DC and Bonds: The End of the Affair...and a New Beginning

10 January 2025

5 min read

David Hutchins, FIA| Portfolio Manager—Multi-Asset Solutions

Henry Smith, CFA| Investment Strategist—Multi-Asset Solutions

Bonds’ traditional role in pension allocations is over. But they have a new purpose in a lifetime income strategy.

Fixed income has always played a key role in building diversified retirement strategies that both deliver real returns and manage risk in the approach to retirement. But it’s time to reconsider their purpose in DC retirement strategies as bonds face a much tougher investment regime.

We believe that DC fiduciaries should prepare for a world in which secular headwinds could reduce the benefits of fixed-income investments in their members’ accumulation phase. In the new environment, we envisage a more comprehensive DC retirement strategy in which bonds will make up a smaller component of the accumulation journey.

A Benign Regime Is Ending

We’ve argued for some time that macro mega-forces herald a change in the investment environment. Increased longevity, higher equilibrium inflation and lower growth rates imply that pension systems’ strategic asset allocations must change. Fixed-income assets will likely face challenges on three fronts:

higher inflation will reduce their real returns
in a return to long-run norms, equities and bonds will mostly be modestly positively correlated, reducing fixed-income assets’ diversification benefits
similarly, bond volatility will be higher, limiting fixed income’s downside mitigation properties

What does this mean for DC savers invested in basic equity-bond glide path strategies?

To answer that question, we’ve applied our forecasts for asset-class real returns to a saver earning a median salary and paying 8% of it each year into a simple target date structure that de-risked in the mid portion of their career before they retired at 65. The result? That person, if they are early in their career, would have a savings pot consistent with a hardship outcome below the “minimum” level deemed necessary for retirement in PLSA’s Retirement Living Standards.

Future Returns Are Likely to Disappoint

DC default funds have maintained a large allocation to risk assets overall, but their glide paths tend to reallocate into bonds as savers get closer to retirement.

In the display below we chart the size of a total pension pot required to achieve a “comfortable” or “moderate” retirement and how the path to that level should ideally evolve over the course of a working life. We also take 2040 target date funds (TDFs) as a case in point, plotting the achieved return for an average of 2040 TDFs from their inception until the present. This cohort of TDFs delivered an average real return of 4.25% annualized since inception—a good outcome, in our view. However, there’s no cushion to help weather the prospect of lower real returns in the future. From today’s level, such funds would have to generate a real return of 7% annualized to achieve a “moderate” level of retirement assets, a level that we regard as unattainable at mass scale.

Returns Will Likely Fall Short of a Moderate Retirement Living Standard

2040 Target Date Funds’ Actual and Required Returns

Actual returns from a sample target date fund cohort have kept up but forecast returns are expected to lag “Moderate” levels.

Past performance does not guarantee future results.
The analysis assumes an 8% salary contribution per year and salary growth of CPI +1% per year. "Moderate" and "Comfortable" retirement levels are defined by the Pensions and Lifetime Savings Association (PLSA). “Moderate” outcome is defined as earning 67% of median UK salary and “Comfortable” outcome is defined as earning 107% of median UK salary. In the absence of UK peer-group data, actual size of savings pot is calculated using US 2040 target date fund cohort; forecast savings pot size assumes a 5% real return.
As of May 30, 2024
Source: PSLA and AllianceBernstein (AB)

Our modelling excludes the UK state pension, which would make a “moderate” outcome much easier to achieve. But we think this may become less predictable in future given fiscal deterioration. The analysis also illustrates how, in a higher-inflation environment, switching to fixed-income assets too early could have a penal impact on real returns. At best, this switch would reduce DC savers’ ability to attain a “comfortable” retirement. At worst, it would potentially result in hardship outcomes for savers. For DC fiduciaries that have relied on simple equity/bond mixes based on their historical track record, we think the new investment regime spells the end of their affair.

Bond Return Shortfalls Have Wide Implications

On that basis, it’s time to rethink the current generation of mechanistic equity-bond de-risking approaches. To generate adequate real returns at current contribution levels, savers will need greater exposure—and for longer—to equities, real assets and other diversifying allocations, such as factor strategies and private markets allocations.

