Insights

Assessing Fixed Income in Target Retirement Strategies

The trend toward index-based target date funds has not only continued but actually accelerated in recent years, as plan sponsors continue to value transparency, low-costs and strong long-term results. The market has generally accepted the key principles behind an index-based approach; asset allocation is the most important decision, broad diversification improves outcomes, and cost savings compound over time.

While index-based implementation comes in many shapes and sizes, and asset allocation decisions are not “passive,” this approach still has its detractors. Two common critiques of index-based target date funds (TDFs) still come up frequently:
1. The strategy relies on issuance-weighted benchmarks to manage fixed income
2. “Passive” approaches lack the requisite flexibility to protect participant wealth in market downturns

Here we will counter the critics, particularly in the context of volatile market cycles.


June 26, 2020


In our full whitepaper, Beyond the Benchmark: Assessing Fixed Income in Target Retirement Strategies, we compared State Street’s fixed income approach to that of a prominent active target-date manager, using data going back to 2005. While we did not contest the idea that an active approach to fixed income can result in outperformance over commonly used fixed income benchmarks, we did raise question the costs, particularly to diversification, of overperformance.

Importantly, how did outperformance impact the experience of the investor in the target date fund, and how does diversification play a role in mitigating key risks?

We found that the excess return of individual active fixed income funds has typically been delivered via credit over weights, and subsequently higher correlations to equities. The fixed income allocation from the active target date manager had performed well in risk-on and growth-oriented markets, and it had modestly outperformed the State Street fixed income allocation over the time period analyzed. However, the active approach lagged significantly in negative equity markets, when participants value the diversification that fixed income is expected to provide.

While Q1 2020 presented a difficult environment for markets and the participants that rely on them for retirement savings, it also served as an opportunity to reexamine the performance of these approaches in a period of heightened market volatility. During March, as equity markets were rapidly selling off, fixed income markets were pressured due to liquidity being tested, and transaction costs were significantly elevated.

It was in this market context that we conducted our analysis by taking the five largest active target retirement strategies by assets under management and comparing the normalized monthly returns from each fixed income portfolio to the State Street fixed income allocation in both a longer-dated (far from retirement) and income fund (in retirement). We made this comparison by aggregating the performance of the fixed income components in the glidepath at these two stages.

While target date strategies differ in their objectives, generally glidepaths feature equity-heavy portfolios in the longer-dated vintages (the median glidepath holds 90% in equities for younger investors) and more balanced risk approaches in the income funds. The allocations of the income vintages vary depending on whether the glidepath is “to” or “through” retirement, but our analysis included both approaches.

  State Street Fixed Income Return Average Active Fixed Income Return Average Excess
January 2020 6.60% 1.70% 4.90%
February 2020 6.53% 0.92% 5.61%
March 2020 5.94% -3.31% 9.25%

Source: State Street Global Advisors. Morningstar Direct as of March 31, 2020. Active managers chosen were the five largest actively managed Target Retirement strategies by AUM per P&I as of 12/31/18. Fixed Income return is calculated by weighting each underlying fund return by its normalized allocation in each respective vintage as of the beginning of each month.

In longer-dated vintages dominated by equity risk, outperformance from fixed income in down markets is key. During Q1, the majority of active strategies failed in this regard.

Most notably, the State Street fixed income allocation outperformed the average active manager by 925 basis points for the month of March. 



SSGA Fixed Income Return Average Active Fixed Income Return Average Excess
January 2020

1.11% 1.19% -0.08%
February 2020 0.86% 0.43% 0.43%
March 2020 -1.53% -3.81% 2.28%

Source: State Street Global Advisors. Morningstar Direct as of March 31, 2020. Active managers chosen were the five largest actively managed Target Retirement strategies by AUM per P&I as of 12/31/18. Fixed Income return is calculated by weighting the monthly performance of each underlying fixed income fund in the listed vintage by its percentage of the overall fixed income allocation, using allocations at the start of each month.

Income funds can be more difficult to compare, as each manager lands at a very different point on the glidepath. Objectives for retirees are more complicated, needing to balance wealth preservation with inflation management and the need to combat the risk of running out of money in retirement. As such, fixed income allocations must balance downside protection with generating sufficient return from a bond-heavy portfolio. Still, in Q1 we found that the State Street fixed income allocation outperformed its active peers by an average of 228 basis points during March.

In Closing

Using Q1 2020 as the most recent example of a negative equity market, we saw State Street’s approach to fixed income continue to outperform the average active manager. Importantly, while the State Street fixed income exposures are index-based, using more granular building blocks rather than relying on a single fixed income exposure to US Aggregate bonds allows for more appropriate risk and return characteristics for participants at each step of their careers. This led to smaller drawdowns relative to their active peers in the income fund, and substantial outperformance relative to those active peers in equity-heavy longer-dated vintages.

In our business, diversification is synonymous with preparedness. Recent global events have enforced the value of anticipation and shown that a thoughtful index manager won’t be caught flat-footed.