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Bransby Whitton, Ying Gao, Justin Blesy
We engineered the asset allocation approach in our glide path using three frameworks: real return liability-driven investment, total risk management and return optimization through risk factor diversification. The result is a glide path structure designed to offer plan sponsors the potential to increase median expected real income replacement, improve the consistency of outcomes and minimize the chance of participants falling short of an acceptable income replacement level. Importantly, we believe that success should be achievable regardless of the economic environment.Key points:Our approach results in an asset allocation that is different than the typical target date approach. Specifically, our glide path:
The impact of these differences includes:
However, given the relatively low real return of TIPS, it is important to view TIPS not as the sole asset, but rather as a core asset – one that should be complemented with potentially higher return assets that have links to inflation in an effort to increase the long-term real return potential of the glide path. Equities should be among these higher return assets because they are an important driver of long-term portfolio returns. However, they also add volatility, especially in light of their inflation-adjusted returns. So it is important to consider other liquid, high risk, potentially higher return asset classes with an implicit link to inflation, namely, commodities and real estate investment trusts (REITs). These assets may not only improve the inflation fighting power of the portfolio, but also further improve the diversification of the asset allocation mix in the glide path.
It is worth noting that our approach is not driven by a traditional mean-variance optimization. While we do use a constrained mean-variance analysis as an input to guide our allocation, the optimization uses a block bootstrap1 simulation rather than a normal distribution and allocates the portfolio based on risk factors rather than solely by asset classes. Despite these expansions beyond traditional mean-variance analysis, there are several reasons why this type of optimization analysis is not the primary driver of our glide path allocations. First, it may be deficient over long-term horizons; we believe claiming any certainty regarding risk and return estimates over 40 years would have required a high degree of hubris on our part. In addition, a key input to the mean-variance approach is the covariance matrix of asset classes, which, we have observed, is inherently unstable over time. Finally, when we did run mean-variance optimization on the glide path, it resulted in “corner solutions,” or portfolios with high concentrations in a single asset, and this did not align with our objective of risk diversification.
1Bootstrapping is a procedure by which new samples are generated from an original data set by randomly selecting observations from the original data set. “Block” bootstrapping in particular uses contiguous blocks of data.
Our analysis spanned the full 40-year periods over each glide path. Conditions during the first 30 years of each analysis were consistent, while the final 10 years were subjected to the three economic scenarios. The outcomes are illustrated below. In each case, the PIMCO Glide Path provides a comparable, or in some cases improved median income replacement outcome, a tighter distribution of income replacement outcomes and fewer extremely low income replacement outcomes.Summary and ConclusionsPIMCO set out to reengineer target-date strategies by constructing a new glide path for the DC market. Starting with a “blank sheet,” we first embraced a real return LDI framework. Then we defined what we believe to be the appropriate level of total risk, or maximum potential for loss, along the entire glide path. Finally, using this risk budget, we endeavored to construct efficient return-maximizing portfolios based on risk factor diversification.The result of our efforts, the PIMCO Glide Path, seeks to provide several advantages over other glide paths:
PIMCO has launched a suite of target-date strategies based on this glide path methodology. The PIMCO RealRetirement Strategies provide DC plans with a next generation solution for target-date strategies.Please contact your PIMCO representative for further information.
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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