Target Retirement Annual Review Optimizing Our Approach to Fixed Income in a Low-Yield Environment

Long-duration US government bonds (referred to here as long government bonds) have played an important role in the State Street Target Retirement series glidepath since the inception of the strategy in 2005. Our long government bond allocation is primarily used during the accumulation phase, when participants hold a higher equity allocation, starting at 10% in the earlier stages of the glidepath and reducing to zero as participants approach retirement. Long government bonds have provided strong downside protection, owing to their role as a safe haven asset class, and a meaningful source of return, aided by a secular decline in interest rates. Following the significant market sell-off in Q1 2020 driven by the COVID-19 pandemic, interest rates are now near all-time lows, and we find ourselves in a uniquely challenging return environment for fixed income. While diversification is key in providing participants with a smooth journey toward wealth accumulation, potential negative returns from our fixed income exposure means this diversification comes at a higher cost.

In light of the above, effective April 2021, the State Street Target Retirement glidepath will add an exposure to intermediate US government bonds (referred to here as intermediate government bonds) in the accumulation phase, funded from the existing long government bond allocation. The overall allocation to US government bonds will not change as a result of this enhancement, but the allocation will now be a mix of long government bonds and intermediate government bonds.

Potential Benefits:

• The enhancements improve long-term expected returns while modestly reducing forecasted volatility in the earlier stages of the glidepath.
  
  
• Retaining long government bonds within our investment opportunity set allows the strategy to maintain a longer fixed income duration, providing higher expected downside protection.
  
  
• The overall glidepath allocation to fixed income and US government bonds remains unchanged.

Because long-term return forecasts are highly sensitive to interest rates, the strategic mix between intermediate and long government bonds will be established closer to the implementation date, and is expected to be evaluated as part of our annual review process in future years.

To further explain the rationale behind this change, and why we believe it is additive and consistent with our core philosophy, we review the desirability, suitability and investability of long government bonds in light of the current market environment, and discuss the rationale for introducing an allocation to intermediate government bonds.

Desirability

Would enacting this change to the glidepath be expected to improve participant outcomes?

To address the desirability of a new asset class, we start with a review of the existing allocation — long government bonds. Long government bonds have historically been an appropriate allocation for younger investors, driven by two key characteristics:

1.   Higher long-term returns than shorter duration alternatives and

2.   Superior diversification benefits relative to fixed income asset classes that include credit risk, such as aggregate bonds.

These features have contributed to strong long-term outcomes for the State Street Target Retirement strategies, buoying returns in our earlier-dated vintages in down markets as yields have fallen. Most recently during Q1 2020, long government bonds delivered a +20% return during the equity market sell-off, compared with +3% for US aggregate and +0.2% for non-US bonds.²

Figure 1: Long Government Bond Index: Yield to Worst

The result of this significant change in yields is that, going forward, long-term return expectations are challenged. According to the Q3 2020 long-term capital markets forecasts generated by State Street’s Investment Solutions Group, we expect long government bonds to return -1.5% annualized over the next 10-plus years, driven by an assumed long-term increase in interest rates toward historical norms. In keeping with our strategic asset allocation process, we incorporate the expectation for long-term rate normalization into our review of long government bonds and their role in the glidepath.

While the return outlook for longer-duration long government bonds is challenged, we believe that there still is significant diversification benefit in holding US government bonds, and continue to favor a 10% allocation to this sector of the fixed income market for younger participants. However, while diversification and overall portfolio efficiency are key elements in providing participants with a smooth journey toward wealth accumulation, potential negative long-term returns from the fixed income exposure in the early points in the glidepath presents a higher cost. Thus, it is important to assess whether we can improve the efficiency of this allocation while maintaining key elements of diversification, allowing for a consistent risk profile.

Rather than seek to add higher risk exposures that meaningfully increase correlations to equities, we elected to maintain our dedicated US government bond exposure while adjusting the duration profile within the allocation. Relative to an exposure to US aggregate bonds or non-US bonds, a mix of US government bonds maintains the key attributes that have benefited the target date funds historically — namely strong diversification in falling equity markets.

Figure 2: US Government  Bonds Have Offered  More Consistent Diversification

By virtue of the extreme interest rate environment that we find ourselves in today and the outlook for rates going forward, introducing an allocation to intermediate government bonds improves expected returns while maintaining a similar risk profile in the longer-dated vintages of the strategy.

Figure 3: Introducing Intermediate Government Bonds Improves Expected Efficiency in Longer-Dated Funds

Suitability

Is the investment decision under consideration suitable for all DC investors?

What is the role of fixed income in the early stages of the target date glidepath?

