If this is the start of a “more normal” era for markets, what does that mean for defined contribution menus?

Historically, defined contribution plan menu diversification has centered on traditional allocations between equities and fixed income—classically a 60/40 split, but varying depending on the age of the participant, and evident in the composition of target-date funds serving as default investment options. In a low-interest-rate and low-inflation environment, this traditional approach to asset allocation largely met the needs of participants.

Seeds of Change

For background, the Global Financial Crisis of 2008 (GFC) ushered in an era of near-zero interest rates where, amid slow economic growth, central banks were often challenged to maintain inflation at their stated targets. Enter the COVID pandemic, which pushed rates back down to zero and helped prompt a surge in financial assets that drove inflation to 40-year highs. This, in turn, caused the Federal Reserve and others to initiate their most rapid rates hikes in history.

With that rates campaign likely over and economic slowing on tap, overnight rates may ease to less-extreme levels but remain above the GFC-era lows, auguring a return to more normal economic and market dynamics, where we believe fundamentals may trump monetary engineering in driving investor returns.

For DC plan sponsors, this landscape creates important issues to grapple with around plan menu options and their potential impact on participant investment success—particularly relating to diversification. In our view, it’s important to explore ways to expand beyond traditional asset classes so participants can take advantage of asset classes that can potentially increase diversification and offset the impacts of an inflationary environment.

Moving Beyond the Traditional

Today, style analysis and reasonable stock/bond allocations make sense as intuitive building blocks for diversification, but are they enough? In our view, it’s important to go to the next level of diversification, considering not only choices within the broad stock/bond categories to enhance potential risk mitigation and return opportunity beyond a given segment’s benchmark, but also to look to other available asset types that may offer significantly different return patterns.

Within equities, sponsors may wish to tap equity strategies that emphasize fundamental research and quality in order to lessen exposure to markets and create potential for return away from the benchmark. Within fixed income, we believe the emphasis should be on flexibility, to provide access to assets across sectors and geographies, as well as duration positioning, left to portfolio managers well-equipped to assess yield and return potential dynamics.

Beyond those segments, additions can be drawn from real and alternative asset classes with the historical ability to “zig” when traditional asset classes “zag,” and still hold the potential for meaningful price appreciation and/or yield. For example, real estate investment trusts derive much of their returns from high dividends and—given the ordinary-income status of those payouts—are ideally suited to the tax-deferred environment of a DC plan. So-called liquid alternatives funds can draw on a range of hedge fund strategies with low correlations to stocks and bonds, such as global macro, special situations and low-volatility trades. Finally, private equity may be an effective addition for target-date options offering low-correlated returns from private companies that would otherwise be unavailable to plan participants.

Working in combination with traditional asset classes, these segments have the potential to help smooth potential performance and increase the likelihood of a successful retirement outcome.

Searching for Differentiated Return

Asset Class Correlations

Next-Level Diversification for DC Plans 

Source: Neuberger Berman. Projected correlations for asset classes over the next 20 years, as of November 2023.