INVESTMENT
RETIREMENT
INSIGHTS
INSIGHTS
PORT FOLIO DISCUSSION
Fixed income diversification
within DC plans
February 2015
A critical part of helping defined contribution (DC) plan
participants achieve a financially secure retirement
is delivering effective retirement solutions that
generate strong risk-adjusted returns. Aligning a plan’s
investments with its goals and objectives, and ensuring
that they are best-in-class, is essential to achieving
successful results. Equally important is building
an investment menu of options that enables plan
participants to invest wisely and provides opportunities
for diversification, income generation and growth while
managing risk.
Fixed income should play an important role
AUTHOR
Anne Lester
Global Head of Retirement Solutions,
J.P. Morgan Asset Management
As the most commonly represented asset classes in a DC investment menu, equities
and fixed income need to be considered both individually and in relation to one
another. While equities often receive the lion’s share of attention, evaluating the role
of fixed income in a DC plan is also important. As with equities, plan sponsors should
seek to diversify a plan’s fixed income exposure to help manage risk. An examination
of the industry landscape, however, shows a lack of diversification in the fixed income
investment strategies offered by DC plans. The average plan has more than 10 equity
options in its investment lineup, but fewer than three fixed income options. We
believe this is often too narrow to provide sufficiently varied exposure to the entire
asset class.
For their part, participants may have a broad range of sophistication levels and may
not fully understand the strategies and solutions in their plan lineups, including the
benefits that may be derived from how target date funds use fixed income within a
fund’s glide path. Participants who make their own allocation choices may place too
much or too little in fixed income, exposing their retirement portfolios to added risk.
A prime example of inappropriate fixed income allocation can be seen when younger
workers are too conservatively invested, holding too much in fixed income and
potentially forgoing the opportunity to optimize returns. At the other end of the
spectrum, older workers who hold insufficient fixed income investments may also be
putting their retirement security at risk due to the potential for volatility and underperformance in a declining market (as shown in Exhibit 1).
NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE
RETIREMENT
INSIGHTS
PORTFOLIO
DISCUSSION:
Title Copy
Here DC plans
Fixed
income
diversification
within
EXHIBIT 1: DO-IT-YOURSELFERS’ FIXED INCOME POSITIONS
100%
90%
ULTIMATELY, PARTICIPANTS
Younger workers are
too conservatively
invested and may
forgo years when
their money could be
working for them.
80%
70%
60%
50%
40%
FACE MANY RISKS
WHEN INVESTING FOR
RETIREMENT, NOT THE
LEAST OF WHICH IS THAT
Older workers not holding enough fixed income are
putting their retirement savings at risk because of
increased market volatility.
30%
20%
THEY MIGHT MISUSE
INVESTMENT OPTIONS.
10%
0%
20
25
30
35
40
45
Age
50
55
60
65
70
= percent in Fixed Income
Source: J.P. Morgan Asset Management. Analysis measurement period is June 30, 2009, through June 30, 2014. The scatter plot shows the percentage that 3,000
randomly selected Do-it-Yourselfers hold in fixed income options for each age range presented.
The power of prudent diversification
Prudent diversification can help mitigate many market-related
risks, including rising interest rates. After more than 30 years
in which interest rates have more or less steadily declined, we
believe rates are likely to rise next year. This will pose challenges for even the most sophisticated investors, who will not
only face the potential for declining asset values in the short
term, but will also face the fact that fixed income securities
are unlikely to deliver the kinds of returns over the medium
term that many investors have experienced over the past
three decades.
Where there are challenges, however, there are also opportunities. Since different fixed income sectors respond differently
to changes in interest rates, managers who diversify their
fixed income exposure may be able to improve the risk-adjusted
performance of their portfolios. As shown in Exhibit 2, the
potential impact of a 1% move in rates on different fixed
income sectors can have varied results.
options that, if used properly, will deliver optimal diversification versus facilitating a spiral of inertia by overwhelming participants with too many choices. Streamlining the core menu
to include a diversified fixed income solution with more traditional sectors such as Treasuries and high-grade corporates
and mortgages, as well as extended sectors such as high yield
and emerging markets debt, can simplify choices for participants and provide them with adequate diversification.