Our approach to evaluating the suitability of various allocations in the glidepath starts with the objectives for DC participants and the key investment risks they face. For younger participants, the key objective is to efficiently accumulate wealth and, aligning with this focus on growth, the State Street glidepath holds 90% in equities at its earlier stages. We further manage at the sub-asset class level in order to better align with objectives, holding higher strategic allocations to segments of the equity market expected to deliver stronger long-term returns (e.g., US small-cap stocks and international stocks). Importantly, the decision to maintain a 10% allocation to fixed income in these early years considers how portfolio returns — and risk — impact ending wealth accumulation by incorporating expected participant savings. For younger participants who have relatively small balances, holding more than 90% in stocks has the potential for increased returns, but does not result in meaningfully higher expected balances at retirement. At the same time, holding more than 90% in stocks does result in much higher levels of risk, and fixed income has historically played a valuable role in improving overall efficiency by delivering downside protection when stocks perform poorly. Managing risk at the starting point allows the glidepath to hold on to equity exposure during participants’ middle and late career years, which have a larger overall impact on wealth accumulation.

For these reasons, we continue to emphasize efficient wealth accumulation — prioritizing the strong diversification benefit from fixed income while seeking to maximize returns in the equity portfolio through thoughtful sub-asset class allocations.

What fixed income allocation is best suited for this role?

While we prefer to maintain a 10% allocation to fixed income even at the earliest points in the glidepath, not all fixed income allocations provide the same level of diversification or improvements to portfolio efficiency.

We can evaluate the diversification benefits of different exposures as measured by correlation, which provides insight into the direction of returns for bonds relative to stocks, as well as downside beta, which highlights the magnitude of this downside protection. While long government bonds have historically provided the best combination of characteristics, intermediate government bonds have similarly offered negative correlations and downside beta to equities, and at greater levels than aggregate bonds.

US aggregate bonds present an opportunity to modestly improve return expectations, but are not expected to provide the desired level of portfolio diversification, and feature elevated levels of interest rate risk compared to historical norms. Non-US bonds offer very low yields, as well as questionable diversification benefits when the impact of currency exposure is removed. More volatile asset classes like high-yield bonds and increased equity exposure would materially increase the risk profile of the strategy, and were excluded due to our view on the role of fixed income for these younger investors.

Figure 4: US Government Bonds Offer Greater Correlation
Benefits

In addition to the historical diversification benefits that intermediate government bonds have provided, they also offer benefits relative to long government bonds in light of our market outlook, namely, a significantly lower level of interest rate risk and a positive long-term return expectation. The persistent decline in interest rates over the past decade has caused the duration of the long government bond index to extend from its historical average of roughly 10 years to 19 years, while intermediate government bonds have a duration of just under four years. Combining these US government bond exposures in a strategic mix allows the target date funds to better control for these characteristics and improve the long-term return expectation from our fixed income allocation, while maintaining a higher level of expected downside protection relative to alternative options with a comparable risk profile.

Figure 5: Historical Quarterly Fixed Income Returns During Different
Equity Market Environments

Investability

Can we implement this investment theme efficiently?

A key question when assessing the investability of an asset class using a passive approach is whether we are able to replicate the returns of the index. For example, if an asset class is very illiquid or if transaction costs are high, it will probably not be possible to accurately track the index returns. While intermediate government bonds will be incorporated as a new strategic allocation in the glidepath, US government bonds as an asset class have been a part of the State Street Target Retirement glidepath since the strategy’s inception in 2005.

State Street’s fixed income teams have extensive experience managing exposures to US government bonds and, as of September 30, 2020, managed $85 billion in US government bond index strategies, of which more than $24 billion was in dedicated intermediate-duration strategies. From an implementation standpoint, reducing the duration within our US government bond exposure presents a low-impact change. By simply replacing longer-duration government bonds with the intermediate index, there are no added concerns around liquidity, cost or tracking error.

More broadly, investability is an important consideration for the universe of asset classes that were included. There has been much debate about the appropriate way to account for the questionable benefits of fixed income going forward — ideas like option strategies, gold, currency overlays and other less-correlated asset classes. It is important to consider these strategies in the context of a low-cost target retirement strategy designed to account for the day-to-day cash flow requirements that DC plans feature. We believe that the most appropriate asset class in light of the considerations for investability is maintaining our government bond exposure while reducing the duration profile of the strategy.

In Closing

The State Street Target Retirement series follows a rigorous, transparent annual review process where investment decisions are constantly re-evaluated to ensure that they reflect our long-term investment beliefs. Following this framework, and avoiding changes based on short-term tactical views, allows the strategy to deliver an intuitive, transparent solution that seeks to maximize value for fee and deliver successful retirement outcomes to participants. While we still believe in the diversification benefits of long government bonds, today’s low yield environment has increased the perceived cost of this diversification in light of the long-term return outlook. Incorporating intermediate government bonds into the strategic mix maintains the overall exposure to US government bonds, and improves the long-term return expectations for participants prior to retirement. We have a systematic framework in place to continuously evaluate this decision within the context of our long-term forecasts and, as interest rates normalize, we are committed to continuing to deliver the optimal trade-off between downside protection and long-term return expectations.

Figure 6: Evolving a Glidepath that Balances Long-Term
Returns and Key Risks