In designing successful defined contribution (DC) plans, we need to keep the desired outcome – sustainable retirement income – clearly in focus. Most DC plans will need to replace 30% to 50% of an American worker’s final pay throughout retirement, and this pay replacement must keep pace with inflation. (And in the event that Social Security benefits are cut back at some future date, DC plans would become even more important to retirees for real income replacement in retirement.) In other words, it’s not simply the accumulation of dollars that matters, it’s building and preserving purchasing power that retirees need to maintain their lifestyles in retirement. Workers only have one chance to save for this need.
At PIMCO, we believe many DC plans fail to manage inflation risk. While we do not anticipate double-digit inflation over the secular horizon, even 2.5%–6% inflation can rob retirees of over a quarter of their purchasing power or as many as five years of spending power. Inflation could be devastating, but by revamping DC plans to include an appropriate level of inflation hedging, sponsors may help their participants preserve purchasing power throughout retirement.
Outcome-focused DC design DC plan investment structures should focus on the plan’s desired outcome: meeting the real income replacement target (e.g., 50%) in order to provide sufficient purchasing power to fund the future consumption of goods and services. That desired outcome, or investment objective, helps define the appropriate asset allocation and risk management strategy. For DC plans, inflation-hedging or “real” assets such as Treasury Inflation-Protected Securities (TIPS) may be deemed the “risk-free” asset underpinning the allocation. Placing real assets at the core of the DC plan can help minimize the mismatch between plan assets and participants’ spending needs. The size and structure of the real asset allocation depends on a plan’s specific objectives, and may vary between default (“do it for me”) and core (“do it myself”) lineups.
Outcome-focused risk management in Tier I “do it for me” default strategies Many participants are relying more and more on their plan sponsors to manage their DC asset allocation over time. Today, we have found that DC assets are building most rapidly in target-date strategies, which may manage the participants’ risk exposure up to, as well as through, their retirement years. Target-date strategies are the most prevalent DC default option and are offered by nearly 70% of DC plan sponsors, according to the Plan Sponsor Council of America 2012 Survey.
Unfortunately, we believe the vast majority of target-date asset allocations (or “glide paths”) are not aligned to meet sustainable income replacement goals or to remain within the risk capacity limits of the median worker. Rather, the market average glide path’s composition appears to focus on the wrong objective: maximizing nominal returns without regard to risk. Of course returns are important, but so is risk management: PIMCO’s glide paths start with real assets, including TIPS, commodities and real estate, and then add other assets geared to maximize real return potential within the constraints of the risk budget. This outcome-focused optimization results in a significant allocation to real assets, as shown in Figure 1. By comparison, the market average glide path includes only a small allocation to real assets.
PIMCO’s outcome-focused, more diversified glide path aims to reduce risk over time; note how near retirement, the allocation to risk assets is much lower and to inflation-hedging assets is much higher than in the market average glide path, and the risks are more diversified as well. While the higher-risk market average strategy may appear to target higher returns – i.e., greater accumulation – the risk of loss may far exceed a participant’s capacity for loss, potentially jeopardizing his or her retirement date, lifestyle or both.
The PIMCO glide path seeks to reduce the likelihood of these unacceptable losses: diversifying risks, including inflation risk, with the goal of delivering sufficient purchasing power throughout retirement. We established the PIMCO glide path based on the loss capacity we believe a participant has – and we differentiate capacity from tolerance. Loss capacity can be quantified based on the amount of income the participant will need the plan to replace, how many years the participant still has to save, and what percentage of salary can be put away. Determining loss capacity is a critical first step in determining an appropriate glide path or other default retirement strategy. By including inflation assets in the PIMCO glide path, we believe we can lower the risk to a level that the median participant has capacity to take on (for more on risk capacity, please see our May 2012 Viewpoint: “ Loss Capacity Drives 401(k) Investment Default Evaluation”).
By adopting an outcome-focused approach to target-date strategy management, our analysis suggests the probability of meeting participant retirement income needs improves relative to the market average glide path in both inflationary and turbulent market environments (see Figure 2). And even in “normal” markets – which we do not anticipate experiencing any time soon – PIMCO’s outcome-focused glide path has nearly the same level of success as the market average.
What about the risk of failure – that is, not even reaching a threshold of at least 30% of final pay? We have found that the outcome-focused approach offers significantly less likelihood of failure, while the market average glide path has an 8% to 33% probability of failure, depending on the market environment. What’s more, an outcome-focused glide path is more likely to last throughout retirement, with expected depletion at 80 to 84 years of age: up to four years longer than the market average glide path (sources: MarketGlide and PIMCO). Bottom line: The outcome-focused glide path approach results in a higher probability of success and significant reduction in the risk of failure in meeting income goals.
Incorporating risk management into Tier II “do it myself” core lineups Tier II core DC plan options should allow participants to build appropriate asset allocations to meet their needs in retirement. We believe this tier should offer a range of investment choices that allow for risk diversification as well as return opportunity, and – critically – the investment menu should offer balance such that even naïve diversification (i.e., allocating assets equally across all of the investments in the lineup) would result in a reasonable, risk-managed allocation.
