2024 DC Investment Forum: Addressing inflation risk through DC plan members’ working lives

“If I spend more money on inflation, I have to sell down nominal bonds or sell down growth equities and either one of those two choices will reduce the total return over time.”

That dilemma raises two questions: when to introduce inflation risk protection into the portfolio and how to do so, he said.

Read: Survey finds 77% of U.S. institutional investors worried about inflation and interest rates in 2024

A 2020 BlackRock paper that examined how wages are impacted by inflation found young workers “pass through inflation without a problem” as their salaries are increasing at a rate above inflation, eliminating the need for a portfolio to hold inflation protection assets during employees’ 20s and into their early 30s.

However, as workers enter midlife, that becomes less true, said Nefouse, noting an inflation-hedging portfolio is built in around age 45 or 50 in BlackRock’s LifePath TDFs. In the Canadian market, that allocation includes inflation-linked bonds, commodities, infrastructure and real estate, for a combination of return-seeking and inflation-hedging properties.

Those assets have particular considerations in Canada. With the federal government cancelling real return bonds, BlackRock is looking to short-curve bonds, like it does in the U.S., to provide a more effective inflation hedge than full-curve bonds, he said. Commodities are the highest-cost part of the inflation-hedge portfolio since they’re funded from equities and may have a greater correlation with Canadian stocks.

Read: Expert panel: Cessation of real return bonds increases risk profile for Canadian pension fund model

As well, real estate investment trusts provide good diversification for plan members, particularly in mid-career and later, said Nefouse, adding BlackRock is more interested in the “modern” real estate sectors — including residential, health care and data centres — which demonstrate better growth opportunities and ability to pass through inflation than traditional real estate.

BlackRock has also been re-evaluating its approach to fixed income within its TDFs to serve two aims of offsetting equity risk and return seeking. The U.S. bond market is “very deep,” he said, and allows the investment manager to break fixed income into five building blocks: long credit, intermediate credit, securitized, long government and intermediate government. In its U.K. products, BlackRock broke down global fixed income into five parts.

But Canada’s market is trickier, with very little long-duration fixed income, a credit market that’s heavily concentrated in certain industries and provincial bonds to factor in. Nefouse said the company is exploring whether to stick with North American fixed income or go global in Canadian TDFs.

The TDFs’ life-cycle framework is meant to address all of the risks that DC plan members face throughout their working lives and into retirement, including saving adequately in early career, a large drawdown near retirement and sequence of returns risk.

The goal of LifePath is to provide a smooth, defined benefit-like income in retirement, said Nefouse, and the “next frontier” for the investment manager is turning the retirement savings plan into a retirement income plan to help members maximize their ability to spend, minimize volatility and address longevity risk. The solution would factor in Canada Pension Plan payments and an annuity for income stability to advise plan members how much they can safely spend per year.

Read more coverage of the 2024 DC Investment Forum.