You must unlearn what you have learned.

—Yoda

Selecting a plan’s investment default is by far the most important investment decision plan fiduciaries will make. Indeed, when a default is in place, plan participants may essentially hand over the investment decision-making reins to the plan, trusting that the selected default will help them achieve a secure retirement. If a plan participant makes no investment election, his or her contributions are typically automatically allocated typically to a qualified default investment alternative or QDIA—which might be a balanced, target-risk, or target-date asset allocation fund. Thus active decisions made by plan sponsors, including the selection of the investment default, will largely dictate, if not hardwire into place, whether workers will succeed in meeting the PRICE (refer to Chapter 2 for an in-depth discussion on PRICE) of their retirement. Since participants have only one chance to get it right—just one lifetime to build retirement savings—plan fiduciaries need to select the most appropriate default to help them succeed.

As discussed in Chapter 3, target-date funds are most prevalent and recommended among investment default alternatives. Yet there is not just one type of target-date fund or approach. Rather, there is a broad range of target-date types and structures. In this chapter, we’ll consider the selection and evaluation criteria for target-date strategies. We’ll discuss the types of solutions—custom, semicustom, and packaged—and why they may be attractive. We’ll take a close look at active versus passive decision-making for target-date strategies. Then we’ll consider target-date evaluation criteria, including modeling approaches to compare glide paths. While we focus on target-date strategies in this chapter, most of the selection and evaluation factors we discuss can be applied to any type of asset allocation strategy, such as target-risk or balanced strategies. These solutions can be compared within and across countries, using the asset allocation, asset classes, and relevant assumption sets. For example, we can use the factors in this chapter to compare non-U.S. DC asset allocation structures, such as the UK’s lifestyling strategies and Australian balanced strategies, to a U.S. target-date fund.

During the U.S. financial crisis, dramatic losses occurred in some at-retirement target-date fund vintages (e.g., 2010 target-date funds at that time) even though participants expected their investments to be more conservatively invested that close to retirement. The U.S. Government Accountability Office (GAO) found that the returns of the largest 2010 target-date funds (those with at least five years of returns) ranged from a 31 percent loss to a 28 percent gain. Not surprisingly, given the QDIA status of target-date funds, the U.S. government spoke up to emphasize the important role of target-date structures and to suggest that plan sponsors take increased care in selecting such vehicles for plan participants. In February 2011, the Government Accountability Office released a report arguing that the financial crisis of 2008 showed that target-date funds varied widely in asset allocations and risk levels, leaving plan participants vulnerable to having inadequate retirement assets.¹

The report recommended to the Department of Labor (DOL) that:

• Fiduciaries take into account additional factors when considering target-date funds as qualified default investment alternatives.
• The DOL provide guidance to plan sponsors on target-date benchmarks and the importance of considering the long-term investment allocations and assumptions used to develop target-date funds.
• The DOL should require plan sponsors to provide information to participants about the impact of taking withdrawals from or changing contributions to target-date funds.

As stated in a news release (on February 23, 2011) from U.S. Rep. George Miller (D-Calif.) of the House Committee on Education and the Workforce in reaction to the Government Accountability Office’s report on target-date funds:

While these new options promised to help workers invest more wisely over a career, GAO’s investigation shows that target-date funds are not all created equally. Employers who choose options for their employees and workers building their retirement security need clear and complete information in order to make the best choice. GAO raises serious concerns and highlights the need for employers to undertake a higher level of due diligence [as they select target-date strategies] in order to fulfill their duties under the law to act in the best interest of workers.

In essence, a target-date strategy or other asset allocation default investment can be thought of as taking discretionary control over a participant’s account balance not only by offering advice, but also by implementing that advice for the participant. Plan sponsors should thus carefully evaluate whether the advice embedded in the asset allocation structure or glide path is appropriate relative to the plan’s goals. With the control a sponsor holds in determining the default, the advice provided should be carefully considered and intentionally selected.

TARGET-DATE STRUCTURES VARY BY PLAN SIZE

Consultant target-date fund type recommendations vary based on the size of a plan. As shown in Figure 4.1 for plans with assets over $500 million, the majority of consultants believe plan sponsors will select custom and semicustom strategies most frequently. For plans with less than $500 million but more than $200 million, the majority of consultants believe plan sponsors will select custom, semicustom, or a packaged active/passive blend. Notably, for plans under $200 million, less than half of consultants believe clients will select single manager passive strategies.

CUSTOM TARGET-DATE STRATEGIES

Plan sponsors and consultants often value the control and cost savings gained through custom strategies. Custom target-date strategies offer the plan fiduciary complete control over both the glide path—the asset allocation changes made automatically within the target-date fund as the participant ages—and the underlying investment management lineup. These strategies typically are created using a mix of the plan’s core investment offerings, although adding noncore lineup assets is often possible. From an investment perspective, plan sponsors note the benefits of leveraging core manager selection and monitoring, blending investment structures and styles, and the ability to broaden asset diversification beyond the core lineup. Custom strategies also allow flexibility in selecting the types of investment structures; for instance, they can include nondaily traded strategies such as highly concentrated portfolios that require less frequent trading. Packaged funds generally do not have access to these nondaily investments.

