The Role of Fixed Income in Defined Contribution Plans: A Safe Haven or a Drag on Returns?
Christian LaRiviere
1. Fixed Income Performance in DC Plans During Crises
1.1. The Resilience of the U.S. Corporate Bond Market During Financial Crises
1.1.1. Corporate bond markets proved remarkably resilient against a sharp contraction caused by the 2020 Covid-19 pandemic. We document three important findings: (1) bond issuance increased immediately when the contraction hit, whereas, in contrast, syndicated loan issuance was low; (2) Federal Reserve interventions increased bond issuance, while loan issuance also increased, but to a lesser degree; and (3) bond issuance was concentrated in the investment-grade segment for large and profitable issuers. We compare these results to previous crises and recessions and document similar patterns. We conclude that the U.S. bond market is an important and resilient source of funding for corporations.
1.2. Lifecycle Impacts of the Financial and Economic Crisis on Household Optimal Consumption, Portfolio Choice, and Labor Supply
1.2.1. The direct financial impact of the financial crisis has been to deal a heavy blow to investment-based pensions; many workers lost a substantial portion of their retirement saving. The financial sector implosion in turn produced an economic crisis for the rest of the economy via high unemployment and reduced labor earnings, which reduced contributions to Social Security and private pensions. Our research asks which types of individuals were most affected by these dual financial and economic shocks, and it also explores how people may react by changing their consumption, saving and investment, work and retirement, and annuitization decisions. We do so with a realistically calibrated lifecycle framework allowing for time-varying investment opportunities and countercyclical risky labor income dynamics. We show that households near retirement will reduce both short- and long-term consumption, boost work effort, and defer retirement. Younger cohorts will initially reduce their work hours, consumption, saving, and equity exposure; later in life, they will have to work more, retire later, consume less, invest more in stocks, and save more.
1.3. Contribution Dynamics in Defined Contribution Pension Plans During the Great Recession
1.3.1. We investigatechanges in workers' participationandcontributionsto defined contribution(DC) plans during the GreatRecessionof2007-2009. Usinglongitudinalinformationfrom W-2 tax recordsmatchedto a nationally representativesample ofrespondentsfrom the Survey ofIncome andProgramParticipation,wefind that the recent economic downturn hada considerableimpacton workers'participationandcontributionsto DC plans. Thirty-ninepercent of 2007 participantsdecreasedcontributionsto DCplans by more than 10 percent during the GreatRecession. Ourfindings highlight the interrelationshipbetween the dynamics in DC contributionsand earningschanges. Participantsexperiencing a decrease in earningsofmore than 10 percent were not only more likely to stop contributingby 2009 than those with stableearnings(30percent versus 9percent), but they also decreasedtheir contributionssubstantially (-$1,839 versus -$129). The proportionofworkers who decreasedor stoppedcontributionsduring the crisis exceeded the proportionobservedpriorto it (2005-2007).
2. Safe Haven vs. Drag on Returns
2.1. Are Gold and Government Bonds Safe-Haven Assets? An Extremal Quantile Regression Analysis
2.1.1. This study reexamines gold and government bonds as potential safe-haven assets (SHAs) during market turmoil from daily data in 16 international mar- kets over the past 20 years. We apply the extremal quantile regression model by Chernozhukov and Chernozhukov and Fernandez-Val for empirical inves- tigation. The outcomes indicate that a government bond is more likely to be qualified an active SHA, which can increase in value during market turmoil. Gold can be generally evaluated as a passive SHA, which is uncorrelated with market slumps. However, at the extremal 0.001 quantile level, neither asset can be qualified as a SHA. Since both assets exhibit a similar number of cases of being qualified as SHAs, we cannot significantly differentiate the “flight- to-liquidity” and “flight-to-quality” hypotheses. In terms of market selection, United States and Singapore are the top two choices while France and Hun- gary are the least commended markets to invest their local gold market as SHA.
2.2. Asset Market Linkages in Crisis Periods
2.2.1. We characterize asset return linkages during periods of stress by an extremal dependence measure. Contrary to correlation analysis, this non-parametric measure is not predisposed towards the normal distribution and can account for non-linear relationships. Our estimates for the G-5 countries suggest that simultaneous crashes in stock markets are about two times more likely than in bond markets. Moreover, stock-bond contagion is about as frequent as flight to quality from stocks into bonds. Extreme cross-border linkages are surprisingly similar to national linkages, illustrating a potential downside to international financial integration.
