CAPTRUST Senior Manager
After more than a generation of declining U.S. interest rates, investors and plan sponsors are once again facing the risks and opportunities posed by rising interest rates. The Federal Reserve has raised its target for short-term interest rates six times since December 2015, and with the prospects of continued growth and the potential of inflation re-entering the picture, we expect more hikes over the next several years.
Given the lengthy period of declining rates we have experienced, many retirement plan committee members are facing a rising-rate environment for the first time in their careers. It will be important for them to understand this reversal in economic conditions and its broad impacts as they navigate this new environment and help participants do the same.
A Little Backstory
Several factors contributed to the 35-year decline in interest rates we witnessed—most notably, sustained lower inflation. Inflation and the level of interest rates are positively correlated, meaning that investors will demand higher yields and higher returns from income-producing securities when inflation is higher to protect their purchasing power.
In the late 1970s and early 1980s, the annual cost of goods and services was increasing at a rate of 15 percent a year at the peak; the 10-year U.S. Treasury carried a similar yield in response. As Figure One shows, interest rates have steadily declined since then. In recent years, the Fed has kept rates low to allow companies to remain viable as the U.S. economy recovered from the deep recession that followed the financial crisis. Today, Treasury rates must only compensate investors for an inflation rate that has been stubbornly below 2 percent.
Figure One: 10-Year U.S. Treasury Yield (1981 – Present)
More recently, a strengthening U.S. economy has spurred the upward movement in interest rates. We can observe these increases on both the short end of the yield curve that is directly influenced by the Fed and the longer end that is more market-driven and typically measured by the 10-year Treasury yield. The first catalyst for higher rates has been the Fed, which initiated its rate-tightening campaign in December 2015 when it became convinced that the economy was in a solid, sustainable expansion that could eventually lead to inflation.
So far, the Fed’s rate hikes have been measured and moderate so as not to disrupt financial markets. However, a pickup in GDP growth and emerging signs of inflation have raised the threat of an overheated economy. As Figure Two illustrates, Treasury yields have moved meaningfully higher in response—more than doubling since the summer of 2016—with the sharpest move occurring over the last three months.
Figure Two: 10-Year U.S. Treasury Yield (July 2016 – Present)
We expect a continued gradual move up in rates that will dampen some of the downside for bonds. Importantly, this view now appears to be priced into markets. Six hikes into the tightening cycle, we believe we are about halfway to the Fed’s short-term interest rate target.
Rising interest rates affect various retirement plan investment options in different ways. Core bond fund and capital preservation options are obvious areas of interest. However, 60 percent of plan sponsors surveyed during a recent CAPTRUST webinar on this topic listed target date funds as the investment option they are most worried about during a period of rising rates. This makes sense since target date funds are a commonly used qualified default investment alternative (QDIA) in defined contribution plans—so there is a lot at stake.
Capital preservation options are divided into three main categories:
- Guaranteed funds. Guaranteed funds offer investors a principal guarantee and interest rate that resets over some period. Assets in these products are usually invested in intermediate- and long-term bonds and provide a yield premium over stable value and money market funds. The impact of rising rates on a particular guaranteed fund is highly dependent on the fund’s contract terms, with the methodology and frequency of rate resets being the most important variables.
One set of risks unique to guaranteed funds is plan-level termination provisions, also called market value adjustments, which may come into play if a plan sponsor terminates a contract. In a rising rate environment, plans are more likely to have a negative market value adjustment—a loss—at termination. It is, therefore, important for plan sponsors to understand these provisions before making key decisions.
- Stable value funds. Stable value funds are the most common capital preservation products in defined contribution plans. They consist of short- to intermediate-term fixed income portfolios wrapped with an insurance contract that guarantees principal—but not interest (like guaranteed funds). The interest rates paid by stable value funds are directly tied to the underlying bond portfolios. Therefore, a plan sponsor should understand the investment approach and duration of the underlying fixed income portfolio. Underlying portfolio interest rate risk varies widely; durations can range from 1.5 to 6 years.
It’s important to note that rising rates, in and of themselves, are not bad for stable value. It is the timing of rate increases and fund cash flows that will determine the impact on stable value performance. A gradual move higher in rates combined with positive cash flows is the best-case scenario.
- Money market funds. The last category of capital preservation is money market funds. These funds have a duration of less than one year, with most securities maturing within 60 days. Since money market reform in 2014, two primary types of money market funds dominate: government money market funds that invest in government securities, and prime money market funds that invest in corporate and government securities. Money market funds have the shortest maturity of the three capital preservation options discussed here and are constantly reinvesting their maturing principal. As the Fed raises rates, money market fund yields will be most directly and quickly impacted.