In PIMCO’s February 2007 DC Dialogue called “To Build, or to Buy: That Is the Question,” Stuart Odell, assistant treasurer, Retirement Investments at Intel Corporation, explains the benefits of custom target-date strategies:

By building one’s own, the plan sponsor both has the flexibility to determine the active-passive mix, and maintains control over the offered asset classes and allocations by age group. You determine your plan’s glide path.

You also have the flexibility to add asset classes that some managers may not choose to provide because the manager isn’t qualified to provide a particular asset class, or it doesn’t have expertise in real estate or commodities, for example. Providers may exclude an asset class from their off-the-shelf product simply because they don’t have professionals to manage it; whereas, when you build it yourself, you have the flexibility.

Custom target-date strategies may be implemented using trust vehicles (e.g., separate accounts) or a model portfolio approach. From a participant perspective, trust-based target-date strategies show a single investment holding (such as “Target-Date 2030”), whereas a model portfolio approach shows the breakout of the target-date allocation (e.g., 50 percent global equity, 20 percent inflation-hedging, 20 percent global bonds, and 10 percent capital preservation). Plans with assets over $500 million are most likely to consider a trust approach as the size of assets under management allows for cost-efficient setup and ongoing operation of target-date trust structures. As custom strategies have grown in prevalence, custodians and recordkeepers have improved and simplified the process of launching these structures, whether trust-based or a model portfolio approach.

While the benefits of custom strategies are clear, the work required to create them often is not. It is important to recognize that creating custom investment blends is not new; large plan sponsors have taken this approach in one asset category or more since the inception of DC plans. Custom funds require the plan sponsor to address several issues, including:

• Structuring, developing, and monitoring asset allocation
• Establishing and maintaining operations
• Rollout and ongoing participant communication
• Cost considerations
• Legal issues

All of the above issues and more are addressed in our 2010 book, Designing Successful Target-Date Strategies for Defined Contribution Plans.

SEMICUSTOM TARGET-DATE

Semicustom strategies offer plan fiduciaries partial control, typically allowing selection of the underlying investment managers but no control over the glide path design. This structure may be most attractive to mid-size plans as they lack sufficient assets to reap cost efficiencies within a trust structure, but they retain the significant advantage of tapping into their selection of best-in-class asset managers. This set of strategies may include white label/multimanager structures, stand-alone core funds, and possibly funds beyond the core (i.e., an investment strategy that the plan offers only in custom options, such as alternative investments).

PACKAGED TARGET-DATE

Packaged target-date strategies include both mutual funds and collective investment trusts (CITs). Unlike custom and semicustom options, packaged target-date strategies do not allow the plan sponsor to control the glide path or the underlying investments. Rather, the target-date provider packages both the glide path and the lineup of managers. Packaged funds vary significantly. They are often compared based on the following attributes:

• Glide path structure: to or through retirement
• Open or closed architecture
• Active, passive, or blended packages
• Static or tactical glide path oversight

In Figure 4.2, you can see that consultants expect selection of one type versus another based on plan size. Consultants expect mid-size plans to migrate toward a blend of active and passive, rather than purely active or passive. A blend offers the benefits of both active management in asset classes where plan fiduciaries and consultants believe active management is most important (i.e., fixed income and small-cap equity), and the cost efficiencies of passive in asset classes where active management may be less important (e.g., large-cap U.S. equities).

TARGET-DATE SELECTION AND EVALUATION CRITERIA

As plan fiduciaries consider which target-date structure and approach is right for their plan, consultants in PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey help by ranking the most important factors fiduciaries should consider: the glide path structure (92 percent), diversification of underlying investments (79 percent), and fees (79 percent). Notably, the Department of Labor (DOL) target-date tips for fiduciaries also highlight the importance of considering the glide path, diversification, and fees. Unsurprisingly, they also note the importance of considering the risk of loss, which falls within a fiduciary’s duties. As addressed in Chapter 1, one of the ERISA fiduciary duties or rules is that “a fiduciary must diversify plan investments in such a manner that the risk of large losses is minimized to the extent possible, with the exception of certain circumstances when it is clearly not prudent to do so.” In this section, we will take a look at each of the factors identified here, beginning with the most important: the glide path structure.

We agree with the consultants and the DOL that evaluating the glide path is most important, as both the risk and opportunity for return will be driven primarily by this structure. As discussed in Chapter 2, we believe investment portfolios should be evaluated relative to their objective. With this in mind, as shared earlier, we also asked consultants in PIMCO’s 2015 Defined Contribution Consulting Support and Trends Survey what they believe is the number-one glide path objective: They answered to “maximize asset returns while minimizing volatility relative to a retirement liability.” We illustrated in Chapter 2 how to evaluate target-date funds relative to this measure. In this chapter, we will introduce additional analyses and considerations for evaluating glide paths and target-date strategies more specifically.

