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An Update to PIMCOs Glide Path for Target‑Date Funds

Refinements seek to advance three key goals: return maximization, robust diversification and certainty of income during retirement.

PIMCO’s glide path for target-date funds is the collective expression of our firm’s view on how to deliver an age-appropriate asset allocation that best prepares defined contribution (DC) plan participants for successful retirements. As Managing Directors Mihir Worah and Ravi Mattu explain in the following Q &A, our glide path seeks to meet three key goals: return maximization, robust diversification and certainty of income during retirement.

Q: What are the objectives of the PIMCO glide path?
Worah: Our glide path philosophy centers on providing all participants enough income to sustain their lifestyle throughout retirement. Its unique asset allocation is designed to optimize the goals of retirement income, return maximization and diversification of investments in an effort to generate returns no matter the economic conditions over long investment horizons.

By designing our glide path around an income objective, our starting point differs from traditional asset allocation approaches. While customary asset allocation starts with cash as the risk-free asset, we view cash as a risky asset. This is because the amount of income cash generates can vary widely and depends on prevailing interest rates. Therefore, our asset allocation is more closely aligned with the goal of providing steady retirement income. Treasury Inflation-Protected Securities (TIPS) serve as the glide path’s risk-free asset. Further, our focus on return maximization goes well beyond just U.S. stocks: It includes meaningful positions in other high-estimated-return asset classes such as non-U.S. and emerging market (EM) equities. Our glide path also is highly diversified, with significant allocations to real estate, EM stocks and bonds, commodities, high yield and TIPS. These are assets that can help deliver returns to participants in a variety of growth and inflation scenarios.

Q: How often do you revisit this strategic asset allocation?
Worah: We reassess it annually following our Secular Forum. I lead a team of senior portfolio managers through a rigorous process where we revisit our priors, incorporate our firm’s latest views and review recent industry-related data. Ravi Mattu, Joachim Fels, Jim Moore and I form the leadership team. We present our findings to PIMCO’s Investment Committee, which must validate and approve our conclusions.

This review is critical because strategic asset allocation is the most important consideration, second only to the level of participant savings, in shaping retirement outcomes. And while our overall strategic allocations may not change in a meaningful way on an annual basis, we are committed to ensuring that our glide path reflects current retirement industry data along with PIMCO’s latest economic research and analytical modeling.

Q: Can you elaborate on how analytical modeling helps guide this process?
Mattu: As Mihir noted, our glide path is designed around three key tenets: Risk-adjusted wealth (utility) maximization, robust diversification and a risk budget guided by a retirement income-oriented goal. Key inputs to our modeling include PIMCO’s long-term capital market assumptions. We also incorporate the most current retirement industry data for housing wealth, savings/contribution rates, company matching, Social Security, etc.

Two important aspects to our modeling include a participant utility function and a long-horizon return simulation engine. The utility function provides guidance on how we allocate risk along the glide path by recognizing that participants prefer portfolios that seek to avoid retirement goal shortfalls over striving for outcomes that overshoot their retirement goal. Our long-term simulation model provides critical insight into how much income replacement we can expect our glide path to deliver across a full range of interest rate environments a participant could face at retirement. This is essential as the level of interest rates will largely define the return environment a retiree faces and therefore determine the amount of expected retirement income. Our simulation model considers thousands of plausible scenarios.

Q: How did PIMCO’s capital market assumptions change in 2015?
Worah: Updates to our 2015 capital market assumptions resulted in a modest reduction of forward-looking return estimates for most asset classes with only a few outliers, such as high yield.

While our overall expectations for long-term equity returns declined slightly, within equities, EM received the largest adjustments. To be clear, we believe EM equities continue to have, by far, the highest return estimate among equity markets, though on the margin this advantage is less pronounced than in our 2014 capital market assumptions. In fixed income, we’ve seen an outsize increase in the relative attractiveness of credit, especially high yield, compared with higher-quality fixed income sectors such as intermediate core-plus and long-duration Treasuries.

Q: Did your team make any refinements to the model that affected the glide path?
Mattu: One important enhancement to our modeling relates to housing wealth. Housing wealth is one of three major components affecting expected levels of income replacement during the decumulation phase of retirement investing; in other words, we consider that most participants have built real estate wealth outside of their DC savings through home ownership. This guided us toward lower allocations to real estate in the glide path – especially closer to retirement.

Worah: We also made a few other modest changes intended to improve the overall risk/reward characteristics of the glide path. As Ravi alluded, we decreased exposure to real estate investment trusts (REITs) given the significant real estate allocation most participants hold via home ownership. Also, REIT valuations are no longer quite as attractive as they were in the last few years.

While EM valuations continue to be attractive, we recalibrated the EM exposure and somewhat reduced the overall EM risk budget. These adjustments reflect our outlook for growth and elevated EM currency volatility, and seek to limit concentrated exposures to political- and commodity-related risks associated with EM. Most of the downward adjustments in EM allocation were directed to U.S. high yield (and to a lesser degree, U.S. equities), based on our favorable views on the potential returns offered by high yield.

Finally, our retirement income optimization guided us toward reducing duration in the allocation furthest from retirement. This change in the optimal portfolio was primarily related to our revised capital market assumptions, which reflect compressed duration risk premiums. In other words, the model made a small trade-off: an improved return estimate for slightly diminished income sensitivity. We agreed with the models’ guidance as younger participants do not need as much of this sensitivity relative to those nearing retirement when this objective is central.

Q: Can you speak to what has changed since PIMCO originally designed its glide path?
Worah: We first developed our glide path about 10 years ago
and it has evolved since then. Importantly, however, the underpinnings of this strategic asset allocation have remained a constant. We have always designed our glide path to deliver on an income replacement goal by focusing on maximizing wealth and embracing extensive diversification.

What has evolved over time is our asset allocation and analytical capabilities, along with changes in the DC marketplace. For example, features like automatic enrollment and automatic escalation of contribution rates have helped improve how individuals participate in DC investing. Ravi, Joachim, Jim and I strive to ensure PIMCO’s glide path remains at the leading edge of DC-related asset allocation.

Q: How can we learn more about the research and analytics used in the review process?
Mattu: For those keen to dig into the details, please refer to our Quantitative Research and Analytics pieces, including “Investing in Retirement” and “Rethinking Retirement Risk.”

The Author

Mihir P. Worah

CIO Asset Allocation and Real Return

Ravi K. Mattu

Global Head of Analytics

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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 risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. 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. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. 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. 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. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations.Equities may decline in value due to both real and perceived general market, economic, and industry conditions. 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. Diversification does not ensure against loss.

Glide Path is the asset allocation within a Target Date Strategy (also known as a Lifecycle or Target Maturity strategy) that adjusts over time as the participant’s age increases and their time horizon to retirement shortens. The basis of the Glide Path is to reduce the portfolio risk as the participant’s time horizon decreases. Typically, younger participants with a longer time horizon to retirement have sufficient time to recover from market losses, their investment risk level is higher, and they are able to make larger contributions (depending on various factors such as salary, savings, account balance, etc.). Generally, older participants and eligible retirees have shorter time horizons to retirement and their investment risk level declines as preserving income wealth becomes more important.

Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous 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. No guarantee is being made that the stated results will be achieved.

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Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over the long term. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods.

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