The fixed income allocations in our target date portfolios are designed to reflect the nuanced roles that the asset class plays within multi‑asset portfolios. These range from the goal of mitigating equity risk to seeking to preserve purchasing power against inflation. We have thoughtfully evolved our fixed income design over time as part of our efforts to improve outcomes for investors.

In 2017, after careful review, our target date portfolio team made a number of enhancements to the fixed income allocations in our target date strategies, changes designed to take advantage of a broader global fixed income opportunity set and better align those allocations with the changing needs of retirement investors as they move along their target date glide paths.

A review of the performance of our fixed income allocations since those changes were fully implemented demonstrates that our efforts to enhance fixed income diversification have yielded tangible benefits for retirement investors.¹ Our performance analysis illustrates that the enhancements delivered the diversification benefits expected by our target date team—confirming the rigor of our design process.

We found that the enhancements improved the overall performance of our target date strategies by enhancing fixed income returns on both an absolute and a risk‑adjusted basis at various points along their glide paths, relative to T. Rowe Price’s previous strategic allocation design (Figure 1).

The Evolution of Our Fixed Income Design

The growth of global fixed income markets in recent years has greatly expanded investment opportunities. A broader opportunity set has created additional opportunities for diversification and for skilled active management to generate excess returns.

"A broader opportunity set has created additional opportunities for diversification and for skilled active management to generate excess returns."

To take fuller advantage of these opportunities, our target date team decided that a number of allocation enhancements had the potential to dampen total portfolio volatility and improve risk‑adjusted returns. These enhancements affected two major categories in our target date fixed income portfolios:

• The core component, which consists primarily of investment‑grade bonds and a lower‑volatility foundation for the overall fixed income allocation. The core component represents 70% of the total fixed income portfolio² across the entire glide path.
• A diversifying component that includes additional return‑seeking sectors, such as high yield bonds and emerging market (EM) debt. This component represents 30% of the fixed income allocation across the glide path, but the weights within it are dynamic, changing over time as the target date portfolios move along their glide paths (Figure 2).

Our 2017 design enhancements, and the thinking behind them, are summarized in Figure 3.

The Benefits of an Active Approach

In our view, the expansion of the global fixed income opportunity set has created additional opportunities for skilled active management to seek uncorrelated sources of excess return. Taking advantage of these opportunities is a key goal of our fixed income design.

The use of passive investment components can be especially problematic in the fixed income arena. 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.

Replicating benchmark exposures also may result in unintended or undesired risk concentrations, resulting in higher risk of loss from potential defaults or downgrades in the largest issues. An active investing approach allows for credit research that we believe may help mitigate certain default risks.

Many of the fixed income diversification enhancements we have made to our target date design would be inefficient or impossible to replicate using only passive components. A purely passive approach also can foreclose potential opportunities to generate excess returns.

The addition of a nontraditional global bond fund in our core component, for example, was designed to supplement traditional fixed income qualities with a focus on downside risk management, providing diversification during periods of risk aversion. The fund manager also has the ability to use multiple active levers—such as duration; yield curve positioning; and sector, country, and currency exposures—to seek excess return opportunities.

Likewise, the addition of a floating rate bank loan fund to the diversifying component—supplementing a portion of the high yield bond allocation—provides additional mitigation against duration risk and extends the potential benefits of T. Rowe Price’s credit research capabilities.

In addition, T. Rowe Price takes an active approach to managing allocations to the underlying building blocks in our target date strategies with dynamic tactical adjustments. We believe we can harness the insights of leaders in the firm’s equity, fixed income, and multi‑asset investment divisions by leaning into or away from asset classes based on our 6‑ to 18‑month market outlook. In our view, having a diversified set of underlying strategies gives us the ability to implement our views as markets evolve over the shorter term, which can support our investors over the long‑term as well.

Performance Analysis

A review of the performance of our target date fixed income allocations verifies that our enhanced design improved returns relative to their previous strategic allocations.

We looked at the five‑year performance of our enhanced fixed income design at different points along the glide path for our Retirement Funds—40 years before retirement, at retirement, and 30 years after retirement. We compared these results with the performance of the strategic allocations in our previous fixed income design. The results of our analysis are summarized in Figure 4.³

Overall, return improvements along the glide path, relative to our previous fixed income design, ranged from 0.23 to 0.62 percentage points (23 to 62 basis points), annualized.

At retirement (age 65), for example, the enhanced fixed income design raised annualized returns by more than 0.56 percentage points (56 basis points), relative to our previous design.

Our enhancements also had the additional effect of reducing overall fixed income volatility—a key benefit amid 2022’s bond bear market. This resulted in higher Sharpe ratios for the entire fixed income allocation at all three points on the glide path that we examined, relative to the previous strategic allocation.

Not All Fixed Income Is Created Equal

In addition to the components outlined above, our target date fixed income design also includes an allocation to short‑term TIPS. This allocation is designed to help offset the potential negative impact of inflation—especially an unexpected acceleration in inflation—on real portfolio values.

The TIPS allocation is dynamic, and increases as portfolios move along their glide paths, both as a share of the total fixed income allocation and as a percent of the entire portfolio (Figure 5).

The shorter duration of our TIPS allocation made a meaningful contribution to relative performance during the 2022 bond bear market. While many target date fixed income models include a TIPS component, those allocations often are benchmarked to broad TIPS indexes that include longer‑term securities. Reflecting their longer durations, many of these indexes experienced losses comparable to traditional core bond benchmarks in 2022.

The Bloomberg U.S. Government Inflation Linked 1‑10 Year Index, for example, posted a 7.38% loss in 2022. In contrast, the Bloomberg U.S. Treasury TIPS 1‑5 Year Index fell less than 4%, as its more limited duration helped cushion interest rate risk while still mitigating the erosive impact of inflation on real yields.

Strengths of T. Rowe Price’s Target Date Design Process

T. Rowe Price has been an industry leader in target date investing for nearly two decades. We constantly reassess our design to seek improved outcomes. Our fixed income portfolios reflect the depth of our asset allocation expertise and the rigor and discipline of our target date design process.

Our target date team was early in understanding that traditional fixed income allocations based on “core” U.S. investment‑grade sectors might be suboptimal for retirement investors. They recognized that:

• The growth and evolution of global bond markets had created attractive diversification opportunities.
• A larger opportunity set had expanded the field for skilled active management.
• Dynamic diversifying allocations could better serve the needs of retirement investors at various points on the glide path.

We also were early in recognizing that defined contribution plan sponsors want more sophisticated fixed income allocations for their participants. One T. Rowe Price survey, for example, found that 79% of plan sponsors believe it is important to offer participants a range of fixed income options based on their risk, return, and retirement income preferences.⁴ By incorporating a broader range of asset classes within a target date solution, we believe we can bring a more sophisticated and risk‑aware approach to plan participants.

Conclusions

Overall, we believe the performance of our fixed income allocations testifies to the strengths of T. Rowe Price’s target date design process:

• prudent innovation backed by rigorous research;
• allocations that we seek to make durable under a variety of return, volatility, and correlation assumptions;
• rigorous scenario testing to analyze potential performance under varying market and/or economic conditions.

As always, we will continue to evaluate our allocations to ensure they reflect our best understanding of asset class relationships and capital market conditions. Our goal will remain the same: to construct portfolios that effectively further the long‑term objectives of target date investors

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