve capital and TIPS can provide the inflation accruals.
MARTEL: We particularly like two aspects of using these types of assets. The first one is diversification. As the correlation between stocks and bonds typically goes up when inflation is high or rising, the addition of inflation-sensitive assets, as a complement to stocks and bonds, can create more resilience in target-date funds given that those investments’ diversification properties and correlations tend to hold better in those types of markets.
The second is inflation protection. While this may sound obvious, we think this consideration is not reflected to the extent that it should be in most target-date funds. Case in point, the average exposure to real assets for the 10 largest TDF providers only ranges from 2% for younger participants to 9% for those in retirement. We believe target-date funds ought to have more significant allocations to at least some of these inflation fighters, especially given that the primary objective of retirement saving is to maintain a given standard of living in retirement.
P&I: How would long-term, higher-than-average inflation expectations change asset allocations for TDFs?
MARTEL: It depends. If you had the proper amount of inflation protection in your glidepath going into that higher-inflation environment, then you don’t need to make drastic changes. You would be prepared for it. For example, our flagship TDF product already had a meaningful allocation to inflation-protection assets — approaching 20% in the retirement vintage.
However, as I mentioned earlier, many [other] providers have much lower allocations to inflation-sensitive assets and may need to take a closer look at this aspect. It would not be surprising if a period of elevated inflation led to more significant inflation-protection allocations. Another option might be to take a bigger swing with equity allocations in the hope that higher returns will wash out that problem. But this may not be prudent, because many target-date funds already run high allocation to equities, so the response is on inflation-sensitive assets, not more risk.
THOOFT: Our view is that while a decent amount of inflation is related to the current macro environment — the drivers of supply-chain issues, lack of labor supply and the Russian war against Ukraine — a portion of it is transitory. We believe that inflation is something that gets embedded in the psychology of people. The longer it sticks around, the harder it is to combat. We also believe that a portion of it is structural; and so, based on how we think about target-date portfolios, we have the active ability to have greater exposure to those types of assets that would benefit in a more structural environment for higher inflation. Many of those are the ones we talked about earlier as a portion of the overall portfolio. Are we going to change the glidepath? No, not necessarily, but we’ll be overweight those asset classes during the period where it is appropriate from an inflationary-concern perspective.
BALAKRISHNAN: While recent events have increased short- and intermediate-term inflation expectations, long-term inflation expectations have not moved much, so we don’t see the need to make strategic changes to allocation. But if we were to expect long-term inflation expectations to move higher from where we are today, we would add to equities and alternative investments.
The extent and type of equities would depend on the nature of the forces that are driving inflation up. At MissionSquare, alternative investments comprises of private equity, private real estate and private credit.
P&I: How do low real rates on fixed income affect glidepaths and capital preservation? With the Federal Reserve’s tightening, does that meaningfully change returns that are more beneficial to TDF investors?
BALAKRISHNAN: Real rates have been low for more than a decade now. Most of the glidepaths have adjusted by adding more equity and, within fixed income, by adding more credit. If the Fed can get to a new normal where inflation is around 2% to 2.5%, the cash rate is above inflation and the U.S. economy grows by 2.5% to 3%, then allocation to bonds will be meaningful to target-date fund investors who are approaching retirement and to retirees. [That’s] for two main reasons: One, bonds provide better inflation-adjusted yield; and two, they offer better diversification benefits to equity allocations, which will help increase returns for retirees.
THOOFT: We have a couple of different glidepaths available to our clients. We offer a more conservative glidepath that is more focused on risk aversion and downside protection. However, our most popular glidepath focuses on longevity, or minimizing longevity risk. To address that, Manulife is one of the few vendors that have historically maintained a high amount of equity through the glidepath. There has been a shift where other target-date vendors are moving their equity weights higher. [But] we have not had to do that because our equity weights have historically been in the range that we felt necessary to minimize two significant risks throughout the glidepath and into retirement, which are longevity mitigation risk as well as the under-saving risk that many participants exhibit.
