The EDHEC-Princeton Retirement Goal-Based Investing Index Series October 2019 Highlights
Date 29/10/2019
Goal Price Index Series
After a general downwards move that began in November 2018 and lasted until end of August 2019, rates on US Treasury bonds have recently featured alternating periods of downs and ups, resulting from competing forces at work. Markets are uncertain over the outcome of the trade war between US and China and are concerned with the resurgence of diplomatic tension with Iran, but the Federal Reserve is continuing its quantitative easing policy, putting long-term rates under downwards pressure. As a result, US rates of maturities ranging from 1 to 5 year(s) are now lower than the rates on 1-month and 3-month Treasury bills. One interpretation of this yield curve inversion is that the market anticipates that interest rates will further decrease in response to a recession yet to come;
The recent erratic moves in interest rates are reflected symmetrically in bond prices in general, and retirement bonds in particular. All Goal Price Indices displayed an increasing trend during the first six months of 2019, in response to the decrease in Treasury yields, but October values are lower than September values, owing to higher interest rates. The pattern of rates in the next few months will tell us whether this is just a temporary break in the decreasing trend or the beginning of a new trend;
Lower Goal Price Index values mean that replacement income is less costly to acquire for investors. For instance, an individual planning to retire in 2038 and wanting to secure income for the period from 2038 to 2057 would have to pay $18.9 per dollar of income in October, while the price for the same guarantee was $19.7 in September, a decrease by about 4%;
As usual, indices with a shorter horizon are less impacted by interest rate movements than their long-term counterparts. For the individual planning to retire in 2023, the price to pay for $1 of replacement income was $20.7 in September and $20.3 in October, so the decrease was a more modest 1.9%.
Goal-Based Investing Index Series
Goal-Based Investing Indices are impacted both by changes in interest rates, through their goal-hedging building block, but also by equity market movements, since their performance-seeking portfolio is designed to replicate the performance of a cap-weighted index of the 500 largest US stocks. After a rally from January to April 2019, a downturn in May and a vigorous recovery in June, US equities featured a more quiet period during the summer, with slightly negative returns in July and August (–0.22% and –0.70%), and a small positive return in September (+ 0.44 %);
The big event that affected the 2058 indices for the income goal was the breach of their floor in August. Two indicators reveal this breach: the probabilities of reaching the essential goal have fallen down to 0% – which happened already in September – and the two indices are now fully invested in their GHP, a situation sometimes referred to as “monetization” in traditional portfolio insurance;
What happened in August that led to this situation? Recall that the essential goal that the insurance strategy is supposed to secure – and does secure most of the time, except in this case – is to achieve at least 80% of the performance of the GHP over every calendar year. At the beginning of August, the equity allocation of the 2058 index without a COLA was 49.7%, and the PSP return in this month was a small –0.70%. But the GHP return was huge, at 27.86%, because the GHP duration is large (greater than 40 years), and borrowing conditions substantially improved in August, with the 10-year Treasury constant maturity rate going down from 1.90% to 1.50%. Like for any portfolio insurance strategy, strong underperformance of the “risky” asset (here, the PSP) with respect to the “risk-free” one (here, the GHP) can result in a violation of the floor. As a matter of fact, the year-to-date gross return of the GHP as of September 2 is 1.665, and that of the index is 1.318, hence less than 80% of the GHP return, a threshold equal to 1.332. Overall, this event is live evidence that gap risk is not just a theoretical risk;
This situation will not last forever. The ground rules of Goal-Based Investing Indices stipulate that their floor is reset at the start of each civil year, to 80% of the current fund value. This revision regenerates a positive risk budget which can be consumed again during the year if the PSP again severely underperforms the GHP in a month. After the floor reset, the probability of reaching the essential goal will be back close to 100%;
The same thing happened to both 2058 indices for the income goal (with and without the COLA), but not to other indices, because these have GHPs with shorter durations. For these indices, equities still represent a positive fraction of the mix, and the probability of reaching the essential goal is still virtually 100%, while a deterministic target date fund can reach this goal only by chance.