Before we get into the analytics, however, we need to address the active versus passive target-date debate. Since some plan fiduciaries may believe the first decision to make is whether they should select actively or passively managed funds, we would like to emphasize that in our view, there’s no such thing as a passively managed target-date fund.

NO SUCH THING AS PASSIVE

In 2011, we published “No Such Thing as Passive Target-Date Funds: Three Active Decisions Plan Sponsors Must Make,” in which we argue that there is “no such thing” as a passively managed DC program. Instead, plan fiduciaries must make many critical—and active—decisions to define the structure of and select the suitable investments for their plan, including the investment default. While some in the DC market may argue to keep it simple and just go passive, we suggest that there are at least three active decisions plan fiduciaries must make as they structure their DC plans and select the investment default.

As discussed in the paper, we believe plan sponsors should consider the plan’s risk relative to its objective, how to allocate the risk among asset classes to gain the greatest return potential, and whether shortfall relative to a retirement income goal (e.g., replacing less than 30 percent of final pay when 50 percent is needed) or other risks should be managed beyond relying upon only asset allocation and diversification. We share the following:

First, the plan sponsor must decide what the plan’s risk level will be relative to the plan’s objective; that is, decide the “risk budget” or tolerable shortfall relative to meeting a retirement income replacement goal. For instance, if participants need 50 percent of final pay replaced during retirement, what’s the tolerance if the plan falls short of this need and only provides 30 percent—or worse, 20 percent—of final pay? This first and most critical active decision begins with deciding the types of employer-provided retirement plans that will be offered and how they will be funded, and concludes with determining the investment design—in particular, the plan’s investment default asset allocation, or “glide path.”

Once the risk budget is set for the plan, the sponsor is ready to make the second active decision: how to allocate the risk among asset classes to gain the greatest return potential. For example, with the default investment, the plan sponsor will determine which asset allocation provides the greatest expected return, given the risk budget. Whether the sponsor creates custom strategies or selects off-the-shelf target date strategies, this evaluation and active decision regarding the asset allocation must be made.

Finally, the plan sponsor must make an active decision as to whether shortfall or other risk should be managed beyond asset allocation and diversification. This active decision-making may include considering risk-hedging strategies, such as buying investment instruments or insurance to cushion participant assets against market shocks.

In working with plan sponsors, we often ask, “What is the investment objective for the DC plan?” Most tell us the DC plan is the primary retirement program for their workers, yet a specific income replacement target has not been identified or stated—let alone identifying how much risk the plan should take relative to that goal. As discussed, we believe plans should begin with the objective and, at minimum, evaluate and compare how the glide paths may deliver or fall short of that objective. As mentioned in Chapter 1, consultants suggest (as shown in Figure 4.3) that a DC plan replace 60 percent of final pay when assuming the participant lacks both a DB plan and retiree medical. Thus the questions that plan sponsors need to ask when evaluating glide paths include:

• Are plan participants likely to succeed?
• Will they have sufficient DC assets to cover the PRICE of a lifetime income stream?
• Are the glide paths designed to build retirement income or to maximize wealth without regard to downside risk?

LOW COST AND LOW TRACKING ERROR DOES NOT EQUAL LOW RISK

As discussed earlier, the Employee Retirement Income Security Act (ERISA) guides plan fiduciaries to act with prudence in selecting the investments for a DC plan. The goal of meeting a plan’s objectives should drive investment selection. While managing plan costs is an important component of prudently selecting a plan’s investment lineup, we believe cost is only one factor to consider when selecting investments. The ERISA also specifically identifies the need to diversify in an attempt to help minimize the risk of large losses. Note that the rules do not define risk as tracking error relative to an index, but rather the actual risk of incurring large losses in absolute terms.

As mentioned, the asset allocation structure and underlying investments drive both risk and return. Unfortunately, as discussed earlier, recent fee litigation against DC plan sponsors may have prompted some sponsors to shift their plan’s default to passively managed index funds, with the belief that this typically low-cost and low-tracking-error investment approach may reduce litigation risk to the plan sponsor. In our view, this belief and resulting action are misguided, as ERISA attorney Brad Huss of Trucker Huss APC explains in PIMCO’s DC Dialogue (April 2010):

With the focus on fees, some plan sponsors may believe the government is providing a safe harbor if they select low-cost index investment vehicles rather than actively managed investments. I don’t think choosing all passive is inherently a fiduciary safe harbor. What’s important is that plan sponsors use a prudent process to select the investment lineup and that they document their approach. Keep in mind, even if the plan sponsor selects passive funds, fiduciary oversight requirements remain. There’s not a “set it and forget it” approach with index funds.

We agree with attorney Huss and suggest a framework for selecting and evaluating target-date strategies, including three active decisions plan sponsors must make.

