The fixed-income offerings in a typical defined contribution (DC) menu can sometimes seem uninspired, but it doesn’t take much to improve the selection. The right combination can enhance core fixed-income allocations, providing diversification and reducing risk.
Most DC plans are limited to a couple of fixed-income options—usually a US aggregate and/or a stable value fund. Equities, in contrast, are generally represented by 10–12 different funds diversified across market capitalizations, styles and regions. We think it’s outdated to have so few fixed-income choices.
The Optimal Fixed-Income Allocation
A DC plan that restricts its fixed-income allocation to a few basic options may unintentionally see investors come up short in their retirement goals. A US aggregate bond fund may help offset equity market volatility, but it lacks diversification and higher return potential. It may also expose investors to the risk of rising US interest rates. The right mix of bond funds in a menu of core options can help participants make the most of their fixed-income allocation.
Our ideal DC fixed-income menu follows a four-point strategy: go global, add high yield, access inflation protection and anchor with US bonds.
Here’s how we suggest offering participants a more diversified approach—through “multi-manager white label” allocations. These are single investment options that use multiple managers to add greater diversity among investment-management styles (Display). They use a broad naming convention that describes the plan and leaves out fund managers’ names.
Global Hedged Bonds:While the US remains a major bond player, it no longer dominates the world’s fixed-income market—its share has been steadily shrinking for decades. Plans that include global hedged bonds have delivered a less volatile experience than US bonds alone over the past couple of decades, with better risk-adjusted returns (Display).
In down months and during market crises, global hedged bonds have been an effective complement to stocks. They can also help diversify economic and interest-rate risk. Hedging the various currencies in global bonds back to US dollars helps keep portfolio volatility low while offsetting equity volatility. White-label allocation: 35%
High Yield:A high-yield bond option may boost investors’ return potential and reduce interest-rate sensitivity. That’s because high-yield bonds have been historically strong when rates rise and can generate substantial income while maximizing growth. However, US high yield has a high correlation with equities, so we think a more moderate allocation is appropriate. White-label allocation: 15%
Treasury Inflation-Protected Securities (TIPS):With inflation rising, adding TIPS can help shield participants’ portfolios from purchasing-power erosion. TIPS are designed to outperform Treasury securities when inflation is rising. But participants also need to keep an eye on duration when investing in TIPS. The standard TIPS index has a very long duration (around eight years), so we think an intermediate-duration portfolio makes more sense: it doesn’t sacrifice inflation uplift and it reduces interest-rate risk. White-label allocation: 15%
US Aggregate Bonds:In recent years, US bonds have faced challenges that include historically low yields and higher interest-rate sensitivity. But US aggregate bonds have traditionally been a good offset to equity market volatility. We think it’s important to keep an allocation here, although at a smaller percentage to reduce US interest-rate exposure. However, investors could consider passive approaches in this part of their portfolios, which often reduce costs. White-label allocation: 35%
Whether a plan uses stand-alone funds or custom white-label offerings, diversifying US bond exposure by adding global hedged bonds, high-yield bonds and TIPS to the menu has the potential to reduce US interest-rate risk and generate more income over time.
We believe there’s no time like the present to reevaluate core menu fixed-income options—and the structure in which the plan presents these options. More specifically, we see this as an opportunity to consider either adding these individual fixed-income options to a menu or exploring creating a white-label, multi-manager solution that spans all these strategies in one option.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.