It’s important to be aware that past money market results could impact future performance. An extended period of historically low interest rates pressured money market fund yields. Some funds waived management fees during this period to protect investors from losses. Now that rates are rising, some money market funds have instituted clawback provisions to recover fees lost in the past. These clawbacks can lower returns in vehicles that already earn very little, so this is an important factor to be aware of when selecting or switching money market funds.
Core and Core-Plus Bond Funds
Core or core-plus bond funds invest in a mix of government and corporate bonds as well as Treasury inflation-protected securities (TIPS), high-yield bonds, mortgages and even international bonds. They are present in nearly all the plans we advise on. While a quality active manager can broadly diversify across these sub-asset classes to add value, none of them are immune to interest rate risk, and they may be exposed to other significant risks. For example, while interest rates will impact bond funds, especially those with longer durations, the primary risk for most active core bond funds is credit risk, the likelihood that the issuer of a bond will default on its payment obligations.
Another consideration with bond funds is whether your manager follows an active or passive approach. In general, passive bond managers tend to have more interest rate sensitivity than active managers. Passive managers are more concentrated in high-quality areas of a market that generally have more sensitivity to interest rate changes. Active managers, on the other hand, can invest outside these high-quality areas to enhance the yield or portfolio total return.
Plan sponsors may want to help participants think about the role bond funds can play in a portfolio. For example, when used to help insulate a portfolio from stock market losses, passive options have historically been the most reliable. This type of investor should be willing to endure small bond fund losses in return for the higher probability of cushioning broader portfolio losses during market downturns.
On the other hand, investors looking to enhance returns may be better served by an active manager who seeks to deliver outperformance through a market cycle. A risk to consider here, however, is time horizon. Some core and core-plus managers may not be prepared to protect assets when they are most needed.
Target Date Funds
The least understood, but perhaps most critical, impact of rising rates is on target date funds. Because they are asset allocation funds—where no two target date fund series have the same allocation and they change over time—it’s difficult to isolate the risks specifically resulting from rising rates.
A participant’s experience with rising interest rates is going to depend upon two primary factors: the shape and length of the target date fund’s glidepath. More specifically, how quickly is the asset allocation moving from equities into fixed income?
One factor to consider is whether the manager is targeting a static allocation at a participant’s retirement age (sometimes referred to as a “to retirement” manager) or planning for an allocation that will balance risk and return through retirement (called “through retirement” manager). At retirement age, a “to retirement” manager is likely to have a higher fixed income allocation—and more exposure to rising rates—than a “through” manager. To add a little more perspective, fixed income exposure for 2015 funds—considered appropriate for participants at point of retirement—varies from 40 to 70 percent. That is a significant range.
Figure Three illustrates the higher fixed income allocation of a typical “to retirement” 2015 fund compared to a typical “through retirement” 2015 fund. In addition to the allocation to fixed income, not all target date fund series hold the same types of fixed income, and the different types of fixed income securities held will react differently to rising interest rates. So we think it is critical for plan sponsors to understand, in detail, the composition of their target date funds’ fixed income component.
Figure Three: Fixed Income Composition – “To” vs. “Through” Retirement
As with core bond funds, active bond fund components of target date funds have the potential to add to returns but can also make the overall portfolio more susceptible to credit risk. Meanwhile, passive bond fund managers tend to favor higher-quality bonds that may carry more interest rate risk. That said, it is not advisable to evaluate target date funds based solely on the risk of rising rates since this ignores what could potentially be larger potential drivers of risk and return for plan participants—the overall glidepath and allocations to equities and other diversifying asset classes.
How Plan Sponsors Can Prepare for Higher Interest Rates
A new interest rate regime may raise the question of whether certain investment options, such as passive bond funds, should continue to be offered. However, we caution that these options are intended as retirement savings vehicles for, perhaps, 40 years or longer and should not be removed solely due to short-term (or even intermediate-term) trends. But this means that plan sponsors should prepare to answer participant questions related to rising and higher interest rates. Stopping short of providing specific investment advice, they should be ready to answer general questions that participants may have, either through prepared answers or providing access to additional resources on bonds, interest rates and interest rate risk.
Understanding changes in the current interest rate environment and how those changes could impact retirement plan investment options can help plan sponsors evaluate their current investment lineups. A key starting point in analyzing plan-level exposure or interest rate risk is for sponsors to know what they own in their plan, why they offer it and how specific investment options should behave in a period of rising rates. They should ensure that they have the resources to look below the surface of their investment lineups, be comfortable with the investment options they own in their plans, and have a process to document their due diligence while continuing to monitor their plan investments.