Do fixed income allocations for DC schemes need to evolve?

Jon Holquin, Director, UK Institutional, abrdn

Fixed income has typically been used to the greatest extent within the de-risking phase of DC lifestyles as members begin to head towards retirement.  This de-risking usually occurs with about 10-15 years to go until normal retirement date (NRD) and members are automatically switched from the Growth fund into some form of Pre-Retirement fund.  Typically these funds have historically invested in a combination of government bonds and corporate bonds, and over recent years allocations to short-dated variants have also been introduced as a means to reducing duration-exposure.

Given the performance of fixed income during 2022 (UK government bonds down 24%, Sterling Corporate Bonds down 18%) it is not surprising these so-called “less risky” funds delivered negative returns.  Understandably pension schemes (and their underlying members) have been asking plenty of questions about these returns and therefore it does beg the question whether the de-risking phase, and more specifically the allocation to fixed income, needs to evolve to prevent these types of losses happening again in the future.  In some instances clients might simply accept that 2022 was an anomaly and therefore nothing needs to change, however others might take a different view and want to make changes.

Fixed income can be a complex asset class, so DC schemes need to consider the role they want it to perform and the risks they face and the drivers to return.  Historically Fixed Income has been included to:

• Protect assets – high quality and liquidity focus can provide an emphasis on downside protection while delivering a yield level that remains attractive with an attractive premium over cash.
• Grow assets – A wide opportunity set across credit sectors, with a measured balance investment grade and sub-investment grade, allows for an attractive growth profile while harvesting elevated income levels.

With the increased focus upon sustainability within the DC environment, Fixed Income strategies can also deliver a positive real world outcome and deliver additional characteristics such as:

• Decarbonisation – with ever growing climate commitments across DC defaults having the ability to not only decarbonise but support real world decarbonisation through introduction of engagement and climate solutions companies.
• Sustainability Aware – building in clear ESG intentionality as part of bond solutions which combine the delivery of compelling investment returns alongside measurable ESG outcomes.

As DC investors looks to review their Fixed Income allocations and maintain/gain exposure to the above key characteristics, what solutions could schemes look to introduce to their investment strategies:

1. Introduction of short-dated assets to help reduce duration exposure
2. Consideration of Multi-Asset Credit/Diversified Fixed Income funds
   1. Key attraction for investors is that the decision to allocate to duration will solely rest with asset manager, unlike existing gilt/Credit allocations where the asset class itself has inherent duration
   2. Greater diversification within fixed income should hopefully allow opportunity to mitigate the overall poor environment and increase downside protection
3. Some combination of public/private fixed income assets (the introduction of LTAFs should make it easier for schemes to allocate to areas such as private credit)
4. Allocation to Emerging Market Debt (EMD) for increased geographic diversification and yield potential
5. If continuing to hold corporate bonds then allocate to some form of Net Zero/Climate Related solution
6. Naturally any of the options above would need to demonstrate some form of ESG/Sustainability/Net Zero/Climate type characteristics given the increased focus from DC investors.

For 2 & 3, essentially this is taking existing Defined Benefit strategies and trying to determine whether they can work in a DC context.  Some of the strategies within 2 & 3 could be more complex than just investing in gilts/credit, so an element of understanding would be required from trustees/schemes.  In addition these components could result in higher costs, so alongside the complexity element, consideration would need to be given to any cost implications as well.

The traditional negative correlation between bonds and equities is likely to return so, as well as being an attractive investment opportunity in its own right, fixed income can also enable investors to capture and optimise the benefit of diversification within an investment portfolio, whilst also delivering real-world sustainability gains.

Investment involves risk. The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested. Past performance is not a guide to future results. This material is for informational purposes only to illustrate our product development process. This should not be relied upon as a forecast, research or investment advice.