6-month period brings financial storm for many

Defined contribution money managers, like their plan sponsor clients and the millions of U.S. workers who save for retirement with them, are navigating a much different world in mid-2022 than they did at the end of 2021.

"Certainly, these six months have been very different than last year and the year before, which is really quite a statement when you think that in the last two years we were in the middle of a pandemic," said Anne F. Ackerley, New York-based managing director and head of BlackRock Inc.'s retirement group. "But with inflation, with market volatility, plan sponsors are looking at their lineups and saying, 'Do (we) have tools in the toolkit that can help people?"

That's a question DC money managers have been getting repeatedly in recent months, industry sources said, as stocks and bonds have tumbled while inflation has risen to its highest levels in 40 years.

"Plan sponsors are concerned about how do you give folks a sense of comfort amidst the storm?" said Matthew Brancato, principal and head of client success for Vanguard Group Inc.'s institutional investor group in Malvern, Pa.

The storm hadn't yet hit at the end of 2021 when assets in defined contribution retirement plans climbed to a new year-end high, surpassing the previous record set the year prior.

At the end of 2021, U.S. institutional tax-exempt assets managed for DC plans rose 14% to $10.13 trillion, up from $8.88 trillion in 2020, according to Pensions & Investments' annual survey of money managers.

There was a similar jump in internally managed defined contribution assets, which rose 13.7% to $9.04 trillion, up from $7.95 trillion the year prior.

With more assets under management in the defined contribution space, coupled with market volatility and inflation, managers are spending more of their time communicating with plan sponsors and participants about the merits of staying calm.

And so far, there hasn't been any major swings at the participant level, sources said.

"By and large participants are riding out the storm, and hopefully it doesn't last too much longer and they can pop out better risk-aware on the other end," said David O'Meara, New York-based senior investment consultant with Willis Towers Watson PLC. "It certainly has been a challenging year with equity markets down 20% and inflation running as high as it is. There hasn't been a great place to hide, especially with interest rates increasing, bonds are also down."

U.S. equities, as measured by the Russell 3000, and non-U.S. equities, as measured by the MSCI ACWI ex-U.S., were up 25.6% and 8.3%, respectively, in 2021. But in the first half of 2022, they're down 21.1% and 18.2%, respectively. Meanwhile, fixed income, as measured by the Bloomberg U.S. Aggregate Bond index, was down 1.5% in 2021 and fell 10.3% in the first half of 2022.

The Alight Solutions 401(k) index, which tracks the 401(k) trading activity of more than 2 million people with more than $200 billion in collective assets, found that net transfers as a percentage of starting balances were 0.46% in the second quarter of 2022, identical to the percentage seen in the prior quarter, but up from 0.16% in the second quarter of 2021. Net transfers in the first quarter of 2020, at the onset of the COVID-19 pandemic, were 1.59% of starting balances, the highest level for a quarter since the Alight index started in 1997.

At Vanguard, the largest DC money manager with $2 trillion in U.S. institutional tax-exempt DC assets as of Dec. 31, according to P&I data, Mr. Brancato said that only 4.3% of its DC plan participants traded in the first six months of 2022, which is down year-over-year from 5.5% in June 2021 and 6% in June 2020.

"We're really focused on helping participants stay the course, keep that long-term time horizon and continue what they're doing," Mr. Brancato said.

Samantha O'Neil, head of workplace inclusion, insights and marketing at Boston-based Fidelity Investments, said in an email that Fidelity's most important role for plan participants is to be "a calm voice in what can feel like a tumultuous storm of market volatility. As such, we validate participants' potential unease and remind them that market swings, while uncomfortable, are common. We caution that attempting to time the market can increase risk and suggest that, if a participant already has a solid financial plan in place, sticking to it is usually the best choice."

Fidelity was the third-largest money manager with $1.2 trillion in U.S. institutional tax-exempt DC assets, as of Dec. 31, up 15.7% from the year prior. Blackrock was second on the list with $1.39 trillion, up 15.3% from $1.21 trillion at the end of 2020.

Target-date funds' popularity continued in 2021 with $2.6 trillion in assets at the end of the year, up 17.5% from 2020 and 135.7% from the $1.1 trillion total in 2016, according to P&I data.

At Fidelity, 57.8% of new dollars from participants went into a target-date fund in the quarter ended March 31, up from 25.6% in the first quarter of 2017, according to Michael Shamrell, Boston-based vice president of thought leadership. At the end of 2021, Fidelity's target-date strategies held $266.2 billion in assets, up from $233.6 billion the previous year, according to P&I data.

"We're encouraged that a growing number of assets are in target-date funds because that means that the asset allocation is being professionally managed and a lot of participants feel a bit more comfortable knowing that their 401(k) savings are managed by a team of professionals," Mr. Shamrell said.

