In Face of Volatility, Diversity Rules in Retirement Plan Menus

What a difference a weekend makes.

In the opening months of this year, the steep market drops of 2022 appeared to be fading. Inflation, though persistent, was levelling. The job market was doing well. There was talk of recession, but it was to be a controlled one, inflicted in part by the Federal Reserve’s continued interest rate hikes. Then, on March 10, the country’s 16th-largest bank suddenly failed in a matter of days.

“A significant tightening of credit conditions across the economy seems likely,” Stephen Auth, CIO of equities at Federal Hermes, wrote in an investment note last Friday. “Make no mistake, while the initial regulatory response was probably sufficient to stave off a panic, it certainly will have a sobering effect on lending activities at all banks in the near future.”

Craig Lombardi, managing director of DCIO and sub-advisory at Virtus Investment Partners, started the year optimistically as he began meetings with advisers and plan sponsors to discuss their plan menus after a rocky 2022. “January presented itself as a great time for plan sponsors and their advisers to go back and look at those menus and make sure they were aligned properly,” Lombardi says.

Although the Silicon Valley Bank situation is unsettling, Lombardi’s world of defined contribution investing takes a longer view. So while he’s talking to clients about it, he says the message will remain the same: “I’m there to help look at risk and look at diversification,” he says. “When you have 30-year time horizon for investments, you take a longer view—you’re less cyclical than when you’re in the market day-to-day.”

Matthew Eickman, the national retirement practice leader for Qualified Plan Advisors, notes that his firm is reminding plan sponsors of the diversity that protects their participants from failures in specific market sectors.

“Optimism has continued into early 2023, even in light of SVB and other banking system challenges,” Eickman said by email. “Plan committees are interested in the answer to this question: ‘How much exposure do our plan’s investment options have?’ Once they are reminded that most plans are not directly tied to the performance of one market sector or industry, they are able to quickly return to the performance of the plan’s investors, rather than merely its investments.”

Fixer-Upper

Lombardi says he breaks down his plan menu reviews into a few key areas. One is fixed income, in which the investment manager says he considers credit risk, duration risk and whether the funds allocated to the fixed-income portfolio “have any holes in the bucket.” He then goes on to discuss with advisers adding high-yield options that have generally held up well and can further diversify their participants’ portfolios.

“We’re not saying that people should replace anything, but I challenge advisers and managers to complement what they have, and that is really resonating after 2022,” Lombardi says. “When you look at those high-yield options, they are holding up very well, and as the spreads widen, you have opportunity.”

When it comes to equities, Lombardi says to look for the known players. “I tell them that high quality, really good companies weather storms; speculative investing always has a price to pay,” he says. “If you have challenging times, high quality, great management, sustainable businesses … that is what you want.”

Beyond those investment areas, Lombardi likes sponsors to consider alternative areas such as real estate to further protect from one sector or investment area declining. No matter what, Lombardi believes his guidance can help provide participants with the best chance for long-term success.

“Set-it-and-forget-it TDF’s are fabulous and have a place,” Lombardi says. “But it’s a great opportunity when you have challenged times to reset your menus.”

Asset Class Education

Eickman of QPA notes that the push into target-date funds and managed accounts means that “participants are more diversified.” In turn, plan committees are able to focus on broader market volatility and how it impacts those strategies, as opposed to volatility in specific asset classes.

“With that said, 2022 proved to be a difficult year for growth-oriented equities and fixed income, which means first-quarter reviews have shown lagging performance,” Eickman wrote. “Even though participants use those stand-alone investments less frequently (because they’re more likely to be in a portfolio being managed for them in the form of a target-date fund or managed account), fiduciaries retain a responsibility to understand that lagging performance and consider potential replacements.”

Advisers on his team have responded by making a number of changes involving high-profile growth and fixed-income funds, Eickman says.

“Somewhat surprisingly,” Eickman added, “we didn’t experience an inordinate amount of nervousness” among clients. The calmness might have been because 2022 already teed up lower long-term expectations of the markets. It could also have been due to the fact that fewer participants are managing their own retirement accounts, he said. Then again, “it also could be because the swift recovery in 2020 led to overconfidence that we’d be swiftly recovering from the 2022 market challenges.”

Whether 2023 bounces back at some point is more of a question now due to the banking crisis.

“We are still hopeful this combination can allow the economy to lurch into slower-growth/lower-inflation mode without a full-blown recession,” writes the more daily-focused investment officer Auth. “We’ll see.”