FRAMEWORK FOR SELECTING AND EVALUATING TARGET-DATE STRATEGIES: THREE ACTIVE DECISIONS PLAN SPONSORS MUST MAKE

Indeed, there are many active decisions plan sponsors must make. We suggested plan sponsors consider three questions as they evaluate target-date strategies (see Figure 4.4):

• How much risk can plan participants take?
• How is risk best allocated across investment choices?
• Should risk be actively managed or hedged?

As plan sponsors consider each question, we suggest the following process for the selection and evaluation of a target-date glide path or packaged fund. Active decisions are required at each step.

ACTIVE DECISION #1: HOW MUCH RISK CAN PLAN PARTICIPANTS TAKE?

There are many ways to think about risk. As discussed in Chapter 2, beyond what’s suggested by DOL we believe it is most important to think about risk, first and foremost, relative to the plan’s objective. For nearly all DC plans, the objective is to meet a retirement income goal. For instance, they may target the DC plan to replace 50 percent of a worker’s final pay in sustainable income during retirement or as noted above even 60 percent of pay. Once this income-replacement goal is set, plan sponsors can then determine how much risk may be appropriate relative to the goal.

By using this framework, we can define risk in most DC plans as the failure to meet the needed real income-replacement target; that is, a shortfall relative to the inflation-adjusted income goal that we have quantified using PRICE. A central consideration for fiduciaries thus becomes what amount of retirement income shortfall risk they are willing to allow in the plan design, particularly in the plan’s investment default. For instance, if the goal is to replace 50 percent of final pay, is reaching a 20 percent replacement level acceptable?

As we consider the income-replacement objective, we also can consider a participant’s risk capacity by asking, “If they need 50 percent of their final pay at retirement, how much can they afford to lose in any one year and still meet this goal by their planned retirement date?” To answer this question, our models need to consider three factors: a worker’s pay and how it changes over time, the contribution rate and employer match, and investment horizon. In PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey, we asked consultants, “What is the maximum 12-month loss a participant can withstand and still meet their retirement income goal?” (See Figure 4.5.) At the median the 46 respondents said that participants with 40 years until retirement could lose no more than 40 percent of their account balance in a 12-month period and still retire on time; for those at retirement (e.g., 65 years of age), the group said they could not afford to lose more than 10 percent of their account balance (Figure 4.5).

Plan fiduciaries should understand the risk of loss and compare this relative to participants’ risk capacity. We suggest considering a value at risk (VaR) analysis with a confidence level of at least 95 percent. Using this approach and our standard salary, contribution, match, and time horizon assumptions, we believe the consultant-suggested loss capacity in some cases may be too high. What’s more, we can analyze any glide path and determine the risk of loss. As we wrote in the PIMCO Viewpoint article titled “Loss Capacity Drives 401(k) Investment Default Evaluation” (May 2012), we believe that, based on DC participant savings patterns at the time and a 50 percent final income replacement goal, the value at risk a participant can accept in a year without derailing their retirement plans (such as the planned date of retirement or planned lifestyle in retirement) is about 10 percent at 10 years prior to retirement, and less than 7 percent at retirement. We noted that the market-average glide path builds in a risk of loss at a much higher percentage.

In the article, we also calculate the value at risk 10 years from retirement at less than 17 percent, and the at-retirement vintage at a potential loss of more than 11 percent. During the 2008 market downturn, those invested in the market-average at-retirement vintage lost 24 percent of their market value. During this time frame, we also witnessed the greatest outflows from the at-retirement strategies. While we may attribute these transfers to fear or other factors, what’s critical to recognize is that many participants in those strategies were subjected to a (realized) risk of loss that exceeded their capacity for loss.

Human Capital May Not Be Sufficient: Understanding Risk Capacity versus Risk Tolerance

In our annual DC consulting trends survey, often at least one consulting firm responds each year that in their view, participants who are 40 years from retirement can afford to lose 100 percent of their account value and still retire on time. The consultants who take this view may differentiate between human capital and financial capital. Young workers are rich in human capital, but typically poor in financial capital. In PIMCO’s February 2009 DC Dialogue “Diversify, Diversify, Diversify,” Thomas Idzorek, Chief Investment Officer at Ibbotson Associates, explained the concept of human capital and how to incorporate human-capital thinking in target-date glide paths:

There’s a rationale behind investing aggressively when a participant is young. Our approach starts by evaluating an individual’s total economic worth. Most people are familiar with the idea of financial capital or financial worth. But for a number of people, the largest element of their total economic worth includes the “total value of their human capital.” If you discount a person’s life-long expected wages into a single number, you’d see that in most cases this value, or the amount of human capital, far exceeds the amount of financial capital.

The tradeoff for any given individual between how much human capital and how much financial capital he or she has evolves in a fairly consistent pattern as an investor ages from, say, age 20 into his retirement years.

Consider the total economic worth of a 20-year-old. Most 20-year-olds have little financial capital but large amounts of human capital. Next, when you think about cash flows or investment characteristics of that human capital, you see that most people’s human capital provides a fairly steady stream of inflation-adjusted income.

Conceptually we can think of that human capital as a kind of large inflation-linked bond. Again, that 20-year-old’s human capital represents a large proportion of his total economic worth. And so 20-year-olds have an overweight in a bond-like asset.

