New Directions in Retirement Investing

Five yearsafter the financial crisis began, investors still have much to worry about—namely, market volatility, economic uncertainty and the impact of inflation. Modern portfolio theory and style-box diversification just didn’t work so well during the market crash.

In an interview with PLANADVISER Managing Editor Lee Barney, Julia Lawler, senior vice president of investment services at the Principal Financial Group®, discusses how financial professionals can use an outcome-based approach to help create a more informed, more intelligently-constructed investment lineup. This approach develops investment lineups intended to help mitigate the risks that undermined participant allocations following the market crash and seek to address future risks such as inflation.

PA: What has changed for investors since the financial crisis? What risks do they still face?

Lawler: During the financial crisis, most investors saw the biggest loss to their investments they’ve probably ever witnessed. They truly faced volatility and downside risk, which made many investors more risk-averse than ever before.

At the same time, individuals are increasingly being asked to take on more of the responsibility for retirement, with fewer defined benefit (DB) plans available.

In light of these factors, we think investment lineups need to change—particularly to include strategies intended to generate income, protect investors’ purchasing power from inflation and better manage downside risk.

We think this presents a significant opportunity for financial professionals to demonstrate value by helping plan sponsors structure retirement plan lineups to better address these needs.

PA: As financial professionals work with plan sponsors, what are the enduring lessons of the financial crisis?

Lawler: Most notably, we learned modern portfolio theory is not the full answer, because all of those typical investment styles became highly correlated.

The second thing we learned is that the law of averages over long periods of time, while it still holds, doesn’t help an investor in a steep bear market. For example, in 2008 and 2009, many equity portfolios lost 30% to 40% of their value. It takes a very long time to recover a loss like that.

As a global investment management leader, we believe a different approach is needed, one where asset allocation and portfolio construction—with exposure to alternative asset classes and outcome-based investment strategies that seek to address certain risks—would play a much greater role. 

PA: Does this mirror the investing approach of defined benefit plans, large endowments and foundations?

Lawler: Yes, institutional investors focus on manager selection, asset allocation and portfolio construction—not investment style boxes—because of the impact they have on generating outcomes.

A target-date series can address these dynamics, providing individual investors access to professionally managed asset-allocation investment options.

PA: How are you applying these lessons to defined contribution (DC) plan investment lineups?

Lawler: We call our approach outcome-based investing, which seeks to address specific risks. Asset-allocation decisions are based on what an investment does rather than what it is.

Instead of simply aligning to an investment style, this approach uses strategies that seek to minimize four key risks. The first is market risk, or volatility. The second is inflation risk. Third is emotional risk—the danger of an investor making a decision out of fear at exactly the wrong time. And finally, there’s longevity risk.

We created a series of portfolios for investors that are constructed to specifically respond to these risks. Our target-date series includes allocations to address these risks as well.

PA: How does this new outcome-based approach diminish inflation risk?

Lawler: Investment performance needs to outpace inflation to preserve capital.             

One strategy we developed invests in real assets such as commercial real estate and commodities. These real assets tend to keep pace with inflation. The fund also invests in Treasury inflation-protected securities (TIPS), which are linked to inflation rates. And it invests in floating-rate debt, where coupon payments reset frequently in order to mitigate inflation-rate risk.

Finally, we’ve included master-limited partnerships and global infrastructure investment options. Companies in these sectors tend to be pay dividends and have a history of increasing dividends during periods of mild inflation due to their tie to commodities.

PA: How do you address volatility?

Lawler: One strategy to help minimize downside risk combines multiple alternative-investment specialists and strategies into a single mutual fund. It offers diversification by strategy and manager with the goal of reducing downside risk during very volatile periods of time.

PA: How does an outcome-based approach combat longevity risk?

Lawler: While more traditional core income strategies still play a critical role in portfolio construction, we believe there is also a need to further diversify investments focused on generating income.

One of our strategies invests in equities seeking to generate income and growth, and to preserve capital—all key to managing longevity risk.

But investment options are only one part of the equation. The best way to fight longevity risk is to make sure participants are saving enough for retirement in the first place.

This is an important opportunity for financial professionals to work with plan sponsors on smarter plan designs with features such as automatic enrollment at a 6% or higher deferral rate and automatic escalation.

That includes defaulting participants into an institutionally-driven asset-­allocation choice, such as a target-date series, that includes outcome-based investments.

PA: How can financial professionals educate plan sponsors about using alternative approaches to managing risk, and why are they so important?