2.3. Asset Market Linkages: Evidence from Financial, Commodity, and Real Estate Assets
2.3.1. We use a general Markov switching model to examine the relationships between returns over three dif- ferent asset classes: financial assets (US stocks and Treasury bonds), commodities (oil and gold) and real estate assets (US Case–Shiller index). We confirm the existence of two distinct regimes: a ‘‘tranquil” regime with periods of economic expansion and a ‘‘crisis” regime with periods of economic decline. The tranquil regime is characterized by lower volatility and significantly positive stock returns. During these periods, there is also evidence of a flight from quality – from gold to stocks. By contrast, the crisis regime is characterized by higher volatility and sharply negative stock returns, along with evidence of contagion between stocks, oil and real estate. Furthermore, during these periods, there is strong evidence of a flight to quality – from stocks to Treasury bonds.
3. Bond Market Interventions and Fixed Income Returns in Retirement Plans
3.1. Comparing Retirement Investing with Fixed and Life-Cycle Funds Using a Variety of Asset Classes
3.1.1. There are many different studies that both reinforce and discourage the use of life-cycle funds for retirement investing, but a majority of these studies only look at life-cycle funds that include the three main asset classes, which are stocks, bonds, and cash. This study compares fixed funds, four different types of life-cycle funds, and the use of three other non-traditional asset classes in the life-cycle funds. The three non-traditional classes which we add to the study are real estate, commodities, and high yield bonds. We evaluate these different portfolios based on the average rate of return and their level of risk, by conducting random simulations based on historical data. Our simulations found that the use of non-traditional assets (commodities, real estate investment trusts, and high yield bonds) can be useful in a portfolio as they produce a higher mean rate of return than the portfolios with traditional assets (bonds and cash) that we studied. The downside of the use of non-traditional assets in a portfolio is that on average they are riskier than the traditional portfolios. In the study, we tested two portfolios that were focused primarily on high yield bonds, which showed that high yield bonds are a valuable asset class. These two portfolios are the only ones that have a mean rate of return that is indistinguishable from our 100% stock portfolio. They also have a much lower risk than the all-stock portfolio which is very rare to see.
3.2. The Impact of COVID-19 Pandemic on Government Bond Yields
3.2.1. The COVID-19 pandemic is a real shock to society and business and financial markets. The government bond market is an essential part of financial markets, especially in difficult times, because it is a source of government funding. The majority of existing ESG studies report positive impacts on corporate financial performance regarding environmental, social, and governance. Thus, understanding governments’ financial practices and their relevant ESG implications is insufficient. This research aims to value the impact of the COVID-19 pandemic on different government bond curve sectors. We try to identify the reactions to the COVID-19 pandemic in the government bond market and analyze separate tenors of government bond yields in different regions. We have chosen Germany and the United States government bond yields of 10, 5, and 3 years tenor for the analysis. As independent variables, we have chosen daily cases of COVID-19 and daily deaths from COVID-19 at the country and global levels. We used daily data from 02 January 2020–19 March 2021, and divided this period into three stages depending on the COVID-19 pandemic data. We employed the methods of correlation-regression analysis (ordinary least squares and least squares with breakpoints) and VAR-based impulse response functions to evaluate the effect of the COVID-19 pandemic on government bond yields both in the long and short run. Our analysis revealed the impact of the spread of the COVID-19 pandemic on government bond yields differs depending on the country and the assessment period. The short-term responses vary in direction, strength, and duration; the long-term response of Germany’s yields appeared to be more negative (indicating the decrease of the yields), while the response of the United States yields appeared to be more positive (i.e., increase of yields).
