Future Market Expectations Call for a Change in DC Plan Investing

Many retirement income replacement rate calculators use stock and bond return assumptions based on long-term historical returns; however these returns may not be achievable in the future, contends AQR Capital Management in a recently published white paper.

Traditionally, a savings rate of 8% over one’s career, along with common return assumptions, would have allowed defined contribution (DC) plan participants to reach a target income replacement rate in retirement of 75%, the paper says. But, current market yields indicate that both stocks and bonds may deliver lower returns in the coming years.

AQR finds that roughly 2% lower expected returns could double the required savings rate for DC plan participants in order to achieve the 75% replacement rate. In light of their finding, AQR advocates that DC plan sponsors focus on both incentivizing more savings and identifying investment options that enhance expected returns, with reasonable risk, to help participants reach their retirement goals.

The paper suggests that a 15% savings rate for DC plan participants will put participants in a much better position to reach their retirement goals.

AQR also suggests DC plan sponsors and participants modify their investments to boost expected returns. To achieve this, participants should consider casting a wider net across three separate layers: traditional markets, alternatives, and potentially alpha as well. The bottom layer could incorporate all the major asset-class return premia in the market—traditional equities and bonds, but also credit and commodities which are typically underrepresented but diversifying to the traditional asset classes.

In the middle layer, AQR says, participants could expand into alternative investments including style premia such as value or momentum (either through long only portfolio tilts or long/short strategies), or classic hedge fund strategies such as managed futures or global macro. These alternative return sources can be systematically implemented, easily identified, and many come at reasonable fees.

The top layer is true alpha, the portion of return that is derived from idiosyncratic investment processes. However, AQR concedes what while adding alpha to a portfolio could certainly enhance returns, it could be challenging to find a manager that can provide it on a consistent basis net of fees.