Reflation Brewing: Is Your Retirement Portfolio Ready?
February 22, 2017
For decades, there were two things that workers saving for retirement could count on: falling interest rates and low inflation. Change may be afoot. We think target-date funds should take notice.
Target-date funds are becoming the most critical pool of assets for meeting the retirement needs of American workers. These solutions have seen enormous asset growth over the past decade, but many rely on strategies that don’t adequately guard against today’s heightened retirement risks, including inflation.
The problem? Despite the broad range of strategies available to target-date funds, most are still concentrated in traditional blends of large-cap US stocks and domestic core bonds. This approach worked well during the 30-year bull run in bonds that began in the early 1980s; steadily falling inflation and interest rates helped boost overall returns for stocks, too.
For Savers, a Brave New World
But those days may be ending. Inflation expectations have surged since Donald Trump won the US presidential election. Markets are betting that his plans to cut taxes, increase government spending, limit immigration and renegotiate trade deals will push up prices and interest rates.
And it’s not just a US phenomenon. Most developed economies are getting closer to full capacity, and that’s pushing up the cost of labor (wages) and materials (commodities). Meanwhile, governments are moving toward more aggressive fiscal policies, and there’s a risk of increased trade protectionism. Both developments could be inflationary.
Higher inflation eats away at savers’ spending power, and that’s a big concern for bond-heavy investors who are tied to fixed-income payments—especially retirees or those about to retire.
To see what we mean, consider what happened to bonds and other interest-rate–sensitive assets in the fourth quarter of 2016, when the yield on the 10-year Treasury note rose by nearly a full percentage point and the Bloomberg Barclays US Treasury Index fell nearly 4%. That was a sharp departure from what’s prevailed in bond markets over the past five years, and could be a harbinger of things to come.
Equities, too, can suffer when inflation rises—particularly if higher prices aren’t accompanied by a meaningful increase in economic growth. When that happens, investors demand a higher discount rate on equities, which can end up overwhelming any improvements in earnings growth.
That’s why we think investors should have exposure to assets likely to do well during periods of rising inflation. That means taking advantage of global and nontraditional diversifying investments that can limit exposure to interest-rate risk.
Defined contribution (DC) plan sponsors can do that by enhancing their target-date funds with strategies that go beyond traditional stocks and bonds. A few examples:
Real-Return-Oriented Strategies: These strategies can invest in a host of less traditional assets, such as commodities, natural-resource stocks and inflation-protected bonds, that typically do well when inflation is rising—even if only modestly (Display).
Alternatives: Using hedge-fund-like strategies, managers of alternative strategies attempt to diversify returns and limit downside risk by focusing on individual security selection and hedging out broad market exposure. Long-short equity, market-neutral and unconstrained bond strategies are some of the solutions that diversify equity and bond risk while giving managers more flexibility to generate returns through security selection or tactical allocation.
Currency-Hedged Global Bonds: Going global exposes investors to different interest-rate and economic cycles. That adds diversification and reduces portfolio risk. But hedging out volatile currency fluctuations is critical, especially for plan participants who are approaching retirement.
Making a broader array of strategies available should help reduce plan participants’ exposure to interest-rate risk and inflation at different points along their target-date fund’s glide path.
Longevity: A Life Benefit, a Portfolio Risk
In fact, widening the opportunity set has benefits beyond protecting participants against inflation. That’s because it isn’t only bond returns that are at risk. We expect below-average returns in almost all asset classes over the next five years.
For those close to retirement, that’s an acute risk—not least because most Americans can expect to live longer after retirement than their parents or grandparents did. According to a recent Society of Actuaries survey, half of today’s 65-year-old men will live past age 89 and half of all 65-year-old women will live past age 90. For individuals, living longer is a benefit. For their savings, it’s a risk.
Could an unexpected shock cause interest rates and inflation to retreat temporarily in the near term? Sure. But with US growth gaining traction, wages rising and fiscal expansion on the table, we wouldn’t expect it to stay under wraps for long.
After decades of low interest rates, we may be at a major inflection point. Strategies that rely too heavily on the winners of the last few decades may not deliver enough returns to sustain Americans during their retirement. That’s a risk that calls for immediate attention.
"Target date" in a fund's name refers to the approximate year when a plan participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as a participant nears retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested—including at the time of the fund's target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.
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.