DC Design

Designing Balanced DC Menus: Considering Inflation-Hedging Strategies​​​​

Consultants suggest real assets as a core investment choice.

Second in a series of articles exploring diversifying asset strategies, including fixed income, real assets, capital preservation and equities.

​​“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”

- Ronald Reagan

In 1978, when then-candidate Ronald Reagan likened inflation to a mugger, it struck a nerve. Inflation was running at a 9% annual clip, on its way to nearly 15% two years later. Inflation was a harsh reality.

Today, inflation is tame, and the voices of monetary hawks have been drowned out. Nonetheless, when it comes to investing for retirement, consultants concur: Inflation is one of the greatest risks, and inflation-fighting assets should be part of retirement portfolios.

Although inflation may seem a distant threat, we believe inflation-fighting assets are critical to defined contribution (DC) plan portfolios because inflation often strikes without warning. Moreover, for retirees, who often depend on income that does not adjust with inflation, even relatively tame inflation can be devastating. Consider: After 20 years of 3% annual inflation, $50,000 in retirement income would buy only about $27,000 worth of goods and services; with 5% inflation, the value shrivels to only about $18,000.

This helps explain why 89% of respondents to the 2014 PIMCO DC Consulting Support and Trends Survey support offering an inflation-hedging choice in a DC plan’s core investment menu. Inflation-fighting asset classes can help portfolios in other ways, too: They may diversify risk from traditional stocks and bonds, reduce portfolio volatility and mitigate downside risk.

Consultants favor commodities, TIPS, REITs
For core menus, a majority of consultants we polled suggest the addition of a multi-real-asset blend. The blend may include commodities, Treasury Inflation-Protected Securities (TIPS) and real estate investment trusts (REITs), which consultants view as most valuable in fighting inflation.

Less than half advocate adding discrete inflation-hedging asset classes to core menus. Notably, over a quarter of the consultants (27%) suggest a global tactical asset allocation strategy that combines both real and nominal assets; this strategy might also state an outcome objective or secondary benchmark (e.g., CPI plus 5%).

Figure 1A shows the inflation-fighting asset classes that consultants most favored in core lineups. Figure 1B shows the importance consultants placed on individual inflation-fighting assets within multi-real-asset strategies.


Implementation challenges
Regrettably, adding inflation-hedging assets to DC menus is a potentially complex challenge, one that requires thoughtful analysis and preparation. For one, individual inflation-fighting assets respond to inflation in different ways. Then, as detailed in “Designing Balanced DC Menus: Considering Diversified Fixed Income Choices” (April 2014), there’s the “1 over n,“ or naïve diversification, problem – i.e., the tendency of DC participants to allocate their assets evenly among fund choices (see Figure 2).


Broadly speaking, we suggest offering a balanced menu of investment choices designed to boost the odds that participants create reasonably balanced portfolios even when blindly allocating equal sums across menu options. Before plan sponsors can responsibly add inflation-fighting assets to core menus or target-date strategies, however, we believe that measures such as inflation beta, equity correlation, volatility and downside risk need to be evaluated (see Figure 3).


Evaluating real asset strategies
Let’s take a look at how inflation-hedging asset classes and blends perform against these measures:

  • Inflation beta: We believe asset prices are much more sensitive to inflation surprises than actual levels of inflation; i.e., investors react strongly when outcomes differ from expectations. Historically, inflation spikes have occurred quickly and unexpectedly. Therefore, we believe the most important factor for DC participants in selecting a real asset is its sensitivity to inflation surprises. Asset classes with a positive beta to inflation surprises have historically tended to perform well, thus preserving purchasing power, during inflationary market environments.

    As Figure 4 shows, the inflation beta of a stock/bond portfolio (composed 70% of the MSCI World and 30% of the BAGG) was -2.07 as of 31 March 2014. By contrast, all of the asset types and blends except for infrastructure showed a higher inflation beta. Commodities, gold and natural resource equities stood out with the highest inflation betas.
  • Equity correlation: To reap the potential diversification benefits of real assets, each asset type and blend should be evaluated for its correlation to equities. Viewed through this lens, the stock/bond portfolio shows a tight correlation, 0.95, to the S&P 500, while other assets or combinations show lower correlations (thus offering improved diversification potential). Assets with the lowest correlations include TIPS, gold and commodities.

  • Volatility: Selecting an individual asset class or blend with relatively low volatility is important to lessening the risk of participants selling out with a sudden shift in returns. As Figure 4 shows, the stock/bond portfolio had volatility of 12.5%, while other asset types or blends offered smoother rides. Of note, TIPS, bank loans and the expanded multi-real-asset blend showed lower volatility.

  • Downside risk: Although there are many ways to measure tail risk, we suggest evaluating risk exposure by assessing Value-at-Risk (VaR) at a 95% confidence level (VaR estimates the minimum expected loss at a desired level of significance over 12 months). Applying this measure, we observe that the stock/bond portfolio has potential downside risk of -19.3%. Other asset types and blends may have less downside risk. TIPS, bank loans and the expanded multi-real-asset blend stand out again.

Summary comparison of individual and multi-real-asset blends
By comparing asset classes across these metrics, Figure 4 underscores that when it comes to fighting inflation, a multi-pronged approach may be best. It lists individual asset types followed by multi-real-asset and expanded multi-real-asset categories. Lower down, the chart shows the performance of a 70% equity and 30% bond allocation, followed by an expanded multi-real-asset blend that shifts 20% of the stock and bond allocation to TIPS, commodities, real estate, emerging markets, currency and gold indexes.

