The economy's impact on retirement plans
INSIGHT ARTICLE |
According to the third quarter RSM US Middle Market Business Index survey, more than half of middle market executives anticipate the economy will improve somewhat or significantly during the next six months. With back-to-back quarters of higher-than-anticipated 3 percent gross domestic product (GDP) growth, this may not be surprising. To put things in perspective, the long-term growth trend in the United States since 1945 was 2.5 percent up until the Great Recession. The magnitude of that recession was so severe that it took the long-term trend down to 1.5 percent. While the U.S. is unlikely to experience an economic shock as severe as the Great Recession anytime soon, a return to a more normalized economy means there will continue to be periodic industry sector and geographical recessions.
Meanwhile, as the economy continues to normalize, U.S. Federal Reserve policy is beginning to normalize as well, and this could affect retirement plan performance. One of the consequences of an economy where household consumption is growing at a strong 3 percent rate is a shift away from Wall Street to Main Street—that is, to the real economy, the goods and services area of the economy—as the primary economic driver.
As a consequence of this shift, it becomes much more important to pay attention to policy changes in Washington. Going forward there are likely to be much larger annual operating deficits to pay for defense expenditures; rebuilding after the series of storms in Texas, Florida and elsewhere; and much-needed infrastructure investment. The market is in the early stages of beginning to adjust to this anticipated rise in interest rates. Fiscal operations are likely to push inflation and bond yields much higher over the long term.
In this type of environment, what types of investment options or plans should retirement plan sponsors consider?
Whether the company is outsourcing the investment selection to a fiduciary investment manager or working through a committee, the plan sponsor needs to consider overall exposure to mitigate any downside risk and take advantage of opportunities. Which types of investments may be sensitive to rising interest rates? What is the plan’s bond and long-term equity exposure?
For those working with defined benefit plans or traditional pension plans, what should be on their radar? Interest rate increases can have an impact on a plan’s funding status and could lower the annual cash infusions from plan sponsors. As yields begin to move higher, there may be questions from participants.
Risks in the US economic outlook
Any sustained economic growth above 2 percent carries with it the risk of rising interest rates and inflation. In the near term, there are some domestic risks in the auto sector and commercial real estate. But these are cyclical, normalization risks, affecting these specific industries, as compared to the systemic risks seen in 2008 and 2009.
Likely to become more apparent as 2018 progresses are risks to value chains from the rigorous enforcement of trade rules. If administration rhetoric surrounding the North American Free Trade Agreement negotiations plays out, there could be significant price disruptions along value chain, resulting in higher prices passed along to consumers. Other trade disputes—with China or Canada, for example—could produce shocks for the U.S. economy.
Political risks across the European Union and the United States can also produce a riskier economic outlook in the near term. But on the positive side, an upturn in global growth to 4 percent and improvement in the fortunes of emerging markets and Middle Eastern and North African states could affect U.S. growth positively.
Equity valuations are a modest concern. Corporate profits cannot continue to grow faster than GDP and have the equity values hold up. But this is a cyclical, not structural, issue.
The plan investment lineup
It is important for plan participants to be contributing on a systematic basis over a period of years to deal with stock market fluctuations, corrections and bear markets, protecting themselves from sharp declines and taking advantage of opportunities. Even when markets look bleak, participants can benefit.
Most if not all investment lineups will include exposure to U.S. equities and core fixed income. But there are other things to consider:
- Treasury inflation-protected securities: Referred to commonly in acronym form as TIPS, these are bonds issued by the U.S. Treasury that pay a coupon on the adjusted principal of the bond. The bond is adjusted on a semi-annual basis with the rate of the Consumer Price Index and therefore can offer a higher yield as rates move up, making it a good hedge against inflation.
- Diversified international: Also referred to as a foreign fund, these are investments in companies located anywhere outside of the United States.
- Emerging markets: Invest in stocks of companies located in emerging markets around the world, such as Brazil, Russia, India, Taiwan and China. Stocks of companies in emerging markets tend to be more volatile than those in developed countries, which could imply the potential for greater long-term returns.
- Global bond: Invest in fixed-income securities including bonds from global, sovereign governments, investment-grade corporate bonds as well as fixed-income securities from the United States.
By no means are these direct recommendations; in many cases, for example, plans are utilizing target date funds, asset allocation models or custom models as well.
The most important takeaway for participants: Maintain a long-term perspective, based on the individual time frame for retirement. Plan sponsors can help through plan design features such as auto enrollment and auto escalation that help participants save, and save in larger amounts. These types of features will also help keep participants in the plan.
Plan review considerations
While no one can predict what the markets will do for the next 10 years, plan sponsors have a variety of options that can help participants stay the course and have a healthy retirement plan. When reviewing plans and evaluating their designs, sponsors should consider:
- Plan diversification: What is the equity and fixed income exposure? How much cash is sitting on the sidelines?
- Plan investments: Are there new investments to introduce to take advantage of opportunities or to mitigate risk? Should investment decisions and services be outsourced to investment managers or be done in-house?
- Plan design: In addition to auto investment and escalation features, are there features to encourage savings and wellness initiatives? As the economy continues to grow and the labor market tightens, is the plan design competitive enough to be leveraged for talent acquisition and retention?