PIMCO believes target-date strategies should achieve a sufficient level of real retirement income for every participant rather than
focus on the more prevalent goal today of maximizing nominal retirement wealth for the average participant. A real-income orientation
provides several advantages and, importantly, while the difference between real income and nominal wealth may seem subtle, it can lead to big
differences in the ultimate asset allocation. To deliver on the goal of providing real retirement income, we believe that an asset manager must
consider the full distribution of possible outcomes rather than focus solely on the average.
We believe that the ideal glide path should be designed to achieve:
- Real income: An attractive median real income
- High certainty: A compact distribution of real incomes
- Minimal shortfall risk: Few very low outcomes
We believe in a holistic view of retirement readiness and planning. Our target-date analysis expands beyond the narrow confines of the retirement account:
We incorporate common non-retirement assets (such as housing) or retirement income sources (such as Social Security) into our assessment of glide path
performance. We believe this allows for a more complete, more accurate characterization of a household’s retirement risks.
PIMCO’s glide path, reflecting our comprehensive asset-and-liability-based retirement framework, is built around three key components: 1) outcome-focused
real return liability-driven investment (LDI), 2) return optimization through diversification and 3) total risk management.
The resulting glide path offers plan sponsors the potential to achieve attractive real income replacement rates; further improve the consistency of
outcomes; and significantly reduce the chance of participants falling short of an acceptable income replacement level.
Outcome focus: Embracing LDI
It’s not about how much money you have to retire; it’s about how much you can afford in retirement.
We believe that target-date funds should be designed around a retiree’s “liability:” the income that he or she will need for living expenses throughout
retirement. This liability consists of a steady income stream that is adjusted for increases in living expenses or inflation.
In a manner similar to the approach used by defined benefit plans, we developed (and quantified) the “typical” retiree’s liability, based on a deferred
real annuity of 20 years, which then served as the basis for determining the optimal asset portfolio in PIMCO’s glide path. (To learn more, see “Using a
Real Liability to Assess Retirement Readiness and Inform Investment Decisions.”)
Quantifying and tracking the retirement liability over time allows for a dynamic glide path that is designed to significantly reduce the income risk of
retirement savings. As real interest rates rise (or fall), the amount of retirement income available for any given amount of assets increases (or
decreases). Figure 1 provides an example of the amount needed to support $25,000 in real income annually throughout retirement, based on the average life
expectancy of 20 years past retirement and depending on interest rates. The lower the real interest rate at the time of retirement, the more wealth is
needed to support a given real income expectation. To increase outcome certainty for retirees, the asset allocation should be sensitive to changes in
interest rates and provide more income when more is needed.
Not surprisingly, then, an income focus leads to long-duration securities in the asset portfolio for their liability-matching characteristics: They tend to
increase in value precisely when retirement income is the most “expensive” (i.e., when rates are low as shown in Figure 1).
Figure 2 illustrates the duration, or sensitivity to interest rates, of the typical retirement income stream over the 15-year period leading up to
retirement, compared with the duration of the PIMCO and the market average glide paths. The larger the duration differences between the liability and glide
path, the larger the uncertainty around the outcome, i.e., how much income is available throughout retirement.
We believe that the most appropriate measure of risk for retirement income is not the volatility of wealth, but the volatility of obtainable retirement
income: how much the account value changes relative to the cost of retirement liabilities. Figure 3 quantifies this risk (called “tracking error”)
for both the PIMCO and market average glide paths at various participant ages. As shown, our approach is significantly more effective at tracking the
liability – and thereby reducing income uncertainty and shortfall risk – than the market average glide path.
To further minimize shortfall risk, we enhanced this liability-optimized approach by setting parameters for our simulations with an asymmetric objective
function that puts a higher weight on outcomes that significantly underperform and a lower weight on those that significantly outperform. This is described
in detail in “Rethinking Retirement Risk,” by Niels Pedersen and Sean Klein.
Diversification: Optimizing returns
Our next step was to maximize return potential along the glide path while maintaining a focus on the tracking error of the allocation to retirement
liabilities. As part of this process, we incorporate PIMCO’s long-term capital market assumptions to help guide portfolio risk and return expectations.
(See Figure 10 in the Appendix for PIMCO glide path return assumptions.)
In general, we favor portfolio construction based on risk-factor diversification rather than asset-class diversification. PIMCO has found that during
periods of market stress, seemingly different assets tend to be highly correlated. Simply diversifying across asset classes therefore often results in
portfolios that may appear diversified but conceal concentrated risks. We have developed what we believe is a more efficient allocation approach that looks
beyond asset-class labels and focuses instead on the common underlying risks that many assets share, such as equity beta, duration, currency, momentum,
etc. Our approach aims to construct diversified long-term portfolios that can perform in various economic environments and are not overly influenced by our
experiences of the recent past.
