Target Retirement Strategy Annual Review: Evaluating US Treasury STRIPS
Each year, our Defined Contribution Investment Group conducts a comprehensive review of our target retirement strategies, reassessing the capital market expectations and demographic assumptions that underpin the glidepath, while also evaluating new asset classes and investment themes for inclusion in investor portfolios.
The process follows a consistent and transparent three-pronged framework:
Investability: Can we implement this investment theme efficiently? If we’re adding an asset class, is there an appropriate benchmark?
Desirability: Do we expect this change to improve participant outcomes?
Suitability: Is the investment decision suitable for all Defined Contribution (DC)1 investors, and is the impact significant enough to justify the costs (financial and administrative) associated with a portfolio change?
This year, we evaluated US Treasury STRIPS for glidepath inclusion. Our findings follow.
Investability: Defining the Asset Class
Separate Trading of Registered Interest and Principal Securities (STRIPS) are zero-coupon fixed income securities sold at a discount to face value. First introduced in 1985, STRIPS are constructed by financial institutions that “strip” the coupons from US Treasury bonds. By removing the coupons, STRIPS (both principal and coupon) can offer greater interest rate risk sensitivity due to their longer durations. Today, while traditional long Treasury indices have durations of 18 years or less, widely used STRIPS indices have durations of 25 years or more and are sought by asset allocators seeking to match longer-term liabilities.
Desirability: The Inspiration for STRIPS
While people are living longer, long-term return expectations continue to compress, potentially creating a tension that threatens participants’ ability to achieve meaningful levels of income replacement in retirement. This year’s review focused on addressing this reality without deviating from our thoughtful and efficient approach to glidepath construction.
A simple step toward improving expected returns, and therefore wealth accumulation at retirement, is to increase the equity weight in the glidepath. Higher equity weights will improve outcomes in the median case but introduce more uncertainty due to the higher volatility of the asset class. To diversify the market risk of our equity-heavy starting portfolios, State Street holds an allocation of long government bonds.
An increased equity allocation would reduce the long government bonds allocation, which may lead to a bumpier ride for participants and less downside protection in volatile equity markets. To counteract the loss of downside protection, we considered the introduction of Treasury STRIPS as a substitute for long government bonds. Treasury STRIPS offer more concentrated exposure to long-duration government debt and thus can provide a level of downside protection that is similar to long government bonds but at a smaller absolute allocation.
In the chart below, we compared the performance of three different fixed income indices during various equity environments. STRIPS have historically offered materially higher returns during periods when equities were down the most.