At T. Rowe Price, we strongly believe that diversification is fundamental to helping participants achieve successful retirement outcomes over the long term. During their lifetime of investing, participants will face many risks, and achieving adequate portfolio growth during their retirement journey is critical, as is planning for the bumps that can and will happen along the way.

Outlining the importance of diversification can seem like stating the obvious, but market events in 2022 that resulted in a steep, correlated sell‑off in both stocks and bonds prompted valid questions about the role of diversification in helping to mitigate downside risk. In multi‑asset portfolios, diversification should not just be about asset allocation between traditional stocks and bonds. While a mix across these asset classes typically influences portfolio growth, diversification across multiple market segments—such as sub‑asset classes, regions, and sectors, among others—could boost results during different market regimes or hedge against specific risks and help improve retirement outcomes.

For clients who prioritize the efficiencies and benefits that passive allocations may provide for certain investment sectors, but who are also interested in maximizing growth in order to help improve retirement outcomes, the selective use of active and passive management in managed strategies may add another dimension to diversification. Incorporating distinct components in a portfolio also provides additional levers for making tactical (or short-term) adjustments that could further enhance returns and help mitigate near‑term risks.

Data show that target date strategies are the most prevalent default vehicle for retirement investors. While the equity allocation in these strategies is often diversified, many target date providers continue to offer relatively basic fixed income designs that forgo some asset classes altogether. We want to highlight the importance of a well‑diversified fixed income allocation, especially in a complex market environment where inflation persists and interest rates are expected to stay higher for longer.

Time to check under the hood

For over a decade, inflation was not a major concern. Investors had to grapple with the impact of ultralow interest rates on their portfolios and seek additional ways to generate return. In a short period of time, a spike in inflation since 2021 caused the U.S. Federal Reserve and other major central banks to aggressively raise interest rates.

"...many current allocation policies were influenced by the post‑GFC economic environment that was very different from the one we are in today."

In our view, global markets have likely reached a structural inflection point—an end to the extraordinary era of ample liquidity, low inflation, and low interest rates that followed the 2008–2009 global financial crisis (GFC). For plan sponsors, advisors, and consultants that offer target date vehicles or personalized portfolio solutions, there has never been a more important time to reexamine the fixed income asset allocation structure in these strategies. This is especially true considering that many current allocation policies were influenced by the post‑GFC economic environment that was very different from the one we are in today.

Notably, our 2023 DC Consultant Study revealed that large retirement plan consultants and advisors have also taken notice, and many reported a heightened focus on diversification opportunities, resulting in part from poor performance in fixed income strategies in 2022 (Figure 5).

What’s next?

For the first time in over 20 years, a higher risk-free rate⁵ is providing are providing opportunities that may enhance portfolio returns without increasing exposure to equity risk. Meanwhile, inflation risk lingers, and it remains unclear at what levels interest rates will peak, how long they will remain elevated, when they may decline, or when they could normalize to a neutral rate.⁶

When considering components in a multi‑asset portfolio, some asset classes may not contribute equally to short‑term outcomes, but their benefits over the long term could help to make the portfolio more durable over a range of market environments. Segments of the fixed income market can behave very differently from each other. Some have historically had higher correlations to equities, others have demonstrated superior inflation‑fighting properties, and others can potentially provide relatively uncorrelated returns.

In 2022, core fixed income assets largely failed to mitigate equity risk when correlations spiked during the market sell‑off. This experience highlights the importance of fixed income diversification—especially if core fixed income exposure relies on U.S. investment‑grade bond holdings, which can mean a direct exposure to the U.S. yield curve and undiversified interest rate risk. Within fixed income allocations, investors should consider:

1. Looking beyond U.S. investment grade: Our research suggests that supplementing the core fixed income allocation with international bonds (in particular, currency hedged bonds) allows for additional interest rate diversification and could lower volatility. Additionally, less directional and more flexible bond strategies that seek absolute returns across the full global opportunity set could provide a source of diversification during periods of risk aversion.
2. Adding other sources of diversification: Core fixed income assets now provide positive real (inflation-adjusted) yields and can still have a valuable role to play in helping to mitigate downside risk, especially if inflation subsides, allowing policymakers to cut rates in the face of a slowing economy. However, if inflation risk remains persistent, other strategies that could help mitigate risk in market environments like the one seen in 2022 may be beneficial.