But in order to diversify his total economic worth, he’d need to invest almost all of his financial capital in equities. Then over time, hopefully, what happens is that this person continues saving a portion of his incoming salary each month and converts some of that human capital into financial capital. Eventually the financial capital grows to the point where, hopefully, it’s larger than the amount of human capital.

While young plan participants (e.g., those with 40 years left to work) may have high human capital and thus high risk capacity, that does not mean they have high risk tolerance. Young professionals may have a significant percentage of their assets in a DC plan and may be even more risk averse than older workers who may have other assets such as a home. Taking a loss of 40 percent of their account, or losing 100 percent of their account, may discourage young participants from contributing to or possibly even participating in the plan altogether. As discussed in Chapter 3, the UK NEST target-date design reflects the sensitivity to potential loss for younger workers as the glide path starts out with lower risk capacity and then ramps up the risk as assets build and the participant ages. Some financial experts have supported this lower-risk approach, believing that in the earlier years, risk tolerance may actually matter more than risk capacity.

Rob Arnott, founder and chairman of Research Affiliates, established in 2002 as a research-intensive asset management firm that acts as a subadvisor to PIMCO, has written about the glide path illusion, which touches on risk tolerance and risk capacity in early and later years in life. His research examines the range of outcomes for an investor adopting more risk early in life, moving gradually toward more bonds (the classic glide path strategy), an inverse glide path, in which the investor ramps up risk over their investing lifetime, and finally a simple balanced strategy that remains unchanged over the investing life cycle:

The basic premise of a “glide path” approach is that a systematic increase in the allocation to bonds over time leads to less risk in our planned spending power in retirement. But does it?

Markets certainly don’t care about our glide path, so we’re as likely to have our best stock market returns late in our career as early. If the best stock market returns come early, it’s self-evident that we’ll finish richer with a glide path strategy. And, if the best stock market returns come late in our career, we’ll do well to ramp our risk up as our career evolves. But, in our 20s, how can we know whether stock returns will be better early or late in our careers?

Rather than hoping for a repeat of the past, with substantial returns earned on a foundation of far higher yields than today’s yields, we should probably shape expectations based on the current outlook.

Today’s world of negative real yields is … neither risk nor uncertainty. It simply is our current reality. We can choose to accept this new reality … or we can choose to pretend that the investing world hasn’t changed in this profound way. For investors who prefer to pretend that the old norms have not changed, this “new normal” will feel like a black swan, and they will suffer accordingly.

Our message remains largely unchanged. Investors who are prepared to save aggressively, spend cautiously, and work a few years longer (because we’re living longer), will be fine. Those who do not follow this course are likely to suffer perhaps grievous disappointment. Glide path—with less risk taken late in our working lives—is inferior to its counterintuitive inverse. But it is entirely secondary whether we choose a glide path strategy, an Inverse-Glide path, or a simple 50/50 Rebalanced blend. No strategy can make up for inadequate savings or premature retirement.³

Other experts may say that plan fiduciaries should not be as concerned with risk tolerance, as participants who are defaulted into a target-date strategy tend to remain invested regardless of the investment environment or any loss incurred. At PIMCO, we studied this belief and found while most do “stay the course,” many participants do move, particularly when capital markets correct. Unfortunately, this is the worst time as they then lock in losses. They may also make the mistake of not only selling low, but also—years later—buying back into the markets when prices are high.

In PIMCO’s October 2012 Viewpoint article called “Thrown in Over Their Heads: Understanding 401(k) Participant Risk Tolerance vs. Risk Capacity,” we evaluate participants’ risk capacity and risk tolerance by studying whether target-date net flow activity correlates with market movement. Our analyses showed that the market-average glide path may “throw participants in over their heads, in terms of their tolerance and their capacity for accepting risk.” Our analysis on risk tolerance is summarized in the paper:

When we study the correlations between net flows by vintage and by movement in the stock market, using the S&P 500, we observe that the closer the vintage is to the retirement date, the more the net flows are correlated to the market; net flows into the at-retirement target-date funds show the highest correlation to the S&P 500 … net cash flows into the at-retirement target-date vintage do appear to respond to market movement.

During the 2008 market downturn, investors appear to have responded by shifting money out of the at-retirement target-date funds. It may not be at all surprising that money flows into stable value during such downturns, according to the Aon Hewitt 401(k) Index data over time … the correlation of flows to the S&P increases the closer participants get to a retirement date.

Over the time frame analyzed, from January 2006 to June 2012, flow activity in the 2050 vintage has a correlation of only 0.18 to the S&P 500, whereas the at-retirement example shows a much stronger 0.47. Even more notable, the correlations appear to tighten in periods of market downturns. During the October 2007 to February 2009 timeframe, the 2050 vintage showed a negative correlation of –0.20, while the at-retirement vintage tightly moved with the market at a 0.80 correlation.

