Rethinking retirement plan menus to reflect higher rates

Restaurant owners aren't the only ones who need to update their menus in response to inflation and a shifting economy. Sponsors of retirement plans should also make some changes to their list of offerings.

A year ago this week, the yield on the 10-year Treasury bond was a mere 2.15% and the Federal Reserve was just starting to raise interest rates with a mere quarter-point increase to the fed funds rate. Fast forward 12 months and many rate hikes later, and that same benchmark bond is paying investors around 3.5%. Moreover, other bonds priced off this so-called riskless rate — essentially every bond in the market — are also offering investors a higher payout.

As a result of this massive rate realignment, the TINA acronym (“There is no alternative”) no longer applies. Investors indeed have fixed-income alternatives to the stock market. And they want to know the true extent of their options, especially in their retirement plans.    

InvestmentNews caught up with Adam Farstrup, head of multi-asset for the Americas at Schroders, to learn how plan sponsors can adjust their fund menus to ensure they are providing participants with opportunities to benefit from this step-up in yields.

InvestmentNews: Should plan sponsors revisit their fund menus now that yields have risen and could move higher?

Adam Farstrup: There is a global reset happening in financial markets and economies as the structural forces of demographics, deglobalization and decarbonization place upward pressure on inflation, leading central banks to prioritize inflation and governments to focus on growth as economies suffer declines. Therefore I expect interest rates to remain higher for longer and economic cycles to change more frequently. 

In fact, it has been 40 years since we have seen a cycle’s peak in 10-year U.S. Treasuries surpass the peak of the previous cycle. The era of modern DC plans coincides with a period of positive correlation between equities and bonds; both suffered painful losses in 2022 and offered little diversification benefits. I recommend that plan sponsors examine the assumptions embedded in their plan design and consider which adjustments are necessary.

IN: What menu changes should they make to benefit plan participants? What additions? Subtractions?

AF: If my expectation of persistently higher inflation materializes, I think plan sponsors might well examine the real assets they offer in their menu. I believe the new regime calls for a more strategic role for assets like commodities in DC lineups. It is key to help participants understand the impact of sizing an allocation to real assets as well as comprehend how real assets may perform through the full length and shifts of a cycle. For example, REITs are real assets but they usually possess higher interest-rate sensitivity and therefore today may not be the best time for such an allocation.

However, higher interest rates drive higher yields on fixed income, which can greatly benefit DC participants. The challenge is more frequent rate cycles necessitate more guidance from plan sponsors on which areas of the fixed-income market may be most fruitful. Active management of fixed income, particularly in multisector fixed income strategies, can help alleviate the burden on sponsors.

Yet more frequent rate cycles require additional de-risking solutions beyond fixed income in DC plans. The good news is that with higher rates, cash instruments become viable tools in lowering portfolio risk but for participants nearing retirement, an active approach to downside risk management is likely more important than ever.

IN: How long will it take to make these changes? What timeline should plan participants expect before they see the new offerings?

AF: We expect the regime shift to persist in the foreseeable future and so the challenges are chronic as well as acute. The timeline to make these changes will vary by plan but many of the strategies that might help participants are readily available through record keepers. I think plan sponsors should review their strategic lineup with their advisors to identify the most critical gaps.

IN: How should plan advisors work with participants to adjust their asset allocations?

AF: I recommend plan advisors collaborate with investment managers and record keepers to develop communications for plan participants that explain the most salient implications of the regime shift and how different asset classes may behave in this new environment. I think asking participants to do the groundwork required to adapt may be too onerous; offering asset allocation strategies to cope with these challenges and take advantage of current opportunities will help participants considerably.  

IN: What should an asset allocation look like after last year’s 60/40 troubles?

AF: 2022 was the first time in more than 120 years when we saw U.S. Treasuries lose money at the same time that equities declined more than 20% from their highs. While I don’t expect this extraordinary outcome to repeat itself soon, plan sponsors should be aware that inflation surprises are bad for both equities and bonds, so 60/40 portfolios may not be as effective in the future.

Again, I advise adding real assets, like commodities, to a DC plan’s asset allocation. The role of bonds is atypical in this environment. I expect better yields on average but performance may be more variable through the cycle; I therefore endorse active management of asset allocation and within bond allocations. Specifically, active asset allocation approaches that manage downside risk may be optimal in the new regime.