Figure 4 illustrates the benefits of our risk-factor diversification approach. In terms of value-at-risk (VaR), the PIMCO glide path shows lower risk than
the market average glide path by a substantial margin. Looking at stressed situations with high levels of volatility, where the VIX is over 20 – for
example, a financial crisis scenario similar to what we saw in 2008 – the risk-factor focus offers diversification benefits that are even more apparent.
Total risk management: Adhering to age-appropriate risk limits
Optimizing to age-appropriate risk throughout the glide path not only is essential to achieving our goals for an ideal glide path, but also helps to
increase the chances that participants will stay invested in good and bad times.
Our risk-factor-based asset allocation is designed to produce well-diversified portfolios tailored to a participant’s age-based risk capacity. For example,
when a participant has the greatest amount of time prior to retirement, say 20 to 40 years, the optimal asset allocation includes a heavy allocation to
higher-return-potential assets like equities and real estate. When participants are younger, they can tolerate a higher risk level given that most of their
wealth is represented by remaining human capital (present value of future wages); moreover, account balances in the early years are usually significantly
smaller than those near retirement, so there is not as much at stake at the outset. On the other hand, for participants closer to retirement, say within 15
years, risk (relative to the retirement liabilities) in our asset allocation is significantly decreased, with more weight put on less risky assets, such as
Treasury Inflation-Protected Securities (TIPS), nominal bonds and cash. This is consistent with our view that older participants will not tolerate a high
level of market risk: They are likely to have more at stake and have less time to recover from a severe market shock than younger participants.
Of course, we recognize that even though the actual risk of a glide path should be measured in terms of uncertainty of achieving a sufficient retirement
income, participants will feel and see volatility in their accounts in terms of nominal dollars. As a secondary constraint, nominal risk budgets are
therefore set at levels investors can be comfortable with and will help ensure that they stay the course and continue participating in their retirement
plans, even during times of heightened market volatility.
For guidance on appropriate levels of total risk, we employ PIMCO’s annual consultant survey, where we ask for consultants’ views on the maximum loss that
a plan participant can incur and still meet his or her income goal. The 2014 responses are shown in Figure 5.
We compared this guidance to analysis where we estimated the maximum drawdown across each vintage of the glide path. While there is no industry standard
for computing maximum potential loss on a portfolio, we applied a host of risk metrics, as well as our proprietary risk analytics, to “stress test”
potential portfolios; for example, we looked at VaR, conditional VaR, volatility, portfolio equity beta and the probability of outcomes below -5% and -15%.
Combining the external market perspective from the consultants with our internal quantitative analysis, the results of this iterative process were total
risk budgets, or the capacity for loss, along the entire glide path leading to substantially improved outcomes versus the market average glide path, as
in Figure 6.
To test the effectiveness of our glide path in meeting our real-income-centered objectives, we simulated typical participant experiences via long-horizon
Monte Carlo simulation.1 Inputs to the model are listed in the appendix and include real-world-participant and employer contribution levels
combined with PIMCO’s long-term return assumptions for the various asset classes.
Success is measured in terms of the income replacement a participant would have achieved over a typical savings period. Important metrics are the median
income replacement, which is equivalent to the expected outcome, as well as the lowest achieved outcomes, which is a measure for shortfall risk. As
fiduciaries, our goal is to provide a successful outcome to every single participant. Therefore, minimizing shortfall risk is of utmost importance. We also
look at average outcomes but monitor this metric with care as its usefulness is limited. It is skewed by positive outliers – meaning cases when very high
income replacement ratios were achieved – and is therefore not representative of a typical outcome.
As we can see in Figure 7, the PIMCO glide path significantly outperformed the market glide path on both the expected outcome (median income replacement
rate) and shortfall risk (measured based on the lowest 5% of outcomes). As a sign of significant outcome uncertainty, the market average glide path
achieved a slightly higher average outcome – skewed by extreme positive outliers.
The PIMCO glide path embraces a broad set of asset classes, aggressively dials down risk as it approaches the target date and utilizes a full toolkit of
diversifying assets, including core global bonds, equities, emerging market bonds, high yield bonds, TIPS, commodities, REITs and emerging market equities.
The PIMCO glide path seeks to provide several advantages over other glide paths:
- Improved median real income replacement outcome;
- Tighter distribution of expected real income replacement outcomes; and
- Significantly fewer expected extremely low income replacement outcomes.
PIMCO offers two target-date strategies based on this glide path methodology. The PIMCO RealPath and RealPath Blend Strategies provide a next-generation
solution for defined contribution plans.
Please contact your PIMCO representative for
The authors would like to thank Mihir Worah, Ravi Mattu, Vineer Bhansali, Jim Moore and John Miller for their advice and oversight and especially Niels
Pedersen and Sean Klein for their major contributions in the glide path development.
1Details on the simulation engine are described in "Rethinking Retirement Risk," by Niels Pedersen and Sean Klein (2014)