Our correlation analysis may imply that those closest to retirement have the lowest risk tolerance, and that fear may motivate them to transfer their assets out of the target-date funds. Yet this net cash flow activity may also be explained by the reality that those closest to retirement may be moving out of a DC plan altogether, perhaps simply because of retirement or because they are leaving their current employment for other reasons, e.g., downsizing or job change.

Regardless of the reason, participants appear to move their DC assets at unfortunate times: when markets are down. Many of these participants may have moved assets out of fear; they lacked risk tolerance to ride out the storm. Those participants with a less aggressive or volatile asset allocation would likely have been more tolerant to the market moves and better off in the long run (Figure 4.6). Unfortunately, those who moved out of fear may have locked in losses and perhaps decided to delay retirement or downscale their retirement lifestyle.

ACTIVE DECISION #2: HOW IS THE RISK BEST ALLOCATED ACROSS INVESTMENT CHOICES?

What if plan sponsors want the participants to take on a very limited amount of shortfall risk? While there is always risk of some sort, there are also investment strategies that may significantly reduce shortfall risk or help “immunize” a participant’s DC account against risk, relative to their retirement income needs. For example, investing participant assets in individual Treasury Inflation-Protected Securities (TIPS) is considered by many academics and retirement income thought leaders as one of the relatively less risky available assets for retirement when these securities are held to maturity.

TIPS are backed by the full faith and credit of the U.S. government and contracted to keep pace with inflation as measured by the Consumer Price Index. More specifically, the principal and interest on TIPS are indexed to the CPI-All Urban Consumers (CPI-U) so that overall increases in consumer prices are directly translated into higher principal and interest payments on TIPS. In the unusual event of deflation, or a sustained fall in prices, the U.S. government guarantees repayment of principal; at maturity, investors receive the greater of the inflation-adjusted principal or the initial par (face) amount.

In PIMCO’s DC Dialogue (February 2011), Professor Zvi Bodie explains that “we may consider TIPS as the closest we can get to a ‘risk-free’ portfolio, especially for retirees who need to retain the purchasing power of their assets. Their savings must keep pace with inflation.”

Bodie goes on to discuss investing for retirement using TIPS:

The natural benchmark to that is starting at the point of least risk and asking the question, “Well, what if I only want to take minimal risk?” One approach would be to invest 100 percent of your retirement assets in inflation-hedged bonds—that is, TIPS. And let’s even assume that all you’re going to do is keep up with inflation—not earn any real interest above inflation. So whatever you put in, that’s what you’re going to get out, no matter how many years in the future you withdraw your money.

That is still a very useful place to start because, by definition, if you’re going to invest in something that’s riskier and that offers a higher rate of return, then you have to recognize that there’s a downside to taking on that risk. So, yes, you may earn a higher return, but you also may lose principal or not even keep pace with inflation. That’s the downside. And for people who want to anchor their thinking about risk versus reward, the most sensible anchor is a safe rate of return or a minimal-risk portfolio. Again, that’s TIPS.

Now, unfortunately, in this country, “safe investing” is often defined as allocating to cash, which may include such short-term instruments as Treasury bills and certificates of deposit. The minimal-risk portfolio may be defined as a 100 percent cash portfolio. Yet that is not necessarily the case, and it certainly is not true in the context of a retirement savings plan.

I believe the safest portfolio is one that locks in an inflation-adjusted rate of return right through to your mortality date. And in my opinion the closest you can get to that is long-term, inflation-protected Treasury bonds, not cash.

While it is conceivable that DC participants could invest in TIPS—and TIPS alone—in an attempt to reach their retirement goals, this strategy is generally not followed. In practice, the majority of DC plans offer access to TIPS via either a pooled fund in the core lineup, or in a blended core or target-date strategy. You can see in Figure 4.7 an allocation of 3.2 percent to TIPS in the Market Average Glide Path. You can also see stocks, bonds, and other diversifying assets. As discussed in PIMCO’s DC Research article (December 2013) titled “No Such Thing as Passive: Three Active Decisions Plan Fiduciaries Must Make in Offering a Defined Contribution Plan … and Investment Default,” we believe plan participants are best served by asset allocations that are broadly diversified and best use the risk capacity allowable by vintage. The objective in this step is to identify the asset mix that can potentially deliver the highest possible return, given the risk budget. In other words, we want the greatest bang for the buck—we seek to be paid for the risk we are willing to accept.

At PIMCO, we start with the risk budget as a constraint and seek strategies designed to help maximize investment return potential as we identify the asset classes for the glide path. This risk-budget or liability-driven approach differs from that taken by many other managers, as they may tend to look first at the asset classes and then at the risk.

In contrast to much of the DC plan landscape, we believe that participants need a glide path that is designed to maximize risk diversification and return opportunity, regardless of the economic environment. That is, participants need a glide path that can offer acceptable risk-adjusted return during periods with heightened inflation and volatility. As plan sponsors determine the appropriate glide path and asset allocation structure for their plan participants, they should consider how the various glide paths might fare during various economic environments.

