In late October, PIMCO’s CEO and Co-CIO Mohamed A. El-Erian presented the keynote speech at Pensions & Investments ’ West Coast Defined Contribution Conference. He also spoke with P&I about top-of-mind concerns for retirement plan providers and sponsors. The Q&A below is based on that conversation.
Pensions & Investments: Why is passive management not enough today?
El-Erian: When you take a passive approach, you obviously need a benchmark in order to implement it. In other words, you need to postulate: “This is what best captures the available investment set in this asset class, and I don’t think I can do better than what this set can deliver in terms of return generation and risk mitigation. Therefore, rather than pay fees, I will invest using a passive approach.”
This is a powerful approach provided the benchmark captures well the balance of return generation and risk mitigation. And the question then becomes, what is that benchmark?
By definition, most traditional indexes and benchmarks are snapshots of the past rather than good predictors of the future. In addition, many of them use a certain (and quite narrow) methodology – market capitalization – to capture the importance of different segments to the global economy.
If the past were indeed a good predictor of the future, then that snapshot would be a powerful and appropriate one. Yet we all recognize today that the world is going through major economic realignments, monetary policy is highly experimental, the political situation is fluid, balance-sheet healing is uneven, and the regulatory landscape is evolving. Yet, surprisingly, more people are looking to passive approaches at a time when the global system is telling us that it’s evolving and changing.
P&I: How would you measure the success of an active strategy?
El-Erian: It is best to think of three different criteria. The first is how is the strategy performing relative to a passive index or specified benchmark? This means looking at performance over a full market cycle and making a post-fee analysis so you know how much you are actually capturing as an investor.
The second comparison that’s important to consider is how has the strategy done relative to other active managers? It’s not enough to measure someone relative to an index, but also by how well they exploited the opportunities they had available.
And, very importantly, the third element is the level of absolute returns, again measured over a full market cycle. Because at the end of the day, whether you’re a retiree or a pension fund, you don’t pay your bills with relative performance or performance compared to peers. You pay your bills with absolute return.
P&I: How would you design the ideal defined contribution plan?
El-Erian: I think it’s important for providers to enable the individual in three ways. The first is offering the appropriate product lineup. The second is, if that individual is going to opt for a solution instead of a combination of products, then that solution needs to provide both resilience and agility. And third, to make available the information required for individuals to make good decisions. Unless a participant understands what’s going on, she or he may slip into the sort of behavior that can actually be destructive of retirement solutions.
P&I: How do you think DC plans can address the ongoing volatility in the markets?
El-Erian: The first thing to recognize is that volatility is likely to remain with us given the changes I mentioned earlier and the extent of disconnects that currently exist between markets, as well as between fundamentals and markets.
The second issue is to make sure that the volatility doesn’t force you into making the wrong decisions. And behavioral finance provides important insights into why people find it so hard to manage their retirement. Most of us are pursuing long-term objectives, but we’re subject to short-term noise, which creates inconsistent behavior. So it’s important for retirement solutions to enable what PIMCO thinks of as "letting structure do the heavy lifting." In other words, make sure that you maintain a certain structure to minimize the risk of short-term overreaction.
Ultimately, if you provide these two things – information as to why the volatility is going to occur and structures to minimize the impact – it would help individuals manage what is likely to be quite a bumpy road going forward.