Target Retirement Annual Review Optimizing Our Approach to Fixed Income in a Low-Yield Environment
Each year, State Street Global Advisors conducts a comprehensive review of its target retirement strategies. The annual review process is driven by the Defined Contribution Investment Group (DCIG), which blends asset allocation expertise from State Street’s Investment Solutions Group with defined contribution (DC) market insights from the Global Defined Contribution team. The review follows a consistent and transparent framework to reassess the capital market expectations and demographic assumptions that underpin the glidepath, while also evaluating new asset classes and investment themes for inclusion in the investor portfolios. The process is grounded in three key criteria: desirability, suitability1 and investability.
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.
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.
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