Today’s investment regime looks dramatically different compared to just a short time ago. After more than a decade of rock-bottom interest rates, benign inflation, and stable global growth, these trends have kicked into reverse—giving rise to a major risk regime shift with greater global macro dislocations and drawdowns possible.
As a result, old assumptions around diversification and how to best reduce risk in an asset allocation may need to be revisited.
In our experience, the typical DC plan menu offers more than a dozen growth-oriented funds, an entire set of target date funds, and at least 2-3 bond funds. When it comes to capital preservation options, however, many plans have just a single offering that rarely changes and may be woefully out of date. This is despite the fact that about 10% of DC plan assets are invested in capital preservation options. This percentage represents an out-sized share given there is typically only 1 choice out of 20+ options on a DC menu.
We have found that many plan sponsors conduct extensive due diligence on their equity funds, fixed income funds, and target date funds—offering participants a variety of carefully chosen options. But when it comes to capital preservation, in our experience, many plan sponsors simply choose a single option, and that option is commonly a “default” fund provided by the recordkeeper.
Choosing a capital preservation option is an important decision to be made deliberately and not “by default.”
Typical DC fund line-up & capital preservation fund % share of DC plan assets
Sources: Typical DC Fund Line-Up based on the estimates of Franklin Templeton’s Defined Contribution team, as of June 2024. 10% share of DC Plans invested in capital preservation based on the findings of the 2023 Plan Sponsor Council of America 66th Survey of 401(k) Plans.
Demographics of the American workforce are changing. There are more people retired or near retirement age than ever before. A growing number of Americans are working later in life and, as a result, are more likely to contribute to their DC accounts for longer.1 Similarly, due to new rules that delay required minimum distributions (RMDs) to later in life, older participants may be more likely to keep their money in DC plans for longer. In the face of these latest trends, we think it is critical to offer options that meet the needs of this already large, and continuously growing group of plan participants.
Older participants tend to be those closest to retirement, which implies, their investment priorities are likely shifting from growing their account balances to preserving their nest eggs.
Why does this matter to plan sponsors? Having limited capital preservation offerings means your DC line-up may be unintentionally catering to younger plan participants with lower balances, much longer time horizons, and higher risk tolerances. Essentially, you may be unintentionally underserving the group of plan participants with the largest account balances and likely the greatest share of assets invested in your plan.
Source: 2023 How America Saves Study, Vanguard.
Today's higher interest rate environment makes cash management choices far more crucial than in the past decade. Although the Federal Reserve (Fed) lowered short-term interest rates by 1% in 2024, money market rates are likely to settle in the range of 3 -4% in the next few years --a level that can materially affect participants' accumulation and income over a long horizon.
The figure below illustrates that when cash yields averaged 0.25%--which was the case for nearly 15 yearsdf--the accumulation differences were marginal over a 30-year time horizon. But if yields revert to their long-term average of around 3 -4%, accumulation differences can contribute to the difference between a plan participant having either a cash-strapped or a comfortable retirement. With yields normalizing, offering capital preservation options with competitive, inflation-beating yields and the low volatility that plan participants expect may be essential to help reach retirement goals.
The chart above shows a hypothetical compounded annual return over 30 years. This is a hypothetical example only and does not represent the performance of any specific investment product. Actual investments may include fees, charges and other expenses that would affect an investment’s return. It assumes no distributions are made during these periods. Actual returns will vary. Withdrawals of earnings from a tax-deferred account will be subject to ordinary income tax, and early withdrawals can be subject to an additional 10% IRS penalty charge and/or surrender charges tax.
DC plans predominately rely on money market and/or stable value funds for capital preservation. While the vehicles have some characteristics in common—both seek to maintain a fixed NAV and offer participants daily liquidity—a closer look reveals meaningful points of differentiation that should be understood when evaluating a capital preservation option.
*The equity wash rule is a participant-level liquidity provision related to stable value. The rule requires that participants transfer assets from stable value to a non-competing fund and keep them there for a minimum of 90 days before the transfer to a competing fund takes place.
Note: This is intended to be of general interest comparison only and should not be construed as individual investment advice or a recommendation, and does not reflect the performance of any Franklin Templeton fund.
At the end of 2022, about 40% of DC plans offered a money market fund option to their participants, while stable value funds were offered in about 60% of plans. Notably, we have found that about 27% of plan sponsors currently offer both money market and stable value options.
Source: 2023 Plan Sponsor Council of America 66th Survey of 401(k) Plans.
Regardless of your plan’s current capital preservation offerings, we think now is a critical time to revisit this often neglected and increasingly important part of your DC plan.
We believe the combination of major shifts in demographics, regulations, interest rates, and the overall market environment necessitates a deliberate decision on the capital preservation option moving forward— whether it is a money market fund, stable value fund, or both.
As stewards of your participants’ retirement, we believe plan sponsors are better served by approaching capital preservation fund selection with the same level of due diligence and care applied to other parts of their DC plan. Like all important decisions, choices made in years past may be ripe for reevaluation.
FEATURED WEBCAST
Surprisingly, many organizations haven’t taken a hard look at this area of their retirement plan since the Global Financial Crisis—more than 15 years ago.
Today, the combination of major shifts in worker demographics, retirement regulations, and the interest rate environment makes providing best-in-class capital preservation options increasingly vital to support employees’ retirement objectives.
In this webcast hosted by Pension & Investments, DC plan experts from Chevron Corp. and CAPTRUST provide their perspectives on why they revisited this often overlooked, but critically important part of their retirement plan menus.
Key topics:
Contact a member of the Franklin Templeton Institutional team to learn more about investment strategies, solutions and services.
