Glide Path 2.0, or Why Is Paris Upside Down? Dimitry Mindlin, ASA, MAAA, Ph.D. President CDI Advisors LLC

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1 Glide Path 2.0, or Why Is Paris Upside Down? Dimitry Mindlin, ASA, MAAA, Ph.D. President CDI Advisors LLC

2 CDI ADVISORS LLC Dimitry Mindlin, president of CDI Advisors LLC, is an actuary and investment consultant. Prior to founding the firm, Dimitry was the head of the asset allocation group at Wilshire Associates for ten years. Dimitry has completed hundreds of asset allocation projects and asset-liability studies for some of the largest retirement systems. Dimitry has written a number of articles on the subjects that include optimal glide path design, portfolio analysis, the foundation of actuarial science. Dimitry s articles have been published in Pensions & Investments, Contingencies, Global Pensions, Risks & Rewards, Pension Forum and other publications. Dimitry is a Member of the American Academy of Actuaries. He holds Ph.D. in Mathematics from the Academy of Sciences of USSR. CDI Advisors LLC 2

3 WHY IS PARIS UPSIDE DOWN? Why is Paris Upside Down?, The Morningstar Magazine, People prefer to live at the top of buildings. The top floors are the most valuable in NY, Chicago, Miami, Singapore and others, The bottom floors are the most valuable in Paris, i.e. Paris is upside down in this sense. Why? Paris is pre-elevator. NY, Chicago, Miami, Singapore and others are post-elevator. A metaphor for a paradigm shift. CDI Advisors LLC 3

4 GLIDE PATH DESIGN INDUSTRY Increasingly popular products Rapidly growing AUM Shaky foundation Lots of confusion Some of the most fundamental issues are unresolved. CDI Advisors LLC 4

5 THE STAKES ARE HIGH Russell Investments: The battle over intellectual authority over the management of TDF assets in retirement will have increasingly high stakes. Source: Knowles, K., Gardner, D., [2015]. The Date Debate Revisited, Russell Research, Russell Investments, May CDI Advisors LLC 5

6 THE RACE IS ON Morningstar (Idzorek): most target maturity equity glide paths lack theoretical substance.... Little rigorous work has been done to answer how and why the equity-bond glide path should evolve throughout an investor s lifetime BlackRock is reported to have conducted a four-year research project in the area of glide path design. See the press release. Merrill Lynch EDHEC, 3/20/2014 press release: The aim of the research project is to deliver a mathematically rigorous approach to investing for goals such as capital preservation, retirement income... Dimensional Fund Advisors (2013) R. Merton interview: One thing that I think is going to be very important - that remarkably is missing now - is the notion of goal-based investing. This probably won't be for twenty years Fidelity (2014): Enhancements to Fidelity strategies via backward induction. JPMorgan (2015): Retirement withdrawal strategies via backward induction. Voya: a replacement ratio based efficient frontier. CDI Advisors LLC 6

7 THE GOOD, THE BAD AND THE RIDICULOUS OF GLIDE PATHS The good : it is broadly recognized that glide paths should evolve. The bad : the theory of optimal glide path design is in its infancy. E.g. many practitioners don t know why glide paths should evolve; most of those that think they do, do so for the wrong reasons. Paul Samuelson (discussing the history of the calculus of variations): "All this is good enough for the brilliant eighteenth century. But by the nineteenth it was a scandal that a rigorous mathematical theory was still not known."(emphasis added). Samuelson, P. What Makes for a Beautiful Problem in Science? Journal of Political Economy, December 1970, p In the spirit of this quote, Glide Path 1.0 is a major scandal. The ridiculous : plenty. CDI Advisors LLC 7

8 THE BIGGEST MONEY MISTAKE? WSJ (10/26/16): The Biggest Money Mistakes We Make Decade by Decade 20s: Playing it too safe The first full decade of adult life should be about investing heavily, experts say. 20-somethings don t take enough risks with investments to build up big returns. It s a conclusion backed up by a number of studies. Martin Leibowitz: We found that a large percentage of the younger professors were investing in cash. Their allocation was not nearly as irrational as it seemed. Source: Q Group Panel Discussion: Looking to the Future, April 19, 2016, Financial Analysts Journal, July/August 2016, p CDI Advisors LLC 8

