Retirement Funds Built for Skittish Times
By RON LIEBER
You must unlearn what you have learned.
When mutual fund companies start quoting Yoda while trying to persuade you to hand over your money, it’s a sure sign that something new is going on.
Most likely the American investor has gotten a tad, what's that word again? "SKITTISH" about the market, so easily manipulated by the investment banks and hedge fund managers.
But Pimco, a bond specialist now selling the popular target-date retirement funds that blend stocks and bonds and become more conservative as you near retirement, would have you believe that it has a revolutionary approach to these funds, which populate most employers’ 401(k) and other plans.
Pimco believes we are experiencing a “new normal,” where markets in the future are much less likely to deliver the returns people remember from retirement investing in the 1980s and 1990s.
Um, dontcha think stock prices were a tad over-valued in those days, what with all the bubbles and such? And it t'weren't all salad either - well, people with bond funds got a great return as the Fed kept lowering interest rates, but, once you lower interest rates to essentially zero, that strategy pretty much has run its course.
Plenty of people have ended up looking like idiots after declaring that this time is different, so it’s tempting to dismiss their proclamations as a lot of hot air. But Pimco has created its RealRetirement target-date funds with a strategy that appears to be custom-built for these skittish times. There’s less money in stocks, more inflation protection, hedging to protect against large losses and freedom for the Pimco fund managers to make bets on the fly.
For the period that began March 31, 2008, and ended in the middle of this month, Pimco’s funds for people retiring in 2020 and 2040 outperformed each of the big three in the target-date arena, Fidelity, T. Rowe Price and Vanguard, according to Morningstar data.
well, yeah, that would be a much better time to start a new fund than to be an old fund and be mis-leveraged and going long on certain investment houses that will remain unnamed
Still, the margin of victory over the next best-performing fund was less than one-quarter of a percentage point annually in both cases. And as Yoda himself might put it, three years of returns matter not when worried you are about many decades of future.
That outperformance is something, though. So it’s worth a peek under the hood to see what Pimco is up to.
But first, how did we get here? Target-date funds grew out of the utter lack of preparedness that many people felt when employers left pensions and made workers pick investments in a 401(k).
Actually, a 401(k) plan IS a pension plan, it's just that it's a more akin to a defined contribution plan than to a defined benefits plan. The interest rate assumptions underlying the funding of the defined benefits plans of the 1980's, 90's and early 00's was typically on the order of 8%. Not so easy to score that 8% in a zero% interest environment and an unstable stock market.
“People were given investment discretion when they didn’t want it,” said Joe Nagengast, a principal at Target Date Analytics, a research and consulting firm that does not work with Pimco but would like to someday. “The way to address that was to put everyone in these broad age buckets and say, ‘For investment management purposes, we’re not insulting your individuality but if you’re 25, you are the same as every other 25-year-old.’ ”
So a 25-year-old today can invest in a 2050 fund with a high allocation of riskier assets like stocks. Over time, the fund would gradually switch to bonds and other more conservative investments that can reduce risk as retirement looms.
Pimco introduced some of its target-date funds right before the stock market fell to pieces in 2008, which dragged down many other companies’ 2010 and 2015 target-date funds that had a lot of money in stocks. What Pimco had surmised was that one big loss near retirement would set many retirees back so far they’d have difficulty recovering. So it wanted to try to protect people from that.
“You only get one shot to do this properly,” said Vineer Bhansali, the Pimco managing director who oversees the investment strategy behind the target-date funds. “Most participants don’t worry so much about marginal underperformance as they do about underperforming significantly on the downside.”
Mr. Bhansali has a Ph.D. in particle physics from Harvard, did time in the trenches on Wall Street and is qualified to fly all sorts of airplanes even when he can’t see 100 feet in front of him. But he has no instruments for predicting returns, and he worries about once-in-a-while calamities like hyperinflation. “We believe that just like losing your money to someone who doesn’t pay you back is a very immediate threat to your capital, so is a loss of buying power,” he said. “It’s the same thing. You can’t buy stuff that you need.”