Even today, those expected returns for traditional or government-backed bonds, particularly in the U.S., are only in the 2.3% to 3% range, which is still below what most clients are looking for from a withdrawal perspective. For strategies with large allocations to fixed income, there may be a need to ensure their allocations are appropriate and that the expectations of return outcomes are more aligned with the potential outcomes that retirees expect.
MARTEL: In the near term, the Fed tightening is a headwind to asset returns, not just on bonds but on equities too. However, this repricing has pushed fixed-income yields higher, and investors are starting to see attractive bond yields again. Higher and healthier yields are good news for most savers and retirees with a sufficiently long horizon. It is good news because the real yield level is inversely related to how much wealth you need to produce a certain amount of retirement income. So, as painful as this tightening is in the short run, it is a silver lining when saving for retirement because it means that a given amount of savings can produce a higher level of real income in retirement and, potentially, increase the longevity of assets in the decumulation phase.
P&I: Are there other critical risks that DC plan defaults — which are typically target-date solutions — are contending with or should anticipate?
MARTEL: We believe that asset returns over the next 10 years are likely to be lower than in the prior 10 years. If return outcomes turn out to be lower than assumed in the glidepath construction process, participants are more likely to fall short of income replacement ratio targets, especially with target-date funds built around more aggressive return expectations. However, solutions are available to mitigate that risk. For example, increasing the degree of active management within the target-date fund could help DC plan participants get closer to their objectives, despite potentially lower market returns.
Another risk that we are keeping an eye on is the potential for elevated performance dispersion between different TDF offerings as we are entering a more challenging market cycle. In that context, target-date solutions with better diversified glidepaths, with more explicit protection against inflation and with downside risk management like tail-risk hedging are likely to fare better and exhibit less dispersion versus the universe.
BALAKRISHNAN: Longevity risk is one key risk that participants face, and target-date solutions will only work to address this risk if investors can contribute enough in the accumulation phase. Many participants may not have sufficient savings in their retirement account. The lack of contributions might impact the participant’s ability to meet their retirement spending needs. Frequent market downturns may cause investors to invest more conservatively, and this further increases the longevity risk.
There is a need to generate more returns without taking on too much additional risk. A strategic allocation to stable value and alternative investments may help achieve that goal. Stable value provides a return very similar to short-term bonds but preserves capital.
Alternative investments like private equity, private lending and private real estate have been used by pension funds for many years to generate higher risk-adjusted returns. But there are challenges when you try to introduce them in target-date funds such as: How do you value the investments daily? How do you invest the capital that is committed but not called? How do you allocate between various alternative investments to minimize risk? How do you set the liquidity buffer? Despite the challenges in introducing alternative investments to target-date funds, they could be a good addition because they provide better risk-adjusted returns than their public counterparts.
THOOFT: What has become more prevalent in discussions is that while it was a safe bet over the last 10 years to have very simple exposures — the S&P 500 and traditional fixed income — as the critical drivers of your return profile in a target-date fund, it may not be the same approach that will drive success in the future. The biggest positive-return drivers were U.S. equities and U.S. fixed income, so a traditional 50/50 balanced fund worked quite well. We believe that having more tools in the target-date fund toolkit is important for the next 10 years. The ability to express more granular views and to bring diversification through alternatives, such as real assets, bank loans and emerging market debt — where we see better valuations and spread capabilities — are all positive ways to help deliver on investors’ return objectives going forward.
P&I: How are active and passive strategies evaluated for inclusion in a target-date solution today?
BALAKRISHNAN: History suggests that active outperformance is cyclical in nature. We do not know if active or passive will work in the next 10 years. Being 100% invested in active strategies or being 100% invested in passive strategies is a risky position to take. Also, if you analyze asset class performance historically, it is easier to beat the indices in some asset classes versus others. For instance, it is tough to beat the index in core U.S. equity. But in emerging markets, international developed, U.S. small-cap and some fixed-income strategies, active managers have more opportunities to beat the index, either due to less coverage or more inefficiencies to act upon. So a blended approach, active in some asset classes and passive in others, or a combination of both within one asset class, may be more prudent and less risky.
