Since defined contribution plan members will experience a wide variety of market conditions over the course of their working lives and into retirement, it’s important for the strategic asset allocation of target-date funds to be diversified and able to stand the test of time, according to Jon Knowles, institutional portfolio manager for global asset allocation at Fidelity Investments.
Speaking during Benefits Canada’s 2023 DC Investment Forum in late September, he said the strategic asset allocation — also known as the target-date fund’s glide path — is one of the most important decisions plan sponsors will make on behalf of their members. “If you want to strive towards positive retirement outcomes for plan members, you need to spend a lot of time focused on the strategic asset allocation work.”
Knowles referred to research dating back to the 1990s that highlighted this importance. The research — which has been iterated on and proven by many researchers since — looked at the monthly return experience of 100 multi-asset class portfolios against the benchmark of the funds’ strategies. It found that. if a fund went up one per cent over a given month, about 90 basis points of that return could be attributed to the benchmark.
“This really enforces the point of why it’s so important, when you talk about the return experience, you also need to talk about the risk experience because they’re sort of synonymous in this regard.”
Charting the performance of Canadian equities and bonds from the 1980s to the present day, he also noted any plan members invested during that period would have experienced periods of ultra-high and decades-low interest rates, as well as both inflationary stress and deflationary stress. “We need to build diversification that works in each one of these states and then all of the states together.”
In order for plan sponsors to build a diversified portfolio that stands up in all of those states, it’s important to understand the true characteristics of each asset class they’re looking to include, particularly with regards to alternatives, said Knowles.
Alternative assets have been making their way into DC plans for the past few years, partly driven by plan sponsors that also have defined benefit plans and want to include similar strategies in their DC plans. Generally speaking, adding alternatives — whether illiquid options like private equity strategies, private direct real estate or liquid alternative strategies — to a portfolio improves the risk-adjusted return potential for plan members, he said. “[But] this is where the story gets a little bit more complicated.”
While DB plans can take on greater liquidity risk, DC plans have lower tolerance for such risk given the “daily interaction between plan members and the underlying investment strategies,” he noted. Looking back at alternatives’ return experience over the the past 20 years — during a period of of low or declining interest rates and abundant liquidity — DC plan sponsors could be forgiven for extrapolating that trend into the future and feeling they’d be appropriately compensated for introducing the liquidity dynamics of alternatives into their asset allocations.
“This isn’t to deter anybody from utilizing alternatives [because] we think they have their place in the portfolio, [but] we really think you need to focus on the diversification attributes of these asset classes,” said Knowles.
The perceived lower volatility of alternative assets can mask their actual economic sensitivities, he added. Using the NCREIF ODCE index, a broad-based U.S. direct real estate index, as an example, he charted the index’s average volatility at three-month, six-month, one-year and two-year rebalancing frequencies across four distinct market scenarios of falling interest rates, rising rates, deflationary stress and inflationary stress.
During a three-month rebalancing frequency, the average volatility across all scenarios was between 3.1 per cent and 3.7 per cent, but in the two-year rebalancing frequency, the average volatility significantly increased in three out of four market scenarios, to between 6.7 and 6.9 per cent. Only in the rising rate environment did average volatility remain lower, at 4.9 per cent.
“This is all to say that you need to think about alternatives a little bit differently than just looking at the more recent risk and return experience that they’ve had, because they certainly introduce unique risk and return properties to a multi-asset class portfolio.”
Read more coverage of the 2023 DC Investment Forum.