The Americanconsumre b uys so much shit that he doesn't need, that he ought to be re-educated.
One way Pimco tries to avoid that possibility is by gradually moving as much as 35 percent of the target-date portfolio to TIPS, which are United States Treasury bonds with built-in inflation protection. To avoid outsize stock market risk, Pimco’s targets for its stock allocation are never higher than 55 percent.
Another big difference here are the hedges that Pimco has in place to protect against a collapse in the stock market. By using various complex tools, Pimco sets a maximum loss it is willing to tolerate. For a fund with a retirement date that is relatively soon, it wants no more than a 5 percent loss; for a retirement date that is much further away, it may be willing to suffer a 15 or 20 percent decline, though the targets can move some.
Opening the funds in early 2008 was the ultimate test for the strategy, given the enormous losses in stocks over the next year. “We were very nervous about whether it was going to work, but we never busted the boundaries,” Mr. Bhansali said.
Hedging is not free, and its costs, which can range from roughly half of a percentage point to 1.25 percent annually, act as a drag on returns. Mr. Bhansali, however, argues that if the hedges work, he can sell options, say, that are more valuable when markets are in free fall and then use the proceeds to buy newly cheap investments. This, he believes, could enhance returns by a couple of percentage points annually over the long haul.
Sounds good in theory - in practice - the question that won't get asked is this: HOW LOW CAN IT GO? ("The Market?" And NOBODY but NOBODY has a clue unless the FED keeps manipulating interest rates!
It had better, because as John Ameriks, who heads investment counseling and research for Vanguard notes, those hedging costs add up over time. “People fail to appreciate that the numbers come out of the returns every year,” he said. “The math is not perfect, but you basically multiply the annual extra costs by the number of years, so at 1 percent annually you’re losing 30 percent of your gains over 30 years.”
All we know so far about returns are those three-year figures I cited above, which have Pimco’s funds just barely beating its three biggest rivals, thanks in no small part to those hedges. But Pimco’s reduced stock exposure really hurt it in the period starting March 1, 2009, when the stock market was near its nadir, and ending two years later after the markets had bounced back a fair bit. During that period, the Pimco 2020 fund trailed its rivals by about 6.5 to 12.5 percentage points annually while the 2040 fund trailed by roughly 3 to 7 percentage points, according to the Morningstar data.
Again, three years (or 30, even) are not enough to go on, though Mr. Ameriks of Vanguard takes his best shot at using the historical return of stocks to cast doubt on Pimco’s approach. “Theirs is a very skeptical view of what equities will generate,” he said. “I suppose one is entitled to take that view. But it’s not consistent with longer-term history.”
Pimco, for its part, doesn’t want to be a slave to that history — that is, to be in a situation where it is forced, because of strict fund rules, to do something that has resulted in good historical returns but may not lead to good prospective returns. So it gives itself plenty of leeway to shift the allocations, often by many percentage points. If you’re an investor, this means you need to have a ton of faith in Mr. Bhansali and his team.
Or, you could take a fallback position — that you’re willing to earn a bit less with people who have their eyes on the downside. “We for sure don’t have forecasting ability over 30 years,” he said. “But you want to focus on things you can control, and one of those is risk. Do you really have the luxury of taking a risk from which you can’t survive?”
So let’s say you bet your retirement on this unproven model, which anyone can do, given that the Pimco funds are available through brokerage firms. And let’s say you ignore the fact that few big employers have chosen so far to adopt the funds for their retirement plans, due to their lack of a long track record. And assume that these Pimco funds underperform competing funds by a percentage point or two each year over 30 years. What then?
Well, Pimco has its own downside covered here. Its research offers a sober piece of advice that just may solve all investors’ problems, no matter whose fund family they adopt. Pimco, perhaps self-servingly, declares that people may need to save 20 percent of their pay to reach a goal of replacing just 40 to 60 percent of their income in retirement.
So there’s your new normal ladies and gentlemen: 20 percent. Forget the inner workings of your target-date fund for a minute. How many of you can say that you even come close to meeting that standard?
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