DC Solutions: Adding Global Bonds To Target-Date Funds

Includes: BWX, TLO
by: AllianceBernstein (AB)

By Alison Martier and Seth J. Masters

Within U.S. defined contribution (DC) target-date funds (TDFs), whether we’re considering customized TDFs for larger plans or packaged solutions for smaller plans, our research shows that having a bond allocation that is not U.S.-centric can lead to better outcomes and enhance the effectiveness of the glide path.

As with the core menu option, the diversifying and risk-mitigating effect that we expect from a bond allocation can be enhanced through the addition of global bonds.

Superior Risk Mitigation Makes a Meaningful Difference

Our research—which we provide in greater detail in our white paper, Global Bonds: A Better Solution for DC Investors—indicates that hedged global bonds have been a better risk mitigator versus stocks than U.S. bonds have been over time, especially during months when stock returns were more than one standard deviation below their norm.

The concept of risk mitigation is as central to our study of glide paths as the opportunity to add value, whose cumulative effect over time is widely appreciated. (As we saw in a previous post, a global bond allocation also provides the active manager significantly more opportunity to add value compared with U.S. bonds.)

In the display below, we’ve modeled the spending phase of a retiree since 1977. This individual began with $100,000 and has been taking an inflation-adjusted withdrawal of 5.0% annually. The green line illustrates the growth of a portfolio in which the 70% portion of the 30/70 stock/bond allocation is invested in U.S. core bonds.Click to enlarge

The blue line shows the growth pattern of the portfolio in which the 70% portion is invested in hedged global bonds. This portfolio benefited from better risk mitigation during the inflationary environment of the late 1970s and early 1980s, as well as during the crash of 1987.

The result over the full period? A 45% greater asset accumulation versus the U.S.-only allocation.

And when we bumped our withdrawal rate up by just half a percentage point to 5.5%, the U.S. core bond portfolio ran out of money prematurely. It’s clear that the decision to shift at least part of the assets into global is critically important. By mitigating risk drag more effectively, the retiree may add additional years of spending.

How Much to Allocate in a TDF

So how much, then, do we advise allocating to hedged global in a target-date fund? We find that 50% of the total bond allocation (at least) is attractive.

With less than 50%, meeting investor objectives becomes more challenging and less certain; at 50% and above, we preserve purchasing power, avoid sharp market declines and minimize risk of loss.

So tap into the potential power of diversification. Open a broader opportunity set to active managers. But be sure to properly align the investor objective—in this case, an offset to equity volatility—with the risk/return profile of the service, by choosing hedged global rather than unhedged.

Within a core menu option, go global under the cover of Core Bond so as not to disrupt participants. Smaller plans should add a hedged Global Bond offering to their menu, either to replace or to complement their U.S. Bond offering. In an asset-allocation fund such as a TDF, we believe that adopting at least a 50% hedged global bond allocation should benefit the portfolio.

“Target date” in a fund’s name refers to the approximate year when a participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as participants near 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 investedincluding at the time of the fund’s target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.

Alison Martier is Senior Portfolio Manager—Fixed Income at AllianceBernstein, and Seth J. Masters is Chief Investment Officer of Defined Contribution Investments and Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.