Lawler: Financial professionals can change the conversation by helping plan sponsors think about retirement plans in terms of outcomes—retirement income, rather than retirement savings. Help them measure overall plan success based on participant income replacement ratios and the impact risk can have on those ratios.

 Financial professionals can explain, “Your old style-box approach is good—but it’s not enough. A more effective way of mitigating risk is an approach that includes alternative assets.”

It’s important to consider whether the target-date series includes underlying strategies that seek to address key risks facing investors today. Target-date series offer a professionally-managed approach for investors who aren’t equipped, or comfortable, making risk-focused investment elections on their own.

PA: What are the challenges and benefits for financial professionals who bring outcome-based lineups to their clients?

Lawler: Financial professionals who advocate for improved retirement plan outcomes differentiate their practices and demonstrate their value. They can also benefit as plan assets grow. The challenge is educating plan sponsors to think in terms of outcomes.

Most sponsors are aware their participants are not saving enough. They also know participants need to invest more wisely. Financial professionals can introduce plan design changes, including outcome-based investing, that could enable participants to save at higher levels and invest to help mitigate key risks.

We’ve created a resource to help financial professionals start the conversation. Our Retirement Readiness Report calculates the overall retirement replacement ratio of participants and offers best practices on plan design changes.

Steps to Move Clients to Outcome-Based Portfolios

• Move away from the typical fund selection ­conversation
• Take steps to build multi-managed, outcome-based plan lineups
• Use multi-asset income strategies
• Consider real asset investment options
• Select a target-date series that includes exposure to alternative investments

For more information visit www.principal.com/NewDirections

About Target-Date Investing

Target-date portfolios are managed toward a particular target date, or the approximate date the investor is expected to start withdrawing money from the portfolio. As each target-date portfolio approaches its target date, the investment mix becomes more conservative by increasing exposure to generally more conservative investments and reducing exposure to typically more aggressive investments. Neither the principal nor the underlying assets of target-date portfolios are guaranteed at any time, including the target date. Investment risk remains at all times. Neither asset allocation nor diversification can assure a profit or protect against a loss in down markets. Be sure to see the relevant prospectus or offering document for full discussion of a target-date investment option, including determination of when the portfolio achieves its most conservative allocation.

Investors should carefully consider a mutual fund’s investment objectives, risks, charges and expenses prior to investing. A prospectus, or summary prospectus if available, containing this and other information can be obtained by contacting a financial professional, visiting principal.com or calling 800-547-7754. Read the prospectus carefully before investing.

No investment strategy, such as asset allocation or diversification, can guarantee a profit or protect against loss in periods of declining values.

Investment options are subject to investment risk. Shares or unit values will fluctuate, and investments, when redeemed, may be worth more or less than their original cost.

Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options. Fixed-income investment options—inclusive of U.S. Treasury inflation-protected securities (TIPS)—are subject to interest-rate risk, and their value will decline as interest rates rise. Neither the principal of bond investment options nor their yields are guaranteed by the U.S. or any other government entity. Fixed-income and asset-allocation investment options that invest in mortgage securities are subject to increased risk due to real estate exposure. Inflation-linked bonds (such as TIPS) issued by central governments are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. Inflation-linked bonds decline in value when real interest rates rise and could result in a loss. The inflation protection may be insufficient to offset inflation experienced by investors. Investments concentrated in natural resources industries can be affected significantly by events relating to those industries, such as variations in the commodities markets; weather; disease; embargoes; international, political and economic developments; the success of exploration projects; tax and other government regulations; and other factors. Real estate investment trust (REIT) securities are subject to risk factors associated with the real estate industry and tax factors of REIT registration. A master limited partnership (MLP) that invests in a particular industry (e.g., oil and gas) may be harmed by detrimental economic events within that industry. As partnerships, MLPs may be subject to less regulation (and less protection for investors) under state laws than corporations. In addition, MLPs may be subject to state taxation in certain jurisdictions, which may reduce the amount of income paid by an MLP to its investors.

Insurance products and plan administrative services are provided by Principal Life Insurance Company. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Princor Financial Services Corporation, 800-547-7754, Member SIPC and/or independent broker/dealers. Securities sold by a Princor Registered Representative are offered through Princor®. Principal Funds Distributor, Princor and Principal Life are members of the Principal Financial Group®, Des Moines, IA 50392. Certain investment options may not be available in all states or U.S. commonwealths.