In an interesting article about fiduciary risks, Fiduciary News’ Chris Carosa promotes the idea that an excessive weighting of bonds in 401(k) plans could increase fiduciary liability. Reference is made to the recent SSgA DC Investor Survey, which states that, “49% of participants are investing more conservatively than they did five years ago — presumably by holding larger percentages in fixed income.” The article also points out the age-old issue that DC investors, by and large, simply do not understand how bond fund values are impacted by interest rates.
Given that fixed income securities are imbedded in different types of asset allocation funds (e.g., target-date, target-risk, balanced), it is difficult to discern exactly how much “overweighting in fixed income” actually exists. Of course, in order to declare that there is an “overweighting,” one has to assume that someone has figured out the right mix that should exist between equities and fixed income for both the plan’s assets in aggregate, as well as that for each DC investor.
As is always the case with investing, the future is largely unknown. You can find widely divergent views among many investment “experts.” There are stock market bulls and bears, predictions of deflation and hyperinflation as well as concerns about the debasement of the U.S. currency. The latter is viewed by the famed investor, Jim Rogers, as being caused by the “race to insanity” in which, through the printing of money by nearly all central banks, stock markets are being kept artificially high — only to eventually fall back to earth once inflation rears its ugly head. This is just one example of the many views held today about what the future holds for the capital markets.
Given the divergent views of the markets, it is hard to imagine that plan sponsors are being placed in jeopardy from a fiduciary liability standpoint due to a participant-directed induced tilting toward bonds. While plan sponsors are expected to be prudent and reasonable in their actions, they are not required to “read the market.” There are also the protections of the 404(c) and qualified default investment alternatives (QDIA) regulations, as well as the Department of Labor’s Interpretive Bulletin 96-1 on participant investment e3ducation — all of which provide significant support to the notion that plan sponsors are not in the position of being market seers. At the end of the day, DC plans that are self-directed are, well, self-directed.
The article also points out how little most DC investors know about how bonds work, a fact that few industry observers would disagree with. It is common knowledge that the relationship between how interest rates and price movements impact the valuation of bond funds is lost on a majority of DC investors.
In the past, short-term (or ultra-short) bonds have been used in lieu of stable value funds given the fact that they have never “broken the dollar” — that is, until many of them did so for the first time during the Great Recession. Stable value funds, which can be carried at book value, and thus weather short–term interest rate fluctuations without breaking the dollar, are a better choice for stable value.
High-yield bonds may sound to many DC investors like a safe bond fund that has a high yield. The challenge here is the word “bond,” which carries the connotations of being something safe as opposed to a word like “market,” which implies volatility. The term “high yield” does not convey the right message either.
Long-term bond funds, especially government bonds, can be confusing to DC participants. Going back to the DC investment knowledge polls that were jointly conducted by John Hancock and Gallup in the ‘90s, it was consistently the case that more than half of the polled DC investors believed long-term government bond funds to be safer than money market funds. This misperception is no doubt due to the words “bond” and “government” in the description of the government bond fund. The money market fund contains the word “market,” thus implying volatility — even though very little volatility exists in money market funds. DC investors had a misinformed understanding of bond fund pricing back then, and they still do today.
In summary, there probably is no need to shake up plan sponsors with yet another possible fiduciary headache. Plan sponsors that offer an intermediate-term bond fund that has been properly labeled and caveated as to its risk should not be overly concerned. From a liability standpoint, it would be hard to make the case that a plan sponsor is responsible for having control over individual participant risk aversion to stocks.
To the extent that there is liability, it is in the holding out of short-term bond funds as a means to insure protection of principal, high-yield bond funds as just another type of bond fund without highlighting its risky nature and, finally, promoting long-term bond vehicles (especially government) as anything other than a volatile asset class.
It is best to just stay clear of all three types of bond funds as a stand-alone asset class in a DC fund lineup. They can be part of a single asset allocation fund or a broadly diversified bond fund, but otherwise they cause unnecessary and avoidable communication challenges.
