NEW YORK — Target date funds should take a liability-driven investing approach, protecting them from the bumps and grinds of equity markets, officials at Pacific Investment Management Co. contend.
NEW YORK — Target date funds should take a liability-driven investing approach, protecting them from the bumps and grinds of equity markets, officials at Pacific Investment Management Co. contend.
By incorporating such a strategy into these life cycle funds, officials at Newport Beach, Calif.-based Pimco believe, plan sponsors can minimize the risk taken by their 401(k) plan participants.
Numerous experts have criticized life cycle funds for relying too heavily on equities: Some funds targeted for people retiring in 2045 have 94% of the assets in equities. But Pimco appears to be the first manager to advocate applying LDI as a potential solution.
While defined benefit plans use LDI to ensure that corporations can meet their pension obligations, defined contribution plans would seek to ensure that participants have enough money during their retirement.
Pimco’s approach: Use Treasury inflation-protected securities as the riskless asset.
“In our framework, the riskless asset is long-term TIPS rather than cash. Since an inexpensive, readily available and government-guaranteed instrument exists that protects the principal of savings and grows that principal at a rate that exceeds inflation, risk should only be taken if a DC participant can reasonably expect to exceed the returns on TIPS,” Pimco executive vice president Seth Ruthen wrote in a white paper, “Creating the Next Generation Glidepaths for Defined Contribution Plans.”
William Schneider, managing director of DiMeo Schneider & Associates LLC in Chicago, said that Pimco’s approach “partially makes sense.”
“Depending on the risk tolerance of the individual, you need to incorporate cash. The first issue is: Who’s right, and how do you get the best model? It depends on your input assumptions. The second issue is that most people don’t save enough and therefore need something that will generate bigger returns and larger balances. And that takes risk,” Mr. Schneider said.
The problem with the current structure of target date funds is that a participant’s success at accumulating enough retirement income depends on the year they were born, Pimco officials said.
The Pimco paper explained that a participant born in 1919 who retired at age 65 would have experienced a 2.2% 20-year real return, based on Pimco data. Their retirement portfolio value would be $201,503. But a participant born in 1935 who retired in 2000 would have earned a 9.3% real return. Their portfolio would be valued at $807,414 — four times the level of the person 16 years older.
“For our hypothetical plan participant, the difference between being born in a ‘good’ year, versus a ‘bad’ year means that he would retire on $38,576 a year, versus $9,627 a year in the inflation-adjusted dollars, respectively — despite choosing the same investments and contributing the exact same real amount of money,” the paper explained.
“If you’re lucky enough to retire in a bull market, that’s great. If you’re born in a different year, you could have some very disappointing retirement income because you were born in the wrong year. We want to minimize the differences between those outcomes,” Mr. Ruthen said in an interview.
Participants who switch jobs, are laid off, become disabled or otherwise stop working are at even greater risk for not saving enough in retirement plans.
UBS Global Asset Management of Chicago recently launched target date funds that adopt the strategy of incorporating TIPS.
According to a UBS paper, “Beyond the Glide Path — Next-Generation Retirement Solutions,” TIPS must be incorporated into target date funds, which sometimes rely too heavily on equity.
“We believe what participants need most is inflation-adjusted, longevity-protected replacement income, which will guide them closer to cover[ing] their retirement needs,” according to the paper.
Balance needed
Pimco executives think 401(k) plans need to strike a balance between real appreciation potential and downside protection in order to offer the best level of equities, which decreases as participants age, said Stacy Schaus, defined contribution practice leader at Pimco.
Using TIPS as the riskless asset is key because they grow faster than inflation.
“We are looking at risk a different way. Now that DC plans are becoming the primary source of retirement income for more participants, it’s so important that we could help them reach their retirement income goal and reduce unnecessary risk,” Ms. Schaus said.
And more companies are adopting target date funds as their default investment option. According to Hewitt Associates LLC of Lincolnshire, Ill., 57% of plan sponsors offer them, and the number is expected to grow.
“We’re out there looking at people reaching their goal. Right now, the way [target-date] products are structured, the last 10 years will determine how well you will do,” Ms. Schaus said.
“As we’ve talked with companies, immediately, the thought is, if you have a long time frame, why wouldn’t you be heavily invested in equity?” Ms. Schaus said. “But in the last 10 years, you’re hit in a difficult market, you need to have a more secure path.”
How providers structure target date funds is becoming more important as more participants are being defaulted into these options.