With high inflation persisting, Vanguard has seen an uptick in conversations with plan sponsors over target-date fund offerings, Mr. Brancato said. Those sponsors typically leave the conversation "with a good degree of comfort that by having things like short-term (Treasury inflation-protected securities) in a target-date fund (is) part of a balanced asset allocation," he added. "That's a terrific mechanism to guard against the risk of inflation for retirees and folks who are more reliant on those portfolios to draw down."

BlackRock, too, is seeing more inquiries from plan sponsors over its target-date fund offerings, Ms. Ackerley said. Its target-date fund menu provides exposure to real estate, TIPS and commodities, which can help returns in an inflationary environment, she added.

"Our view is if people are in the right target-date, probably the best strategy is to stay the course, and we are largely seeing that," Ms. Ackerley said.

BlackRock's target-date strategies held $383.4 billion in assets at the end of 2021, up 23.7% billion from the previous year, according to P&I data.

James Veneruso, New York-based senior defined contribution strategist at Legal & General Investment Management America Inc., said he will be watching to see how target-date fund managers react to high inflation moving forward.

Inflation-sensitive asset classes, like TIPS, real estate investment trusts and commodities have "been a hallmark of many target-dates for a while," Mr. Veneruso said. "It will be interesting to see, though, if those allocations increase. Because I feel like they were for a while decreasing because there wasn't inflation and there's a cost associated with those strategies when there's not. It remains to be seen in the coming year perhaps if target-date managers, when they re-evaluate their asset allocation, make any shifts."

Target-date fund strategies are usually re-evaluated on an annual basis, typically later in a calendar year, Mr. O'Meara said. "Given where the market turned this year, we haven't really seen this year's market been reflected in target-date fund strategies," he added.

Joshua Cohen, Chicago-based head of client solutions at PGIM DC Solutions at PGIM Inc., the investment management businesses of Prudential Financial Inc., which had $299.4 billion in U.S. institutional tax-exempt defined contribution assets at the end of 2021, up 3.9% from the previous year, according to P&I data, said there's now more of a demand from "participants and maybe plan sponsors and consultants for more inflation-sensitive type solutions."

For many years, inflation-sensitive assets "haven't performed really well compared to the equity markets, but those are the asset classes that have provided really some protection for inflation and now you are seeing more interest in things like real estate and commodities," Mr. Cohen said.

Prior to the rise in inflation, U.S. institutional tax-exempt DC assets in real estate equity strategies were up 42.2% year-over-year to $7.5 billion, as of Dec. 31, according to P&I data. Moreover, REITs saw a 19.8% increase in 2021 over the prior year to $33.2 billion, and inflation-protected securities had a 7.6% increase in 2021 to $82.2 billion.

Drew Carrington, San Mateo, Calif.-based senior vice president, head of institutional defined contribution at Franklin Templeton Investments, which had $28 billion in U.S. institutional tax-exempt DC assets as of Dec. 31, according to P&I data, said plan sponsors are keener to listen about incorporating more diverse asset classes in their plan lineups due to the recent market volatility and inflation.

"Some of the themes we've been talking to plan sponsors about are resonating today in a way that maybe they weren't a year ago," Mr. Carrington said. He added that private real estate is a category Franklin Templeton has discussed with plan sponsors in recent years, and in 2022, private real estate has had positive returns while stocks and bonds were negative.

"The diversification story that has always held true for institutional investors about real estate … it ought to apply in defined contribution plans, too, in a professionally managed setting," he said.

Inflation and market volatility could also play a role in whether money flows into active or passive strategies, sources said. In 2021, assets in passive domestic equity totaled $2.75 trillion — a 22.33% increase over 2020 — compared with active domestic equity at $2.35 trillion, which rose 13.2% year-over-year, according to P&I data.

"For a decade-plus there was no downside to being passive in target-dates from an asset standpoint because you were paying rock-bottom fees and your performance was great." Mr. Veneruso said. "We'll see within a year's time, given the volatility, given inflation … these are environments where that's (active management's) value proposition."

BlackRock's Ms. Ackerley said that with "this kind of volatility, I do think plan sponsors are thinking about the future. If you believe … there's going to be more volatility going forward, you might think that an active manager might have more tools in the toolkit to deal with that kind of environment. We've seen more inquiries into our active target-date."

The full impact of inflation on retirement assets isn't fully known, sources said.

For more than a decade, "Inflation was something that was given a lot of lip service, but because there was never much experienced inflation, managers (and) plan sponsors never really had to focus on it," Mr. Veneruso said. "But now we're seeing it bite."

"When you think about inflation, who does it impact disproportionately?" he added. "It's people living on a fixed income that's not adjusted for inflation, which is a lot of retirees. In this general conversation of retirement income, you're now in this added wrinkle of the impact of inflation. Does the 4% rule mean anything if there's 8% inflation?"