Target date funds may also provide a way to diversify fixed
income exposure. It’s important to realize, however, that levels
of sector diversification and concentration within the fixed
EXHIBIT 2: A 1% RISE OR DECLINE IN INTEREST RATES IMPACTS
Price
Impact ofTYPES
a 1% Rise/Fall
Interest
Rates*
DIFFERENT
OF BONDSinIN
DIFFERENT
WAYS
2y UST
-2.0%
5y UST
-4.7%
TIPS
Diversification of fixed income solutions in a DC plan should
not mean simply adding new investment options to the plan’s
lineup. Plan fiduciaries must take care not to create redundancies
in the name of diversification. They also need to strike a careful
balance between providing participants with investment
2 | Fixed income diversification within DC plans
30y UST
5.0%
6.7%
-5.7%
10y UST
In previous rising-rate environments, long duration bonds
have been especially vulnerable, while high yield bonds have
tended to benefit from the cushion of their relatively high
yields. But no two interest rate cycles are exactly the same.
The coming cycle will have its own distinct characteristics
because it will follow an unprecedented, global central bank
stimulus that drove interest rates to an all-time low.
0.9%
9.5%
-8.6%
23.2%
-17.8%
Floating Rate
Convertibles
ABS
US HY
MBS
US Aggregate
Munis
IG Corps
- 30%
-0.1%
-3.2%
-3.9%
-4.3%
-5.5%
-5.6%
-5.7%
-6.7%
- 10%
0.1%
3.6%
3.9%
4.2%
3.4%
5.5%
5.5%
7.7%
10%
30%
Source: Source: U.S. Treasury, Barclays Capital, FactSet, J.P. Morgan Asset
Management. As of December 31, 2014.
income portion of their allocation may vary significantly from
provider to provider. In some cases, the asset allocation
strategy may be the result of the manager’s biases in managing
for certain risks, which include, but are not limited to, interest
rate risk, inflation risk, market volatility and drawdown risk. The
sample glide paths in Exhibit 3 illustrate different levels of fixed
income exposure that may be found in target date funds.
EXHIBIT 3: DIFFERENT GLIDE PATH FIXED INCOME EXPOSURES
Glide path focused on longevity risk
61.4%
Fixed income
and cash
alternatives
38.0%
Equity
25
30
35
40
45
50
55
60
65
70
75
80
Glide path focused on market risk
88.3%
Fixed income
and cash
alternatives
& cash
11.7%
Equity
25
30
35
40
45
50
55
60
65
70
75
80
Source: J.P. Morgan Asset Management. For illustrative purposes only. Some
totals may not equal 100 due to rounding.
Differences in core fixed income exposure
Plan sponsors who are reevaluating their plan’s core investment
lineup have an opportunity to enhance the level of diversification
within the menu. Traditional core fixed income and core plus
strategies that focus on total return can provide access to a
broad range of fixed income sectors and can be used as standalones, or deployed as complements to fixed income strategies
with different philosophies and objectives. Core bond funds
invest primarily in investment-grade securities and search for
high-quality investments for risk-adjusted returns with lower
volatility. Core plus strategies include both traditional and nontraditional investments in order to provide additional potential
for income and growth. These funds may invest in a range of
strategies and extended sectors, such as high yield, bank loans
and emerging market debt, to both manage risk and take
advantage of opportunities created by changing market and
economic conditions.
Strategic and tactical flexibility
However fixed income exposure is allocated, having the flexibility that active managers have to strategically allocate across
different sectors and then tactically adjust them, combined
with robust risk control, can help active managers craft an
effective fixed income strategy. Strategic flexibility enables
them to construct a portfolio with different sectors and sector
weightings than the benchmark, while tactical flexibility allows
them to employ hedges to mitigate downside risk and opportunistically shift allocations in response to changing investment conditions. In addition to rising rates, changing conditions might include: shifts in inflation or inflation expectations;
unexpected volatility caused by geopolitical instability; and
movements in spreads among the various fixed income sectors. In contrast, managers of passively managed funds that
reflect an index’s sector, duration and credit quality weightings
may find it difficult to mitigate the negative impact of an
underperforming sector or a sharp rise in rates.
Style purity and transparency
As plan sponsors and participants evaluate their fixed income
strategies, they should bear in mind that a strategy’s “style
purity” can be critically important to avoid redundancy and
overexposure to particular sectors. While some investment
managers may drift from their strategy’s stated investment
goals and process, as defined in their fund’s prospectus, a stylepure manager will stay very close to those defined goalposts.