THOOFT: We have several target-date products available in the marketplace: passive, active and hybrid versions. We believe that certain asset classes have inherently better outcomes, either through an active approach or a passive approach, based on their nature. For example, because fixed-income markets are less efficient, a more significant percentage of our fixed-income allocation generally is active versus passive.
On the equity side, we believe there are reasons to use passive in some cases, because it is cheaper, low cost and efficient, and there are reasons to use active in other cases. For asset classes like alternatives and real assets, we find active to be the better opportunity because our view is that there are not a lot of accessible, efficient, high-quality passive alternatives.
MARTEL: We tend to forget that right after the enactment of the Pension Protection Act of 2006 [the legislation that propelled target-date solutions], a large majority of TDF implementation was active. Since then, the pendulum swung materially towards passive approaches. But we believe we are now entering a period of recalibration towards better equilibrium, as investors have realized that it does not have to be all one or the other. Participants can really get the best of both worlds with approaches that use passive where it saves and active where it pays.
In order to optimize participant outcomes, TDF managers must find the right balance between active and passive strategies. And the first step towards that is to recognize that excess return prospects are different by asset class. In fixed income, more than 75% of active managers consistently outperform their benchmark, while barely 30% do so in equities. As such, we believe that the optimal design for a blend target-date fund is to spend the overwhelming majority of the active risk budget in fixed income and for equity exposures to be predominantly passive.
P&I: How can TD solutions increase the personalization and customization of asset exposures and glidepaths to improve participant outcomes?
THOOFT: We are seeing a merging of finance and technology, and we will continue to see that occur, just as we are seeing a merging of technology and health care. We are seeing evolving technologies for robo-advisers and wealth platforms, and these industry innovations on the fintech side will [eventually] be ported over to DC record keepers. For instance, a customized target-date strategy would deploy the same mentality around the glidepath, but that glidepath would be able to focus on the specific demographics of smaller subsets of the population versus the entire population. Although it won’t be customization down to one participant, it will have much broader flexibility with a matrix of glidepaths, a matrix of risk tolerances and a matrix of outcome expectations that a DC client could map into something much more specific to their plan participants’ needs and their expectations for retirement. We are seeing this through the more forward-looking wealth applications that have come to market over the last few years [and] it will take a little bit of time to entrench into a record-keeping DC plan.
MARTEL: Most TDFs and glidepaths are structured around some form of average or representative participant data. And this approach, while not perfect, has proven to be successful in putting many DC plan participants in a better position than they would have been on their own without a professionally managed, dynamic asset allocation.
However, we think we can do even better by providing a more tailored experience and more suitable outcomes to retirement savers. The good news is that we don’t need a drastic shift from the current approach to get there. We can use the same methods, algorithms and implementation techniques that underpin current target-date funds and glidepaths but leverage the individual data points that are already available on most record keepers’ platforms to deliver what we call personalized TDFs. That is, a target-date fund that is designed around participant-specific data instead of broad averages for some of the most critical inputs.
Importantly, all this can be done without requiring explicit participant engagement as we are leveraging data that is already sits on record keepers’ platforms. So in the end, participants can retain an experience that is similar to the one they have come to love with current target-date funds in terms of engagement, but still reap the benefits of a more customized and suitable approach.
BALAKRISHNAN: A personalized solution requires the complete financial picture of the individual investor. Target-date funds today provide solutions based on limited information, like participant age. Managed account programs, either through an online advice platform or through a financial consultant, can gather that information and recommend a personalized solution. The solution could be a combination of target-date funds and conservative options, like stable-value or target-risk options, where investors may take on a particular market risk through 10 or 20 years, or it could be a combination of target-date funds, conservative options like stable value, target-risk strategies and individual investment strategies. A combination of target-date funds with guaranteed lifetime income solutions may be suitable for some investors. ■