Defined contribution (DC) schemes have historically made use of traditional fixed-income investments for their potential capital-preservation benefits as participants approach retirement. However, with the abolition of compulsory annuity purchase radically changing the risk profile of DC scheme members, and interest-rate rises likely to make fixed-income returns more challenging, schemes have been reassessing how they can best meet members’ retirement outcomes. In this article we look at how absolute-return bond fund solutions may be increasingly relevant in today’s uncertain environment, and how they can complement diversified-growth fund (DGF) investments, with which they share many characteristics.
The benefits of diversification
Over the last ten years, DC schemes have increasingly made use of DGFs in order to extend the growth phase for their members and increase the opportunity to grow a larger retirement pot. Although the DGF category encompasses a wide range of funds with varying approaches, the funds under the ‘diversified growth’ umbrella generally share important attributes: namely, they aim to provide a similar return to equities, but with less volatility – thereby aiming to offer smoother and more consistent growth for investors.
In terms of features and objectives, DGFs share many similarities with absolute-return bond funds, which invest in a broad range of fixed-income opportunities and assess elements such as credit quality and geographic exposure, which traditional approaches generally forego. This focus on diversification is especially relevant in a rising interest-rate environment, which can lead to negative total returns as bond yields rise, exposing DC members constrained by traditional fixed-income funds to a real risk of capital loss. A skilful fixed-income manager can generally find somewhere in the world where bond prices are attractive, and should be able to offer an intuitive and transparent investment process to do so. An unconstrained approach is also best suited to exploiting attractive valuation opportunities within credit and emerging markets, while avoiding being trapped in these riskier bond markets when spreads do not adequately compensate for the risks. This type of strategy therefore provides the genuine prospect of capital preservation and real investment returns which are paramount to achieving good member outcomes.
A skilful fixed-income manager can generally find somewhere in the world where bond prices are attractive, and should be able to offer an intuitive and transparent investment process to do so
Understanding and managing risk
With an intelligent de-risking strategy, scheme trustees and pension managers can essentially delegate their fiduciary duty to a manager in a cost-aware manner. A keen and in-depth understanding of the various fixed-income asset classes will in principle achieve an implicit governance process for schemes. A good unconstrained strategy therefore embeds a rigorous risk management approach to help steer the assessment of independent risk factors and how they interconnect. This ensures that no single position or risk factor is outsized within the fund at any given time.
Unconstrained bond investing should therefore appeal to investors who are looking to counter the risk to outcomes that a rising interest-rate environment presents over time. Through a single fund with a sound track record, DC schemes can gain access to the broadest opportunity set in the fixed-income market, while also taking account of the different stages of the economic cycle.
Newton offers a solution that allows for the opportunistic pursuit of risk-adjusted returns, with the intention of withstanding different market conditions and credit events. The Newton Global Dynamic Bond Fund was launched in April 2006 and has a solid track record, delivering a positive return in every calendar year, since inception, weathering the impact of continuing market volatility. The strategy invests in four key return-seeking asset classes: government bonds, emerging-market bonds, investment-grade corporate bonds and high-yield corporate bonds. It also uses a range of other stabilising/hedging instruments to seek to dampen volatility and provide downside protection.
A multi-asset approach
Default lifestyle solutions in DC have typically switched plan participants’ savings into bonds and cash as they near retirement. While target-date funds have offered more flexibility in determining the timing of the switch and how the funds are invested, the glide path for either solution has, until recently, been designed to match annuity risk. Given the freedom granted to plan participants, annuities may no longer be the first choice in retirement. Investments can either target cash, annuity matching or continued growth in investments.
An unconstrained bond strategy can be blended as part of an overall DC solution in a similar way to DGFs being blended with global equity, aiming to offer both downside protection and risk-adjusted returns for savers who continue to seek low volatility capital preservation ‘through retirement’. An income version of such a strategy could also form part of a post-retirement solution.
By building on the success DC schemes have experienced using DGFs in default funds and now beyond, we believe schemes could adopt a diversified and more flexible approach when it comes to the fixed-income portion of pension savings. Such an approach can provide the flexibility to pursue opportunities in a tactical and risk-aware manner on behalf of a DC investor. It is likely to be better designed to address the risk of members outliving their savings, and better positioned to navigate a potentially new interest-rate environment.
Past performance is not a guide to future performance. Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested. You should read the Prospectus and the Key Investor Information Document (KIID) for each fund in which you want to invest. The Prospectus and KIID can be found at www.bnymellonim.com.
Key investment risks
- Objective/performance risk: There is no guarantee that the Fund will achieve its objectives.
- Currency risk: This Fund invests in international markets which means it is exposed to changes in currency rates which could affect the value of the Fund.
- Derivatives risk: Derivatives are highly sensitive to changes in the value of the asset from which their value is derived. A small movement in the value of the underlying asset can cause a large movement in the value of the derivative. This can increase the sizes of losses and gains, causing the value of your investment to fluctuate. When using derivatives, the Fund can lose significantly more than the amount it has invested in derivatives.
- Changes in interest rates & inflation risk: Investments in bonds/money market securities are affected by interest rates and inflation trends which may negatively affect the value of the Fund.
- Credit ratings and unrated securities risk: Bonds with a low credit rating or unrated bonds have a greater risk of default. These investments may negatively affect the value of the Fund.
- Credit risk: The issuer of a security held by the Fund may not pay income or repay capital to the Fund when due.
- Emerging-markets risk: Emerging markets have additional risks due to less developed market practices.
- Charges to capital: The Fund takes its charges from the capital of the Fund. Investors should be aware that this has the effect of lowering the capital value of your investment and limiting the potential for future capital growth. On redemption, you may not receive back the full amount you initially invested.
- Counterparty risk: The insolvency of any institutions providing services such as custody of assets or acting as a counterparty to derivatives or other contractual arrangements, may expose the Fund to financial loss.
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Performance is stated gross of management fees. The impact of management fees can be material. A fee schedule providing further detail is available on request. The Fund aims to deliver a minimum return of cash (one-month sterling LIBOR) +2% per annum over 5 years before fees. In doing so, the Fund aims to achieve a positive return on a rolling 3-year basis.
Source: Newton, close of business prices, total return, income reinvested, gross of fees, in GBP, 31 March 2018.
Newton defined contribution investments