Whatever the strategy, transparency is key. As fiduciaries, plan
sponsors should have a clear understanding of the role that fixed
income plays within the plan’s core investment lineup and also be
knowledgeable about how specific menu options are allocated
across sectors, duration and credit quality, as well as how and why
derivatives are being used in the portfolio. For target date funds,
plan sponsors should also understand how fixed income is used in
the glide path across the plan’s chosen target date fund series.
In conclusion, plan sponsors need to educate participants on the
important role fixed income can play in a retirement portfolio.
This asset class can reduce overall portfolio volatility and help
participants diversify, which may mitigate risk in different market
environments. Given these potential benefits, and those gleaned
from having a well-diversified fixed income portfolio that may
fare better in a rising interest rate environment, plan sponsors
should take a close look at their plans’ investment menus. Fixed
income is and will continue to be an important asset class for
the retirement solutions of today and tomorrow.
J.P. Morgan Asset Management | 3
RETIREMENT
INSIGHTS
PORTFOLIO
DISCUSSION:
Title Copy
Here DC plans
Fixed
income
diversification
within
RETHINKING A DC PLAN’S FIXED INCOME OPTION
Some key questions plan sponsors should ask when evaluating a plan’s fixed income investment allocation and options include:
• What is the role of fixed income in the plan?
• How do the plan’s fixed income selection(s) line up with the needs of plan participants?
• Should fixed income be available as a stand-alone option in the core menu or is it best deployed through an asset allocation fund?
• Have there been any material changes to the investment option that require additional due diligence?
• Should the plan use the resources of managers who service the company’s defined benefit plan?
• How should the plan’s Investment Policy Statement (IPS), be updated to reflect changes in the criteria for selecting and monitoring
fixed income managers?
Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no
guarantee of future results.
We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale
of any financial instrument. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax
advice. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
Interest rate risk: Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops.
Securities with greater interest rate sensitivity and longer maturities tend to produce higher yields, but are subject to greater fluctuations in value. Usually, the changes in the value
of fixed income securities will not affect cash income generated, but may affect the value of your investment.
Credit risk: Credit risk is the risk that issuers and counterparties will not make payments on securities and investments held by the portfolio. Such defaults could result in losses
to an investment in the portfolio. In addition, the credit quality of securities held by a portfolio may be lowered if an issuer’s financial condition changes. Lower credit quality may
lead to greater volatility in the price of a security. Lower credit quality also may affect liquidity and make it difficult for the portfolio to sell the security. The portfolio may invest in
securities that are rated in the lowest investment grade category. Such securities are considered to have speculative characteristics similar to high yield securities, and issuers of
such securities are more vulnerable to changes in economic conditions than issuers of higher grade securities.
Inflation risk: Inflation-linked debt securities are subject to the effects of changes in market interest rates caused by factors other than inflation (real interest rates). In general, the
price of an inflation-linked security tends to decline when real interest rates increase. Unlike conventional bonds, the principal and interest payments of inflation-protected securities
such as TIPS are adjusted periodically to a specified rate of inflation (e.g., CPI-U). There can be no assurance that the inflation index used will accurately measure the actual rate of
inflation. These securities may lose value in the event that the actual rate of inflation is different from the rate of the inflation index.
Target date funds: Target date funds are funds with the target date being the approximate date when investors plan to start withdrawing their money. Generally, the asset allocation
of each fund will change on an annual basis, with the asset allocation becoming more conservative as the fund nears the target retirement date. The principal value of the fund(s) is
not guaranteed at any time, including at the target date.
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current
market conditions.
Certain underlying funds of target date funds may have unique risks associated with investments in foreign/emerging market securities and/or fixed income instruments.
International investing involves increased risk and volatility due to currency exchange rate changes; political, social or economic instability; and accounting or other financial
standards differences. Fixed income securities generally decline in price when interest rates rise. Real estate funds may be subject to a higher degree of market risk because of
concentration in a specific industry, sector or geographical sector, including, but not limited to, declines in the value of real estate, risk related to general and economic conditions,
changes in the value of the underlying property owned by the trust and defaults by the borrower. The fund may invest in futures contracts and other derivatives. This may make the
fund more volatile. The gross expense ratio of the fund includes the estimated fees and expenses of the underlying funds. There may be additional fees associated with investing in a
Fund of Funds strategy.
J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.
JPMorgan Distribution Services, Inc., member FINRA/SIPC.
© 2015 JPMorgan Chase & Co.
RI-FIDIV-DC
NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE