What do My Relatives and PIMCO Have to do with the Future of the Defined Contribution Market?

My relatives recently asked me what they should do with their fixed income allocation now that Bill Gross left PIMCO. My answer was simple: find fixed income funds that minimize sequencing risk. You probably want to stop reading at this point, but please let me finish the story.

I suggested to my relatives that they switch to another bond fund. Their response was “which one?” Then they showed me the funds they had to choose from. Their choices were a stable value fund and the PIMCO Total Return fund. Their plight concerns me. First, how is it possible that they had such few fixed income options? More importantly, however, why should my relatives’ nest eggs be tied to one person’s ability to get the future paths of interest rates correct? I can understand why funds with concentrated risk positions can work in a Defined Benefit (DB) plan with multiple managers and where the retirement risk is born by plan sponsors. However, in a Defined Contribution (DC) plan–where the retirement risk is born by the plan participants–I was not so sure. After all, what makes a good DB fund may not make a good DC fund.

So what makes a good DC fund? This is where sequencing risk fits in. Sequencing risk refers to the individual return difference that one reaps depending on when they entered or left a fund. Put differently, this is the difference between the actual fund performance based on when you entered and left versus the long-term fund performance. U.S. Treasury bills have little sequencing risk because it does not matter when you get in or get out. On the other hand, equity funds have significant sequencing risk. It matters a great deal when you add to or reduce your equity exposure. Get the timing call correct and you look like a rock star; get it wrong and you are working more years to make up for the lost income.

Fixed income funds also have sequencing risk but typically much less than equities. However, not all fixed income funds are the same. Some funds have much more sequencing risk than others; the more concentrated the risk positions the greater the sequencing risk. Sequencing risk is not just volatility but rather it relates to the expected time horizon and size of the risk positions in the fund. A fund with two big risk positions implies that an incorrect duration or yield curve call will weigh more heavily on the performance of a fund until the trade turns around and performance snaps back. Sequencing risk is your ability to get into a fund before the trade snaps back not after, which is really quite difficult when the risk is purely idiosyncratic, i.e. when the risk positions are large and the time horizon is uncertain.

The key for a DC plan is finding those funds that minimize the sequencing risk. My relatives should not be exposed to funds with significant sequencing risk in their fixed income portfolio. They do not want to wake up at retirement and realize their nest egg has been eroded because the short 10-year futures trade (direction of rates) or the 5-10-30 yield curve slope trade didn’t work out. They need a fund with lower sequencing risk. So how do they get it?

The key is finding managers with a repeatable investment process. A repeatable investment process doesn’t rely on the views of a single person to drive performance. Rather, it’s a systematic way that portfolio managers (PMs) and analyst communicate on how to get bonds into and out of the portfolio. An example of this would be a traditional bond fund that relies on a deep team of analysts to do independent security research combined with multiple PMs that together drive the macro strategy.

I believe that Mr.Gross’ departure from PIMCO—combined with my relative’s plight—changes the way DC plan sponsors will approach fixed income fund choices. To minimize sequencing risk in the short term, I expect to see more information put around dollar-cost averaging into DC funds. As well as more DC money in motion compared to DB plans. Longer term, I think there will be more fund choices on DC platforms and the adoption of a core-satellite approach whereby the plan sponsor combines two core intermediate bond managers and two alpha managers who run more concentrated risk positions into a single strategy for their participants. This will make it look like the fixed income allocation of a DB plan. That said, I think my relatives will certainly be better off for it.

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