Amid increased regulatory attention to fund selection, the threat of rising rates and last year's drama surrounding Bill Gross' departure from Pimco, 401(k) bond fund lineups are undergoing a face-lift.
Historically, while plan sponsors and financial advisers have thrown in a variety of equity funds, bonds have been the sleepy side of the retirement plan fund menu.
“When you look at a 401(k) lineup, you have this rainbow of equity funds to choose from,” said Tim Courtney, chief investment officer of Exencial Wealth Advisors. “But on the bond side, you'll have a money market fund, a stable value fund and maybe the Pimco Total Return Fund.”
That is starting to change.
A recent paper from Towers Watson observed that defined contribution plans have anchored their bond funds to the
Barclays Capital Aggregate Bond Index. Using that index as the benchmark leaves the bond fund menu not only heavily slanted toward domestic bond exposure but also U.S. interest rate risk.
As a result, advisers and plan sponsors are seeking bond choices that will zig when the rest of the U.S.-based fixed income market zags. That means that bond funds that were virtually unheard of in the DC space in recent decades — high-yield bond funds, floating rate bond funds and multisector bond fund strategies — are starting to pop up in retirement plans.
Plan sponsors began to ask even more questions about their bond funds when Pacific Investment Management Co. parted ways with its star manager Bill Gross in September 2014. The firm's Total Return Fund, an intermediate bond fund offering, is a staple of retirement plans.
“That incident influenced and in-formed plan sponsors' thinking about their bond offering,” said Lorie Latham, a director at Towers Watson. “We're seeing large plan sponsors explore how adjusting their bond exposures away from core mandates can add value.”
But none of those decisions can be made off the cuff. Retirement plan advisers who are preparing to overhaul a bond fund menu will need to step up their due diligence and get to the heart of what's driving plan sponsors' interest in updating their fixed-income choices.
SELECTION AND MONITORING
In recent years, a volley of lawsuits brought by retirement plan participants against their employers shone a spotlight on the selection and monitoring process that 401(k) fiduciaries undertake when they choose funds. The U.S. Supreme Court will rule on one of the biggest suits, Tibble v. Edison International, in which plan par-ticipants accused their employer of choosing costly funds.
Perhaps the most interesting development in the Tibble case was both sides agreeing that fiduciaries have an ongoing duty to make sure investments remain prudent.
In practice, plan sponsors not only need to keep an eye on what's currently in the fund menu, they must also be able to demonstrate how they wound up with those funds. And if they decide to change a fund, they need to document the the rationale behind that decision.
“You don't have to make a change if you look to professionals, you have a conversation with your adviser, and the adviser says he can see where you're coming from and this is why we shouldn't move [from the fund],” said Jason C. Roberts, chief executive of the Pension Resource Institute. “You have to have that conversation, document it, document what you decide and why.”
With respect to replacing bond funds, that means advisers need to come up with the right research to back up their guidance.
TURNING POINT
Advisers to 401(k) plans point to the drama around Bill Gross' departure from Pimco as a turning point for bond fund selection.
“It's like Brett Favre was released from Green Bay and went to the Minnesota Vikings,” Patrick Morrell, vice president of business development and investments at Ingham Retirement Group, said. “It knocked us back on our heels, and being quick enough to respond with an adequate answer was difficult.”
Mr. Morrell initially put Pimco on watch, but wound up suggesting that his 401(k) clients stick with the Newport Beach, Calif.-based firm. Some clients were interested in a change, however, which meant he had to compile a list of about a dozen bond funds and call up other fund managers to explore alternatives.
Alp Atabek, chief investment officer and founder of AFS Financial Group, also recommended that his retirement plan clients with Pimco funds stay put.
Both advisers pointed to the strength of the remaining management team as a factor in their recommendations.
Nevertheless, plan sponsors now are stressing the importance of having a team strategy for bond funds.
“More of the investment committees like to see a team approach, so one manager leaving doesn't derail the whole fund,” Mr. Atabek said.
NEW ERA OF BONDS
Diversification is the underlying theme in current bond fund menus as advisers aim to mitigate interest rate risk and broaden exposure beyond intermediate bonds and cash equivalents.
The majority of the industry constructs bond fund menus based on duration, credit risk and the yield the bond portfolio will provide.
Mr. Morrell suggested there is a better way to assess those funds: Consider examining a given fund's risk exposures to cash, Treasuries, corporate bonds and non-U.S. bonds, and use those risk factors to determine how to best build a diverse bond portfolio.
Ingham's 401(k) clients now have complementary bond funds alongside their intermediate bond fund staple, either as standalone options for sophisticated employees or as a component of a customized target-date strategy. “Pimco has a lot of cash and Treasuries, but
BlackRock Strategic Income has corporate bonds and futures,” Mr. Morrell said. “Together, they provide adequate coverage.”
Mr. Atabek, meanwhile, has expanded bond horizons to include multisector bond funds and international bond funds, as well as an intermediate-term bond fund. Normally, these three are actively managed. He also keeps a money market fund or other cash equivalent, and a total bond market
index fund, the latter for employees inclined toward passive investing.
“There is something for everyone,” Mr. Atabek said.
GUIDANCE AND EDUCATION
The true end client in 401(k)s is the employee. Ms. Latham of Towers Watson noted that when her firm analyzes a portfolio, it considers how a plan's participants have been using the fixed income offerings.
In the interest of keeping things simple for participants, Ms. Latham noted that it's possible to combine a variety of diversified strategies into one customized bond portfolio.
“The participant sees one option, but underlying it are two or three components,” she said.
Bond diversification must be paired with participant education, Mr. Morrell said. That can include a breakdown of the funds and how to compare them.
“You're making these [custom bond portfolios and standalone bond funds] available to the participant as tools, but if you don't show them how to use these tools, they're useless,” he said.
