The Role Of Long-Maturity TIPS In Retirement Portfolios by Steven Sapra & Niels K Pedersen –PIMCO
All things equal, we believe long-duration Treasury Inflation-Protected Securities (TIPS) should play an important role in the asset allocation of workers who are within 10 to 20 years of retirement. Long TIPS effectively help hedge retirees against fluctuations in the real wealth required to sustain a given level of consumption in their retirement years. As such, long-duration TIPS act as the “risk-free asset” in the context of retirement savings, and, for investors on a reasonable savings path, an allocation to this asset class may increase the likelihood of a successful retirement outcome.
While the secular tailwind of declining real and nominal yields, which have contributed to favorable returns of long-duration fixed income over the last 20 to 30 years, has most likely come to an end, the prospective returns of long-maturity TIPS are still sufficient to justify a meaningful allocation, in our view. Alternatives such as cash or shorter-duration bonds are expected to have worse performance over the next 10 years than long TIPS, under our base case view. Risk assets such as equities and higher-yielding fixed income, which have the potential to outperform long-duration TIPS, should also be considered for retirement savings portfolios. However, their inclusion increases the uncertainty of final outcomes, particularly as one approaches retirement.
Although changes in market-wide risk premia will inevitably cause both the relative and absolute valuations of asset classes to change in the future, the role of long-maturity TIPS as the “risk-free” asset will remain undiminished. For example, a rise in the equity earnings yield is likely to translate into higher future risk-adjusted returns. A DC investor may optimally allocate more to equities as a result. We believe long TIPS, however, will continue to be the most appropriate asset for hedging the liability, irrespective of valuations, and, as such, should always serve an important role in retirement investors’ portfolios.
The Relationship Between Real Wealth And Real Consumption In Retirement
To evaluate the current state of a retirement plan, we can invoke a basic principle of financial planning, which is that the present value of retirement consumption should be less than or equal to the present value of assets set aside to finance it. For a worker requiring a real income stream of CR, lasting T years, and assuming a constant real interest rate, r, this condition implies a minimum wealth level at retirement, WR, of
The same principle applies N years before retirement, which implies the following condition:
We can consider the current retirement savings to be consistent with a worker’s retirement objective if Equation 4 holds. In other words, an investor is on track to his retirement goal if the current value of his wealth plus the present value of future savings is greater than or equal to the present value of his anticipated future consumption. If Equation 4 does not hold, then the deficit can only be closed by either lowering consumption expectations in retirement (CR) or increasing savings (SR-N). This concept is similar to how a corporate pension plan compares the value of its asset portfolio with its expected liabilities to determine the plan’s funded status.
Figure 1 shows the impact of real yields on the retirement price index, along with the liability duration, assuming 20 years of retirement income. Each line represents the number of years to retirement, ranging from zero (at retirement) to 20 years. The value of the liability is directly influenced by the level of real interest rates in the economy, with lower rates translating to greater liability values and vice versa. Additionally, the further one is from retirement, the greater the duration, or interest rate sensitivity, of the liability. For example, at retirement, the duration of an investor’s liability is about 10 years.
Empirical Performance Of Asset Classes And The Real Liability
Figure 2 shows the retirement price indexes relevant for three different ages – 55, 60 and 65 – from March 1999 to June 2016, alongside the evolution of 10- and 20-year real yields.1 The index is computed assuming 20 years of retirement income. Over this period, the wealth required to finance a given retirement income increased substantially, driven by the steady decline in real interest rates. Real rates were 4% in 1999, then hovered around the 2% level from 2003–2007, before recently falling to an unprecedented range of nearly ?1% in 2012. Since 2012, real rates have rebounded somewhat, ranging between 0% and 1%, resulting in a reduction of the cost of retirement from its peak in 2012.
As a result of this secular decline in real yields, the wealth required to maintain the retirement incomes of a 55-, 60- and 65-year-old worker grew by a staggering 90%, 60% and 40%, respectively, between 1999 and 2016. One million dollars of retirement savings could have supported about $70,000 of real retirement spending in 1999. By 2012, that number had fallen below $50,000, and more recently the number is just over $50,000. Hence, focusing purely on one’s wealth would have given the false impression that the investor was equally as welloff in 1999 as in 2012. Looking at the problem through the retirement income lens, however, shows that real wealth has been a poor proxy for prospective retirement consumption.
To further illustrate this point, consider a worker who was 55 in September 2005, worked for the next 10 years and retired in September 2015. Furthermore, assume that he was fully funded relative to his retirement objective in 2005 and hence on track for a successful retirement. From 2005 to 2015, this worker’s liability grew at a real annualized growth rate of 3.0% per year, which we can compare with the real returns he would have earned by investing in four different asset classes over the same period: cash (three-month Libor), equities (S&P 500 Index) core bonds (Barclays U.S. Aggregate Index) and long TIPS (Barclays 10+ Year TIPS Index). Table 1 shows the real performance of each asset class, along with the liability.
Over this period, equities were the only asset class that outperformed the liability. With the benefit of hindsight, the worker could have more than kept up with the retirement liability by investing 100% of his retirement savings in the S&P 500. However, equities were also by far the most volatile asset class, both in terms of total volatility and tracking error to the liability portfolio, at 19.8% and 24.4%, respectively. At the beginning of 2009, a worker holding 100% U.S. equities would have appeared to be heading for a very dire outcome. In fact, not