The economic crisis of 2008 was a stark reminder to many 401(k) participants that nothing is certain--especially a person's retirement savings. Those affected by the downturn and in some cases subsequent depletion of retirement assets were taught an unfortunate lesson on the importance of asset allocation, diversification, and staying the course with their investment strategies. In today's economic environment, how can retirement plan providers help prepare plan sponsors and their participants for the future, while offering solutions for a secure retirement?
There are many benefits to employing solid investment strategies with touch points on all levels of a retirement plan offering--from the Advisor and plan provider to the plan participant. During the recent downturn, those that fared well did so by establishing a thoughtful investment strategy based on personal goals, objectives and risk tolerance levels as well as remaining invested through the market cycle.
Below is a look at 401(k) investment strategies and industry trends that are helping to protect the future of retirement in an unpredictable economy.
A Turn to Passive Solutions
As witnessed during the credit crisis, markets may exist where core asset classes are closely correlated, moving up and down together. Conversely, there may be periods where passive investing will outperform active investing, and vice versa. As we emerge from the economic crisis, there continues to be a move to passive or index investment options in 401(k) plans. In addition to reducing the risks of active investment management, as lower cost options, passive investing or index funds offer a cost effective solution to participants seeking core exposure to various market sectors.
In bear markets, investors and advisors become more focused on investment expenses relative to their returns. And with the proliferation of new disclosure requirements facing the 401(k) industry, there is an increased focus on the overall fee structure of 401(k) plans. Both factors are further fueling the shift to passive solutions and as a result, plan providers are increasing the number of index fund options available to plan sponsors as a means of managing total plan expenses.
Investors Are Out of Balance
According to a recent study (Cerulli Quantitative Update--Retail Products and Strategies, 2010), the financial crisis could have permanently altered the risk tolerance of some investors and it may be some time before equities reach pre-2008 levels.
In 2009 and 2010, more than 90% of investors' money flowed into bond funds over equity funds. Unfortunately, many of these investors missed the corresponding surge in equity markets. Today, and as interest rates continue to be at historic lows, investors are wrestling with high allocations to fixed income, low yields on assets, and the potential negative impact of rising interest rates and inflation. These investors are increasingly seeking out advice-driven solutions verses moving their assets directly into equities --hence shifting toward asset allocation and a more balanced portfolio. While diversification and asset allocation are not guarantees, these sound investment tactics can help investors better weather volatile markets and achieve their long term retirement goals.
Despite the negative attention target-date funds received after the downturn, these options are likely to remain the preferred Qualified Default Investment Alternative (QDIA) for many plan sponsors and acceptance is expected to increase. Investment managers and plan providers now have a window of opportunity to educate plan sponsors about the differences between investment options and the value target-date funds provide 401(k) participants.
The recent scrutiny of target-date funds, the impact of the economic crisis on plan participant account values and the current economic climate have prompted investment managers to rethink how these funds are managed. In addition, these managers are paying particular attention to plan participants' shifting risk tolerance levels and behavior. As a result, some managers have expanded the allocations within their funds to include more non-correlated asset classes. Others have modified their glide path to be more conservative, holding less in equities as a fund reaches its target-date, or offering custom target-date funds with multiple risk tolerance levels (i.e. 2020 conservative, 2020 moderate and 2020 aggressive). Looking forward, additional innovation could include target-date funds with built-in volatility caps and capital protection strategies that reduce downside risk.
With the growing dependence on defined contribution plans for retirement savings, and the current administration's position on the need for Americans to have guaranteed sources of retirement income, many plan providers and asset managers are expanding their target-date options to include "in-plan" income benefits that can offer participants a Guaranteed Minimum Income Benefit (GMIB) at retirement. Insurance companies--uniquely proficient at managing risk--are now leveraging their expertise with these types of guarantees and turning them into real solutions for the 401(k) landscape.
The traditional asset allocation process for a typical investor includes taking steps to determine their individual risk tolerance level, assuming a certain level of volatility within their portfolio--plus or minus 10 or 12 percent as an example--and factoring in their time horizon to accumulate retirement assets in order to help ensure a healthy future. Through the economic crisis, volatility suddenly spiked, exposing some investors to as much as twice the level of volatility previously held within their portfolio. As a result, today's investors are more risk averse than ever before, leading to an increased need for downside protection. And according to the Cerulli study, ease of use and volatility/risk controls are now the most important characteristics when developing retirement income products.
Plan providers are responding to this decreased level of risk tolerance accordingly. Some are employing a strategy of asset allocation that assumes the participant's investment time horizon is "to" their retirement date, resulting in a portfolio of primarily fixed income holdings at retirement. Yet others continue to employ a "through" strategy that is typified by a heavier allocation to equities, and assumes that the participant's investment time horizon is 10-20 years past target-date. In this scenario, the glide path is modified to include volatility management with downside protection. Although riskier than "to" strategies, "through" strategies help 401(k) participants stay invested, maximize their asset growth potential before and after retirement, and above all, help them to address the concern many retirees face--simply outliving their assets.
Additional product innovation includes comingled investment trust portfolios that offer income benefits to accrue through the retirement glide path as a way to combat risk and provide downside protection in 401(k) plans. Through these innovative options, in-plan benefits characteristic of defined benefit offerings are now brought to defined contribution plans, providing investors with a guaranteed source of income.
And with risk tolerance at its lowest levels, diversification remains top of mind among investment managers and plan providers. However, the risks of diversification within a 401(k) plan could include participants placing too much of their portfolio within one asset class. As we've seen, alternative non-correlated investments such as precious metals or commodities can be good diversifiers, but may also be volatile. Providers and plan sponsors need to determine how to effectively make available diversifiers or non-correlated investments to help participants build retirement assets, while educating them on the risks and the benefits these provide.
A Look to the Future
In today's market, and as a result of recent and pending regulations, there is an increasing need to provide additional investment research, analysis and oversight of the investment strategies available to 401(k) plans. Plan providers are now offering more investment support services to advisors, pension consultants and plan sponsors - including services to support their roles as fiduciaries. This highlights the need for and importance of plan providers retaining a dedicated funds management or investment management team.
It is evident that a solid investment strategy can help to protect 401(k) participants in the event of future economic challenges. Today's 401(k) plan providers are not tied to one investment approach, and continue to provide innovative approaches to investment management--offering investors choices with different features and benefits. These industry pioneers, who have benefitted from lessons learned through the economic crisis, are building investment strategies that are best in breed and are helping to ensure that 401(k) participants realize the secure retirement they envisioned.Daniel Hayes is the Head of Funds Management for Retirement Solutions at Lincoln Financial Group. He may be reached via firstname.lastname@example.org.