Unfortunately, we have found that most DC core investment menus fail to meet this test. They mainly originated in the equity style box approach – growth, income, small cap, large cap, etc. Despite best intentions to offer diversification, this style-box-driven menu tends to offer a predominance of equity strategies and results in excessive (almost entire) exposure to a single risk – equity risk. This means that changes in a participant’s DC account would result mostly from movements in the stock market.
To better diversify risks and more closely match DC assets to outcomes, we believe core plan lineups should evolve away from the style box and toward a more streamlined, balanced list that includes inflation hedging and other diversifying strategies (see Figure 3). Plan sponsors may transition first to an “asset-class-focused” lineup (see center column), which can offer better diversification by consolidating the equity choices and adding inflation hedging and diversifying bond choices. Some plan sponsors may go one step further to a “risk-diversifying” approach: offering an even shorter, more consolidated list of investment choices. Either way, a naïve diversifier would likely end up with a more reasonable, less risk-saturated asset allocation.
Specific to inflation hedging in these streamlined Tier II lineups, many plan sponsors are turning to blended approaches, which may help participants in several ways:
Revamping overall DC plan structure: broader diversification, yet fewer choices Plan sponsors may consider moving toward more outcome-focused programs that include inflation-hedging assets as core components of both Tier I and Tier II options.
Tier I target date strategies can be either packaged or custom; moving away from packaged strategies to open architecture taps into the core asset lineup, gives a sponsor greater control over the glide path and offers greater opportunity to target a plan’s specific objectives.
Tier II core lineups should balance risks, offering solutions for both sophisticated and novice participants. Sponsors may consider narrowing the range to a shorter list of broadly diversified strategies, ensuring inflation-hedging assets are among the core offerings.
At PIMCO, our goal in offering retirement planning strategies is to create investments that enable people to retire successfully, and we define success as building and preserving purchasing power to meet retirement income needs for the majority of the participants regardless of the economic environment. We believe that a focus on inflation sensitivity and protection is key to reaching that objective.
A "risk free" asset refers to an asset which in theory has a certain future return. U.S. Treasuries are typically perceived to be the "risk free" asset because they are backed by the U.S. government. All investments contain risk and may lose value.
Past performance is not a guarantee or a reliable indicator of future results . Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. Government. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Stable value wrap contracts are subject to credit and management risk. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.
The glide path is intended to illustrate how allocations among asset classes change as a target-date approaches. The target asset allocation is based on a target date, which assumes a normal retirement age of 65, and time horizons based on current longevity of persons reaching retirement in average health. The glide path is designed to reduce risk as the target retirement date nears, but may also provide investors diversification across a variety of asset classes, with an emphasis on asset classes that may protect against inflation over time. The target allocations used in this presentation are for illustrative purposes only. They are based on quantitative and qualitative data relating to long-term market trends, risk metrics, correlation of asset types and actuarial assumptions of life expectancy and retirement.
The PIMCO glide path implements an optimal asset allocation mix that moves from higher risk to lower risk over time and is designed to manage the risk of an individual’s savings as they approach retirement. The glide path acts as a “benchmark portfolio,” reflecting an allocation that is optimal with respect to our long-run, real return assumptions for each asset class (referred to above as “capital market assumptions”). The PIMCO glide path optimization takes into account the compounding of returns over the given investment horizon, unlike standard mean-variance analysis. PIMCO’s approach to developing a glide path incorporates liability-driven modeling in a “real return” framework, using a broad opportunity set of asset classes seeking to deliver meaningful improvements over traditional approaches. This approach may increase the median return and narrow the range of expected future outcomes when compared to the typical glidepath, while hedging the risk of future inflation and reducing the risk of a shortfall in future sustainable spending power. More income is likely to distribute near the median.
No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.
The portfolio analysis is based on the Market Average and PIMCO glide paths. No representation is being made that the structure of the average portfolio or any account will remain the same or that similar returns will be achieved. Results shown may not be attained and should not be construed as the only possibilities that exist. Different weightings in the asset allocation illustration will produce different results. Actual results will vary and are subject to change with market conditions. There is no guarantee that results will be achieved. No fees or expenses were included in the estimated results and distribution. The scenarios assume a set of assumptions that may, individually or collectively, not develop over time. The analysis reflected in this information is based upon data at time of analysis. Forecast, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
PIMCO routinely reviews, modifies, and adds risk factors to its proprietary models. Due to the dynamic nature of factors affecting markets, there is no guarantee that simulations will capture all relevant risk factors or that the implementation of any resulting solutions will protect against loss. All investments contain risk and may lose value. Simulated risk analysis contains inherent limitations and is generally prepared with the benefit of hindsight. Realized losses may be larger than predicted by a given model due to additional factors that cannot be accurately forecasted or incorporated into a model based on historical or assumed data.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2012, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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