These data go a long way in explaining why the consultants we polled are most supportive of adding multi-real-asset strategies to a DC plan’s core lineup. Relative to the stock/bond portfolio, both the multi-real-asset and expanded multi-real-asset blends offer inflation-hedging (positive inflation betas) and potential diversification benefits (i.e., equity correlations < 1). What’s more, both blends show the potential for lower volatility and less risk of loss (VaR) than the stock/bond portfolio. Notably, the blends may offer volatility and risk-of-loss levels below those of many individual real assets. To simplify a core lineup and reduce the risk that a participant will chase or flee an investment upon enticing or unfortunate returns, these multi-real-asset blends may be preferable to individual assets.

In addition to adding the multi-real-asset blend or the expanded multi-real-asset blend to the core lineup, a plan sponsor should evaluate their investment default for its ability to stand up to inflation. Plan sponsors may want to add these multi-real-asset blends to the investment default glide path or may prefer adding individual asset classes in different weights based on target-date vintage. As Figure 4 shows, shifting 20% of the 70/30 stock-and-bond allocation to the expanded multi-real-asset blend allows the potential inflation-fighting and diversification benefits to shine through. Most notably, volatility decreases from 12.5% to 9.8% while the potential loss (VaR) drops from -19.3% to -14.6% and the inflation beta increases from -2.07 to -1.19.

A balanced approach
Inflation-fighting strategies are fundamental to DC investment lineups and participants’ need to build and preserve purchasing power in retirement. Plan sponsors should evaluate inflation-fighting assets, separately and in combination, to determine how best to offer them.

Whatever choices are made, selected assets or blends should be designed to deliver the primary benefits of inflation responsiveness, diversification relative to stocks, volatility reduction and downside risk mitigation. To deliver these and ward off the inflation robber baron, plan sponsors may find multi-real-asset blends attractive both as core options and as additions to asset allocation strategies such as target-date funds.

In Figure 5, we list the inflation-fighting assets consultants rated “important” along with suggested index proxies. In addition, we show two multi-real-asset blends, as well as a stock and bond portfolio.


The Authors

Stacy Schaus

Head of Defined Contribution Practice

Ying Gao

Account Manager, Defined Contribution


The "risk-free" rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.

Past performance is not a guarantee or a reliable indicator of future results.

We employed a block bootstrap methodology to calculate the estimated correlation between assets. We start by computing historical risk factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, asset class volatilities and correlations are calculated as a function of their exposures to risk factors, and those underlying factors’ volatilities and correlations. Our models also account for non-factor risk (“idiosyncratic risk”).

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.

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. 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. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Equities may decline in value due to both real and perceived general market, economic and industry conditions. 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. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market.

Value at Risk (VAR) estimates the risk of loss of an investment or portfolio over a given time period under normal market conditions in terms of a specific percentile threshold of loss (i.e., for a given threshold of X%, under the specific modeling assumptions used, the portfolio will incur a loss in excess of the VAR X percent of the time. Different VAR calculation methodologies may be used. VAR models can help understand what future return or loss profiles might be. However, the effectiveness of a VAR calculation is in fact constrained by its limited assumptions (for example, assumptions may involve, among other things, probability distributions, historical return modeling, factor selection, risk factor correlation, simulation methodologies). It is important that investors understand the nature of these limitations when relying upon VAR analyses.

We employed a block bootstrap methodology to calculate estimated volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility. Please contact your PIMCO representative for more details on how specific proxy factor exposures are estimated.

Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Barclays U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $250 million par amount outstanding. Performance data for this index prior to 10/97 represents returns of the Barclays Inflation Notes Index. BofA Merrill Lynch U.S. High Yield, BB-B Rated, Constrained Index tracks the performance of BB-B Rated US Dollar-denominated corporate bonds publicly issued in the US domestic market. Qualifying bonds are capitalization-weighted provided the total allocation to an individual issuer (defined by Bloomberg tickers) does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis. Similarly, the face value of bonds of all other issuers that fall below the 2% cap are increased on a pro-rata basis. The Credit Suisse Institutional Leveraged Loan Index is a sub-index of the Credit Suisse Leveraged Loan Index and is designed to more closely reflect the investment criteria of institutional investors by sampling a lower volatility component of the market. The Index is formed by excluding the following facilities from the Credit Suisse Leveraged Loan Index: facility types TL and TLa, facilities priced 90 or lower at the beginning of the month and facilities rated CC, C or Default. The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the $US-denominated leveraged loan market. The Dow Jones U.S. Select Real Estate Investment Trust (REIT) IndexSM is an unmanaged index subset of the Dow Jones Americas U.S. Select Real Estate Securities (RESI) IndexSM. This index is a market capitalization weighted index of publicly traded Real Estate Investment Trusts (REITs) and only includes only REITs and REIT-like securities. The Dow Jones UBS Commodity Total Return Index is an unmanaged index composed of futures contracts on 20 physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. Prior to May 7, 2009, this index was known as the Dow Jones AIG Commodity Total Return Index. Dow Jones-UBS Gold Sub Index is a single commodity subindex of the DJ-UBSCI composed of futures contracts on gold. It reflects the return of underlying commodity futures price movements only. It is quoted in USD. JPMorgan Emerging Local Markets Index Plus (Unhedged) tracks total returns for local currency-denominated money market instruments in 23 emerging markets countries with at least U.S. $10 billion of external trade. MSCI ACWI Commodity Producers Sector Capped Index equal weights the energy, metals and agriculture sectors at each quarterly index review in May, August, November and February. The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The S&P Global Infrastructure Index provides liquid and tradable exposure to 75 companies from around the world that represent the liquid infrastructure universe. To create diversified exposure, the index includes three distinct infrastructure clusters: utilities, transportation and energy. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the authors 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. ©2014, PIMCO.