9 PORTFOLIO EVOLUTION FREE LUNCH The Glide Path "Takeoff" Conventional Glide Path CDI Glide Path Average Equity Allocation 60% 60% Annualized Expected Return 6.52% 6.52% Annualized Standard Deviation 10.80% 10.80% Terminal Value Mean $662 $973 Surcharge 12 bps CDI Advisors LLC 9

10 GOOD, BAD AND RIDICULOUS ASSUMPTIONS Assumptions represent one of the key aspects of financial models. Assumptions can be reasonable, transparent and necessary. Assumptions can be unreasonable, hidden and unnecessary. A reasonable assumption is good. An unreasonable assumption is bad. An unreasonable hidden unnecessary assumption is ridiculous. CDI Advisors LLC 10

11 FUNDING COMMITMENTS Commitment-Inflow Commitment-Outflow Portfolio Return n 1 FV A R R CI CO R R CI CO n CO RA R 0 1 n k k k 1 n n n k 1 k 1 1 k CI R k k CI CO k k r k Portfolio Return Factor R 1 Existing Assets 0 Future Value Required Assets Present Value FV CI CO PV A A RA R R R R A n k k n k 1 1 k k r k CDI Advisors LLC 11

12 THE PRIMARY OBJECTIVE Future Value is non-negative FV 0 Present Value is non-negative PV A0 RA 0 Required Assets is no greater than the existing asset value RA CO n n k k k 1 1 k k 1 1 CI R R R R k A 0 CDI Advisors LLC 12

13 THE PRIMARY RISK THE SHORTFALL EVENT Future Value is negative FV 0 Present Value is negative PV A0 RA 0 Required Assets is greater than the existing asset value RA CO n n k k k 1 1 k k 1 1 CI R R R R k To manage the shortfall event, it must be measured. Useful measurements include, but are not limited to, shortfall probability, size, and volatility as well as risk adjusted expected FV and PV. The elevator of the transition from Glide Path 1.0 to 2.0 is simulation-free stochastic analysis of funding commitments. A 0 CDI Advisors LLC 13

14 EXAMPLE: SHORTFALL PROBABILITY Probability that Required Assets is greater than the existing asset value n n COk CI k Pr RA A0 Pr A0 Q% k 1 R1 Rk k 1 R1 Rk A 0 is the (1 - Q)th %ile of RA. Problem A: Given commitment-inflows and Q, maximize commitment-outflows such that A 0 is the (1 - Q)th %ile of RA. Problem B: Given commitment-outflows and Q, minimize commitment-inflows such that A 0 is the (1 - Q)th %ile of RA. Problem C: Given commitment-inflows and -outflows, minimize Q. CDI Advisors LLC 14

15 THE FUNDING TRIANGLE Given two corners, optimize the third. CDI Advisors LLC 15

16 PFAU-KITCES (2014) Pfau, W., Kitces, M. (2014) Reducing Retirement Risk with a Rising Equity Glidepath, Journal of Financial Planning 27 (1): CDI Advisors LLC 16

17 30-80 OPTIMAL? Same methodology, 15 years later CDI Advisors LLC 17

18 THE INVESTOR COHORT The key principles: Investors re-examine their strategic asset allocations regularly. Every sub-glide path of an optimal glide path is optimal on its own. time A strategic game : players the investor and his ageing clones ; actions portfolio selections; preferences higher safety, lower risk and required contributions. CDI Advisors LLC 18

19 NASH EQUILIBRIUM GLIDE PATH Under common rationality assumptions, the investor s cohort should produce a Nash equilibrium series of portfolios (a glide path). No member of the investor s cohort can improve his result unilaterally. Every portfolio selection is the best response to all other selections. CDI Advisors LLC 19

20 FREE LUNCHES IN FINANCE Free Lunch #1 Free Lunch #2 Where to Get Optimal Portfolio Selection Optimal Portfolio Evolution Thanks to Harry Markowitz John Nash CDI Advisors LLC 20

21 GLIDE PATH 1.0 VS. 2.0 Objective Glide Path is an Methodology Glide Path 1.0 Glide Path 2.0 To construct professionally diversified portfolios (Vanguard) Input Disclosure Heuristics To optimize outcomes (CDI) Output Indispensable part of portfolio selection Quantitative optimization and valuation CDI Advisors LLC 21