Higher‑yielding fixed income, including high yield bonds, bank loans, and emerging market debt, could generate attractive returns in the current yield environment. Although non‑core bonds can be highly correlated with equities in extreme risk‑on and extreme risk‑off environments, they offer other meaningful diversification benefits that could make them strong complements to equities as sources of growth.

Fixed income diversification with these “plus” sectors could help investors better navigate the various risks they will face over their life cycles, as well as the market conditions they may experience as they prepare for and go through retirement. In many cases, all of these sectors may not be included in a retirement plan’s investment lineup. More importantly, they may not be included in many target date allocations. Since data show that average target date allocations continue to grow, with a meaningful increase among participants over age 60, plan sponsors and retirement industry professionals should consider whether these sectors are included within the fixed income allocations of their target date strategies (Figure 6).

Considerations for plan sponsors, consultants, and advisors

Take a close look at your fixed income menu: The growth of the global fixed income markets in recent years has greatly expanded investment opportunities beyond the U.S. investment‑grade sectors. A broader opportunity set can create additional opportunities for diversification and potential excess returns.

Active management is key for fixed income diversification: While some passive equity strategies have performed well, using passive fixed income components can be problematic. Within some fixed income sectors, it isn’t practical—or in some cases even possible—to hold all the securities in the most common market indexes, making it difficult to replicate benchmark performance without significant tracking error.⁷ In our view, an active management approach is particularly valuable in certain fixed income sectors where credit risk is a primary risk. That’s because firsthand credit research could help mitigate certain default risks.

T. Rowe Price Sources

2023 Defined Contribution Consultant Study: This study included 45 questions and was conducted from February 14, 2023, through March 31, 2023. Responses are from 32 consulting and advisory firms with more than $6.7T in assets under administration. 

2021 Defined Contribution Consultant Study: This study included 51 questions and was conducted from September 20, 2021, through November. Responses are from 32 consulting and advisory firms with more than $7.2T in assets under administration.

2023 Retirement Savings and Spending Study: The Retirement Savings and Spending Study is a nationally representative online survey of 401(k) plan participants and retirees. The survey has been fielded annually since 2014. The 2023 survey was conducted between July 24, 2023, and August 13, 2023. It included 3,041 401(k) participants, full‑time or part‑time workers who never retired, currently age 18 or older, and either contributing to a 401(k) plan or eligible to contribute with a balance of $1,000 or more. The survey also included 1,176 retirees who have retired with a Rollover IRA or left‑in‑plan 401(k) balance.

2022 Retirement Savings and Spending Study: The Retirement Savings and Spending Study is a nationally representative online survey of 401(k) plan participants and retirees. The survey has been fielded annually since 2014. The 2022 survey was conducted between June 24, 2022, and July 22, 2022. It included 3,895 401(k) participants, full‑time or part‑time workers who never retired, currently age 18 or older, and either contributing to a 401(k) plan or eligible to contribute with balance of $1,000 or more. The survey also included 1,136 retirees who have retired with a Rollover IRA or left‑in‑plan 401(k) balance.

Reference Point 2023: This annual benchmarking tool examines trends and highlights and shares commentary to help inform plan design. Data are based on the large‑market, full‑service universe—T. Rowe Price total—of T. Rowe Price Retirement Plan Services, Inc., retirement plans (401(k) and 457 plans), consisting of 652 plans and approximately 2 million participants.

Participant Reactions to Jobs and the Economy, Q2 2023: Analysis of the plans in T. Rowe Price’s recordkeeping database from January 2017 through June 2023. The analysis focused on the effects of inflation on plan participant saving and investing behavior.