Diversified inflation options in DC plans
DC participants typically manage their retirement portfolios with specific goals or objectives.
Therefore, it can be helpful to view an investment menu in relation to common participant objectives, such as capital preservation, income, growth, and inflation protection. Mercer believes DC plan sponsors should consider how these objectives vary among their participant base when constructing a menu of investment options.
One area that often gives fiduciaries pause is how best to address participants’ need for inflation-sensitive options that can benefit portfolios during periods of rising inflation—there are various drivers of inflationary cycles and types of inflation-sensitive options available to DC plans. We divide these options into two broad categories: single asset and multi-asset.
Single asset inflation-sensitive options commonly include standalone Treasury Inflation Protected Securities (TIPS) or commodities funds. On the other hand, multi-asset strategies involve a single investment option blending various asset classes that respond to inflationary pressures in different ways.
In this paper, we explore how to address inflation protection in DC plans, as well as benchmarking considerations for multi-asset inflation-sensitive options.
Addressing inflation in DC plans through multi-asset strategies
Mercer’s advice centers on helping to ensure portfolios can withstand various market and inflationary environments.1 While equity exposure can provide long-term inflation protection for many DC plan participants, some may have shorter time horizons and could benefit from assets that respond to inflationary pressures more quickly.
One approach offered by some DC plans to address this need is a diversified inflation strategy. These are multi-asset strategies that invest in a range of assets, including real estate, infrastructure, and commodities, which may respond to inflationary pressures in different ways. Diversified inflation strategies often provide the additional benefit of general diversification relative to the commonly used investment options in DC plans, such as public equities and bonds. This diversification helps mitigate risks associated with any single asset class or sector, as the performance of the underlying asset classes tends to be influenced by different factors and market environments.
For instance, many professionally managed DC investment options, like target date funds, include exposure to real assets for this diversification benefit (Figure 1).
1 Source: Inflation Playbook: Managing through an inflation cycle
Figure 2 depicts the inflation betas of different asset classes, highlighting that no single asset can fully protect against inflationary pressures in all inflationary environments. Analysis was conducted on September 20, 2024.
While there is no perfect hedge against inflation, one of the reasons Mercer believes diversified (multi-asset) inflation strategies may work as an inflation-sensitive component of a DC investment menu, as opposed to a single asset option, is because the underlying components respond differently across various inflationary environments. This means that participants do not have to constantly switch between different single asset strategies to meet their needs.
It is worth noting that many of the diversified inflation strategies available to DC plans primarily use publicly traded underlying components. Private investments or other alternative implementations may offer better overall diversification and inflation sensitivity, but they are often difficult for DC plans to access, due to operational, administrative, and fee considerations.
Single asset inflation-sensitive options may also experience greater absolute volatility compared to a multi-asset structure, where volatility can be balanced by diverse asset class exposures. For instance, in the early 2020s, we saw increasing inflation in the US coupled with a quickly rising interest rate environment that resulted in greater volatility among TIPS strategies. Similarly, commodities experienced higher volatility in the late 2010s and into the early 2020s.
Participants nearing or in retirement (to the extent that terminated or retired participants are permitted to remain invested in a DC plan) are more susceptible to inflation eroding their retirement savings. This is due to their limited investment time horizons and fewer prospects for inflation-linked wage growth. Therefore, diversified inflation options may be more suitable for these individuals. However, all DC plan participants, including those with long time horizons and a higher potential for inflation-linked wage growth, can benefit from these options.
Diversified inflation funds provide diversification to public equities and bonds. Even if individuals investing in these funds do not specifically require inflation protection, they still receive some general diversification benefits. It is important to note that unlike target date funds, which are commonly offered in DC plans as multi-asset strategies, diversified inflation funds are not intended to be a sole investment option for a participant’s entire portfolio. We expect to see participants’ allocations to diversified inflation funds vary to meet their specific saving or spending needs, which may include consideration of assets outside of the plan. Investment modeling tools provided by a recordkeeper, or managed accounts, can be helpful in determining an appropriate allocation based on individual needs.
While diversified inflation strategies do have benefits, some fiduciaries may still prefer single asset strategies for providing inflation protection. In summary, single asset strategies may be easier to communicate to participants, typically have simpler benchmarking, and offer more representative peer universes for comparison. In the next section, we discuss this in more detail.
Benchmarking Multi-Asset Strategies
As with any multi-asset strategy, benchmarking diversified inflation strategies can be complex. When benchmarking these strategies, fiduciaries should consider using a custom composite index as the primary benchmark. A custom index is typically a blend of multiple underlying indices that reflect the target asset allocation for the fund. For example, suppose a diversified inflation strategy has a target allocation of 30% commodities, 30% REITs, and 40% TIPS; the custom benchmark should consist of a 30% commodity index, 30% REIT index, and 40% TIPS index that aligns with the investment approach employed.
Using a custom benchmark allows fiduciaries to compare the strategy to this index and assess various aspects:
1) Variations in asset allocation from stated target allocations and whether this added value,
2) Performance of active management within each component, and
3) If the underlying components were passively managed, whether tracking error was minimized.
While CPI (Consumer Price Index) or CPI plus a hurdle rate (e.g., CPI+2%) is a commonly used benchmark for diversified inflation strategies, it is important to note that CPI is an economic measure and not an investable index. While CPI can provide long-term context for inflation, it may be a misleading performance benchmark in the short term. Diversified inflation strategies are generally expected to perform well in an inflationary environment, but short-term performance can vary based on portfolio composition and the triggers of inflation. Using CPI as a benchmark is likely to lead to significant tracking error during certain market cycles, which may not accurately reflect the purpose of the strategy or the manager’s skill.
We believe that peer group relative performance should also be examined before being used as a performance benchmark. Diversified inflation peer groups often have a small sample size, and constituents will have varied target asset allocations, leading to notable performance differences. For example, some diversified inflation strategies include TIPS, while others do not. Small differences in allocations or performance can significantly affect a strategy’s percentile ranking within the peer group. Therefore, peer group rankings should be used as a point of perspective rather than the sole metric for evaluating whether the strategy is meeting its objective.
Ultimately, Mercer recommends that fiduciaries:
- Use a custom benchmark as a primary measure for diversified inflation strategies.
- Consider CPI as a secondary benchmark, focusing on longer time periods (e.g., 5 years and beyond).
- Reference peer group universe rankings for informational purposes but remain mindful of asset allocation variances.
The performance of any inflation-sensitive strategy will be differentiated from that of traditional equities and bonds in DC plans. Fiduciaries should take the time to understand the performance drivers of diversified inflation strategies and exercise patience with the perspective of varying market environments.
Conclusion
The volatility of many single asset inflation-sensitive strategies may not be suitable for all DC plan participants, as it requires active engagement and management of their allocations. This can sometimes lead to performance-chasing behaviors. While diversified inflation strategies offer a viable alternative to single asset strategies, there are complexities with benchmarking that fiduciaries need to address to ensure proper oversight and evaluation.
In summary, DC plan fiduciaries should evaluate the need for inflation-sensitive strategies based on the make-up of their participant base. If a single asset inflation-sensitive option is currently offered, it is worth considering the potential benefits and drawbacks of implementing a diversified inflation strategy. Such strategies may be particularly beneficial to participants with shorter time horizons who require some level of inflation protection.
Appendix – Figure 2 Terminology
EMD (LC): Emerging market debt local currency; EM Equities: Emerging market equity; EM FX: Emerging market currency; EM ILBs: Emerging market inflation-linked bonds; FRNs: Floating Rate Notes; Global ILBs: Global inflation-linked bonds; TIPS: Treasury Inflation Protected Securities