22 THE IMPORTANCE OF TRUST Robert C. Merton: Suppose you need surgery. The process can be made more transparent by showing you all of the scientific studies, a list of all the tools to be used, and the step-by-step surgical procedure. Is that transparency? No. You cannot judge how the surgery will come out. Surgery is inherently opaque, and so is financial advice. if something is inherently opaque, then the only mechanism that works is trust. (Emphasis added DM) Source: Q Group Panel Discussion: Looking to the Future, April 19, 2016, Financial Analysts Journal, July/August 2016, p CDI Advisors LLC 22

23 PRODUCTS, SOLUTIONS, MYTHS Andrew W. Lo: Investors are not looking for products; they are looking for solutions. Few people in finance think in those terms, at least not yet, and it will be a sign of maturity when we start developing solutions. (Emphasis added) Jeremy Siegel: the current incarnations of target date funds are based on a variety of different myths about how much you should have in equity and fixed income as you get closer to some projected horizon for the individual. (Emphasis added) Source: Q Group Panel Discussion: Looking to the Future, April 19, 2016, Financial Analysts Journal, July/August 2016, p CDI Advisors LLC 23

24 CDI AS AN ECONOMIC THEORY As an economic theory, CDI takes its roots in the works of Harry Markowitz, Fischer Black, Peter Bernstein, Paul Samuelson and others. Mindlin, D. (2013) A Tale of Three Epiphanies CDI is designed to optimize the outcomes of investment programs. CDI maximizes the standard of living in retirement for a DC plan participant (given saving rate and risk tolerance). CDI minimizes the required contribution rate of a DB plan (given the benefit stream and risk tolerance). Mindlin, D. (2013) Principles of Optimal Glide Path Design The key aspect that distinguishes CDI from other approaches is the first step in CDI is the development of investment objectives. Mindlin, D. (2014) Commitment Driven Investing: The Essentials CDI incorporates conventional portfolios as well as annuities and other matching assets. Mindlin, D. (2012) The Case for Annuities and Matching Bonds in Retirement Plans CDI is the only outcome-driven framework that justifies evolving glide paths. Mindlin, D. (2015) Why Glide Paths Evolve: Expected-to-Do Glide Paths Mindlin, D. (2016) Why Glide Paths Evolve: Will-Do Glide Paths CDI is the only outcome-driven framework that justifies glide path takeoffs. Mindlin, D. (2015) The Glide Path "Takeoff" CDI Advisors LLC 24

25 CDI ANALYTICAL TOOLBOX The analytics for optimal portfolio and glide path selection developed at CDI Advisors is applicable to DB, DC, 529 plans, foundations/endowments and others. The CDI methodology of stochastic analysis is simulation-free. Monte-Carlo simulations are used for model validation only in the development stage. The CDI glide path optimizer is designed to solve a broad range of problems (e.g. mean-variance, safety-first, and downside protection versions of CDI; present and future value optimizations). The optimizer can produce expected-to-do and will-do glide paths. The CDI outcome calculator is designed to evaluate the outcomes of investment programs given economic and demographic data. For a DC plan participant, for example, the calculator estimates the stochastic properties of the variables of interest (e.g. accumulated asset values, replacement ratios, sustainable spending). All variables are evaluated in all years, in nominal and real terms. The CDI analytical toolbox is time- and cost-efficient. It does not require an extensive and expensive computational infrastructure. CDI Advisors LLC 25

26 THE TAKEAWAYS The status quo is unsustainable. A disciplined systematic approach will produce superior products. Thought leadership will be rewarded. A great opportunity to differentiate innovative asset managers. CDI Advisors LLC 26

27 Important Information This material is intended for the exclusive use of the person to whom it is provided. It may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity. The information contained herein has been obtained from sources believed to be reliable. CDI Advisors LLC gives no representations or warranties as to the accuracy of such information, and accepts no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy in such information and for results obtained from its use. This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. Certain aspects of this presentation include features disclosed and/or claimed in U.S. Patent No. 8,396,775. Information and opinions are as of the date indicated, and are subject to change without notice. CDI Advisors LLC 27