Further, we believe that to achieve risk-mitigating diversification, it is critical to begin with the risk exposures—drivers of volatility—rather than the asset classes. For instance, if we look at high-yield bonds, others may see a fixed-income asset. But by identifying the drivers of volatility within high-yield bonds, we note the equity market sensitivity as a primary risk factor. By identifying risk factors (or drivers of volatility), our process seeks to produce portfolios that are more appropriately diversified—and thus potentially able to better manage the exposure to any one part of the market. Part of this process is to seek assets that may help reduce risk and maximize expected return potential in various economic environments.

By starting with risk exposures to help determine asset selection, we believe plan fiduciaries may be better able to meet the duty of diversification; that is, they may be able to diversify plan investments in such a manner that the risk of large losses can be minimized.

Let’s look at the Market Average glide path compared to what PIMCO defines as the Objective-Aligned glide path (Figure 4.7). If we consider the asset allocation first, we see that the Market Average glide path is heavily concentrated in equities and nominal fixed income. Integration of a meaningful allocation to inflation-hedging assets is generally not done. By comparison, the Objective-Aligned Glide Path approach presents much lower equity exposure in exchange for a higher allocation to inflation-hedging securities. Thus, in the Objective-Aligned Glide Path, we see greater diversification from an asset class standpoint.

Now let’s shift our evaluation from an asset-allocation to a risk-allocation view, taking a closer look at the overall tracking error to retirement liability as well as diversification of the sources of this tracking error. You can see in the bar chart in Figure 4.8 that the Objective-Aligned glide path approach appears more diversified, plus the overall level of tracking error is slightly lower, particularly as the retirement date nears.

By determining the asset allocation based on risk diversification, we believe the plan sponsor improves the odds of participants meeting their retirement income goals. A risk-diversified approach may deliver a similar level of expected return as a higher-risk portfolio, yet potentially offer reduced overall tracking error to retirement liability.

Once the glide path and asset classes are set, we finally can turn to how to manage or implement each of the asset classes, including deciding whether to use active or passive management. As plan sponsors consider investment managers and approaches, they may be prone to select both actively managed and passively managed solutions, often based on the asset class. Even Gus Sauter, chief investment officer of Vanguard, one of the largest passive management firms, writes: “We believe both active and index funds can play a role in a balanced and diversified portfolio. They’re not oil and water, but more like peanut butter and jelly.”⁴

ACTIVE DECISION #3: SHOULD RISK BE ACTIVELY HEDGED?

Asset or risk diversification may be insufficient to guard against losses during systemic market shocks. Plan sponsors can also decide whether to actively seek strategies designed to mitigate market shock risk within a plan. This can be done by introducing a number of hedging strategies or by offering participants insurance strategies that may involve a deferred annuity or other type of similar product.

TAIL-RISK HEDGING STRATEGIES

As explored in our December 2010 DC Research paper, “Designing Outcome-Oriented Defined Contribution Plans (DC 2.0),” tail-risk hedging is an investment management approach that aims to cushion participant assets from systemic market shocks.

At PIMCO, we believe there are three basic approaches to tail-risk hedging that may be effective in helping mitigate market risk. These are:

1. Reduce exposure to risk assets by purchasing Treasury securities. As equity markets correct, this strategy is designed to reduce exposure to the negative impact of equity returns and introduce the potentially heightened return of Treasuries, given the expectation of a likely inflow of assets to this perceived safe haven.
2. Buy direct hedges such as long-dated equity puts, put spreads, or collars. As markets correct, these strategies can increase in value to help offset losses. For instance, S&P 500 Index put options may be added to a portfolio in an attempt to cushion the impact of an equity market decline.
3. Invest in indirect hedges. These include strategies such as options, swaps, and interest rate swaptions in deep liquid markets sensitive to macroeconomic events. Such strategies are likely to move in the opposite direction from the long exposure they are intended to cushion. For instance, with credit protection, as equity markets correct, corporate bond spreads relative to Treasury securities tend to widen, thus producing a potential offset to the equity market losses.

Active management of tail-risk hedging allows the portfolio manager to actively seek the most attractive combination and pricing for the above strategies. In general, the cost of indirect hedging may be lower than buying a direct hedge; however, along with the potentially lower cost, the portfolio manager takes on the risk of a possible mismatch to the hedged asset. Since the pricing of the hedging approaches can be dynamic, we believe it’s important to look at the actual pricing of the hedges to determine the potential impact on a portfolio’s return.

INSURANCE

Insurance vehicles are also being introduced into some DC plans. These solutions may offer a degree of market protection (subject to certain conditions), longevity insurance, or both. In our experience, interest in these solutions has been high, but there are obstacles that may still stand in the way of most plan sponsors moving forward with them. According to PIMCO’s 2011 DC Consulting Survey, plan sponsors may be reluctant to add these options, given concerns with cost, transparency, fiduciary oversight, and insurance company default risk. More recently, with increased support, especially from government, plan sponsors may be more willing to move forward in offering these potentially risk-reducing solutions.