Nominal liability management also needs to be revisited. Targeting a specific monetary pot value isn’t suitable for a higher-inflation era, in our view. Instead, DC fiduciaries must find strategies that generate sustainable levels of retirement income, allowing for inflation.

Accordingly, the prospect of weaker real returns and higher interest rates means that DC savers are likely to find the option of buying longevity insurance through an annuity increasingly attractive as part of their retirement planning. In our view, though, savers should consider their annuity-purchase timing carefully; locking into an annuity too early will reduce access to capital and limit the ability to retain market upside that could mitigate inflation, while leaving it too late may prove increasingly expensive. We think the annuity-purchase “sweet spot” lies sometime after age 75 (Display).

The Cost of Delaying Annuitization Increases Exponentially with Age

Required Return (Percent) to Offset One-Year Delay at Different Ages

The return required to offset a one-year delay is significantly less than 1% before age 75.

Past performance does not guarantee future results.
Through June 30, 2024
Source: CMI and AB

DC plan members will be forced to make painful compromises. Potentially lower returns on equities, positive correlations with bonds, higher inflation and greater longevity all require consideration. The options: later retirement, higher contributions, lower retirement income or higher investment risk. All in all, we think that later retirement is an inevitable conclusion for many UK DC savers.

A New Beginning for DC and Bonds

Pension funds are set to own fewer long-dated bonds and more real assets, in our view. But fixed-income investments still have a potentially valuable role in DC retirement strategies: notably, to support annuitization and longevity pooling; as a source of liquidity in savers’ investment portfolios; tactically, when yields are attractive; and as a source of alpha from active management, including adding value across an array of fixed-income assets and factor risk premiums.

Such complex strategies are not only beyond the capabilities of simple DC glide path programmes, but also way beyond those of most retirees. So, is the simple equity/bond mix affair doomed to end in despondency?

We think not. A new generation of DC lifetime income strategies can simplify investing across both accumulation and decumulation phases. These strategies are designed to provide a seamless switch for savers’ pots—from growing assets during their working lifetime to paying out a sustainable income during retirement, all with sophisticated investment management and governance.

Packaged in a TDF structure, they can provide dynamically managed investment solutions, while being easy for savers to understand and simple for fiduciaries to administer. They can also incorporate an annuity-purchase option for later life. Although there can’t be any guarantee of adequate real returns, we believe this approach offers DC plan members a realistic chance of navigating the looming investment challenges—and coming out ahead. The simple equity/bond mix affair may be coming to an end, but lifetime income strategies along with bonds could be the beginning of a beautiful friendship.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

David Hutchins, FIA

David Hutchins is a Senior Vice President and Head of AB's Multi-Asset Solutions business in EMEA. He is responsible for the development and management of multi-asset portfolios for a range of clients. Hutchins joined the firm in 2008 after spending two years at UBS Investment Bank, where he was responsible for devising and delivering innovative capital markets risk-management solutions for pension schemes. Prior to that, he spent 13 years at Mercer, where he served as a European principal and scheme actuary, providing trustee and corporate advice to a range of UK pension funds and their sponsors. Hutchins holds a BSc in mathematics and a PGCE from the University of Bristol. He has chaired the Investment Management Association's Defined Contribution Committee and formerly chaired the defined contribution industry working group for the UK government's "defined ambition" project. Hutchins is a Fellow of the Institute and Faculty of Actuaries. Location: London

Henry Smith, CFA

Henry Smith is a Vice President and Investment Strategist on AB’s Multi-Asset Solutions team. He is responsible for the product strategy and communication of AB’s UK defined contribution, custom multi-asset and sustainable multi-asset solutions. Smith joined the firm in 2019, following more than two years at Lane Clark & Peacock, where he provided investment, research and governance advice to a range of UK defined contribution pension schemes. Before that, he worked at Capita Employee Solutions, where he advised both UK defined contribution and defined benefit pension schemes. Smith holds a BSc in financial economics from the University of Essex and is a CFA charterholder. Location: London

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