4. Behavioral Responses in DC Plans During Crises
4.1. The Efficiency of Sponsor and Participant Portfolio Choices in 401(k) Plans
4.1.1. The COVID-19 pandemic is a real shock to society and business and financial markets. The government bond market is an essential part of financial markets, especially in difficult times, because it is a source of government funding. The majority of existing ESG studies report positive impacts on corporate financial performance regarding environmental, social, and governance. Thus, understanding governments’ financial practices and their relevant ESG implications is insufficient. This research aims to value the impact of the COVID-19 pandemic on different government bond curve sectors. We try to identify the reactions to the COVID-19 pandemic in the government bond market and analyze separate tenors of government bond yields in different regions. We have chosen Germany and the United States government bond yields of 10, 5, and 3 years tenor for the analysis. As independent variables, we have chosen daily cases of COVID-19 and daily deaths from COVID-19 at the country and global levels. We used daily data from 02 January 2020–19 March 2021, and divided this period into three stages depending on the COVID-19 pandemic data. We employed the methods of correlation-regression analysis (ordinary least squares and least squares with breakpoints) and VAR-based impulse response functions to evaluate the effect of the COVID-19 pandemic on government bond yields both in the long and short run. Our analysis revealed the impact of the spread of the COVID-19 pandemic on government bond yields differs depending on the country and the assessment period. The short-term responses vary in direction, strength, and duration; the long-term response of Germany’s yields appeared to be more negative (indicating the decrease of the yields), while the response of the United States yields appeared to be more positive (i.e., increase of yields).
4.2. Trading in 401(k) Plans During the Financial Crisis
4.2.1. Most 401(k) participants did not trade much in their retirement accounts during the recent financial crisis. Yet the proportion of plan participants trading did rise by almost a quarter and the mean portfolio fraction shifted away from equities rose almost eightfold during the crisis. Traders’ responsiveness to monthly stock market volatility also more than doubled, contributing to a sharp increase in the sale of equities. At the same time, traders’ equity selling was offset by their reaction to returns. They shifted from a momentum approach pre-crisis selling equities on weak returns, to a contrarian strategy during the crisis and buying stocks ‘on the dips.’ Also first- time traders during the crisis reacted more negatively to volatility than did experienced traders; these inexperienced traders were nevertheless, and paradoxically, more likely to be contrarian in their return response. Finally, participant plan statements sent during the crisis encouraged net shifts into equities, thereby acting as a modest stabilizing factor.
4.3. Individual Account Investment Options and Portfolio Choice: Behavioral Lessons from 401(k) Plans
4.3.1. This paper examines how the menu of investment options made available to workers in defined contribution plans influences portfolio choice. Using unique panel data of 401(k) plans in the U.S., we present three principle findings. First, we show that the share of investment options in a particular asset class (i.e., company stock, equities, fixed income, and balanced funds) has a significant effect on aggregate participant portfolio allocations across these asset classes. Second, we document that the vast majority of the new funds added to 401(k) plans are high-cost actively-managed equity funds, as opposed to lower-cost equity index funds. Third, because the average share of assets invested in low-cost equity index funds declines with an increase in the number of options, average portfolio expenses increase and average portfolio performance is thus depressed. All of these findings are obtained from a panel data set, enabling us to control for heterogeneity in the investment preferences of workers across firms and across time.
5. Equity's Impact on Returns in DC
5.1. Does Investing in Equity Markets Bring Better Retirement Income Outcomes to Members of Defined Contribution Pension Plans?
5.1.1. This chapter assesses whether investing in equity markets leads to better retirement income outcomes for members of defined contribution pension plans. It first looks at the current practice and trends in equity investments in defined contribution pension schemes across a wide range of countries. It then assesses the impact of investing in equities on investment performance, on the level of assets accumulated at retirement and on replacement rates.
5.2. Examination of Fixed Income Securities Pooled with the S&P 500 Index for Retirement Diversification: From Convertibles to Treasuries to Cash Alternatives
5.2.1. We examine the returns of retirement portfolios containing and diversified stock selection and various fixed income to determine the best risk return tradeoff for the 10 years 2010-2019. The classic 60/40 Equity/Debt hold the track record for delivering returns while reducing risks. For comparison, we test for the optimal mix and 70/30, 80/20 among others; for the 10 years in this study. The lowest risk return combination for a 60/40 mix were found; with Municipal Securities dominating followed by Preferred Stocks, US High Yield, and Convertibles. The worst preforming 60/40 combinations were made with International Bonds, Treasury Bills, and Government Bonds excluding U.S.