TARGET-DATE ANALYTICS: GLIDE PATH ANALYZER (GPA) AND OTHER TOOLS

To help plan fiduciaries consider these factors and compare target-date or other asset allocation strategies, PIMCO built DC-tailored financial models including the Glide Path Analyzer (a self-contained software application designed to allow investment professionals to access, analyze, and compare the glide paths of major target-date providers over varied market environments).

As suggested by the DOL, our models allow for plan-specific considerations such as salary, wage growth, employee contribution rates, employer match rates, and employee tenure. Then users of these models may input any glide path or static asset allocation to show how a participant’s assets may grow, the risks they may face in various economic environments, and the probability of reaching various income replacement levels. The user can compare a custom glide path to a mutual fund company’s glide path as well as to the Market Average Glide Path, which is constructed by NextCapital and is an average of the 40 largest target-date strategies in the market. We suggest considering the reports shown in Figure 4.9.

When evaluating income replacement distributions, in PIMCO’s 2015 Defined Contribution Consulting Support and Trends Survey the vast majority (85 percent) of consultants indicated that a tighter distribution (fewer extremes—both unfortunate and fortunate) is more attractive (Figure 4.10). For example, given a choice of hypothetical distributions, over four times (4.3×) as many consultants selected the one with the highest worst case and lowest best case income replacement level than the one with the greatest upside.

GLOBAL DC PLANS: SIMILAR DESTINATIONS, DISTINCTLY DIFFERENT PATHS

In July 2014, I coauthored, along with Will Allport and Justin Blesy, CFA, PIMCO Product Manager Asset Allocation, a DC Design article titled “Global DC Plans: Similar Destinations, Distinctly Different Paths,” in which we compared asset allocation glide paths across the three largest DC markets: the United States, the UK, and Australia. Unlike the United States, Australian superannuation programs often offer a dynamic balanced allocation as shown in Figure 4.11, rather than a target date that reduces risk as retirement dates near. By contrast, the UK offers a glide path shown in Figure 4.12 that often shifts fully to fixed income in the 5 to 10 years prior to retirement. Comparing the Australian and UK glide paths to both the Market Average and Objective-Aligned target-date glide paths, we note the need to better align each to the retiree need for purchasing power in retirement. We also note for the Australian glide path that the level of risk at retirement may exceed both the participant’s risk capacity and tolerance.

At PIMCO, our glide path analytics allow comparison of DC asset allocation structures globally. This work is valued and important as multinational plan sponsors consider their offerings country by country. They ask whether the asset allocation is aligned to the objective for each market.

IN CLOSING

In this chapter, we have discussed considerations for selecting and evaluating target-date strategies, whether custom, semicustom, or packaged. Regardless of the structure, we explain why there is no such thing as a passively managed DC plan—and more specifically, no such thing as a passive target-date or other asset allocation solution. The plan sponsor must make many active decisions, including:

1. How much risk employees should take
2. How risk is most appropriately allocated
3. Whether risk should be actively mitigated

The active decisions a sponsor makes about a plan’s defaults, including savings and investment options, may influence the success or failure of the participants in meeting their retirement income needs. When it comes to plan design, we believe that plan sponsors, as ERISA fiduciaries, cannot simply “set it and forget it.” Moreover, in managing a DC plan, risk should not be defined as the tracking error relative to a benchmark. Rather, we define risk as participants failing to meet their real retirement income needs—an inflation-sensitive liability. As presented in Chapter 2, we suggest plan fiduciaries consider glide paths that maximize investment returns while minimizing volatility relative to the retirement liability, PRICE.

For plan sponsors to act in the best interest of their participants, including helping them meet their income goals, we suggest that sponsors employ and document their procedural prudence using a three-step process to build or select the appropriate target-date strategies or other plan default.

1. Sponsors should set a risk budget for their plan default investment. This risk budget should be set relative to a real retirement income goal.
2. Given the risk budget, plan sponsors should seek to maximize return potential by first identifying the allocation of risk and then fitting the assets to this risk allocation. Only then do we believe they can be ready to select which managers will be responsible for the plan and to decide which asset classes should be actively or passively managed. While passive management may make sense in developed markets such as large-cap U.S. equities, we believe money may be left on the table and risk may be elevated in less efficient markets as well as in fixed income.
3. Plan sponsors should actively evaluate whether to add risk mitigation approaches such as tail-risk hedging or insurance strategies. Active tail-risk hedging may help cushion participant accounts during market turbulence, as well as enhance return potential over time.

QUESTIONS FOR PLAN FIDUCIARIES

1. Have you read and do you understand the Department of Labor’s guide “Target Date Retirement Funds: Tips for ERISA Plan Fiduciaries”?
2. What target-date investment structures can you consider?
3. What are your participants’ risk capacity and tolerance given your target-date fund’s objective (e.g., income replacement of 50 percent)?
4. What glide path structure is appropriate for your participants’ risk capacity and tolerance?
5. What assets and risk factors are included in the glide path? Is it well diversified, especially across various economic environments?
6. Should market risk be actively hedged?