Glide Path 2.0, orWhy Is Paris Upside Down?

Dimitry Mindlin, ASA, MAAA, Ph.D.President

CDI Advisors LLC

November 15, 2016

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CDI ADVISORS LLC

Dimitry Mindlin, president of CDI Advisors LLC, is an actuaryand investment consultant. Prior to founding the firm,Dimitry was the head of the asset allocation group at WilshireAssociates for ten years. Dimitry has completed hundreds ofasset allocation projects and asset-liability studies for someof the largest retirement systems.

Dimitry has written a number of articles on the subjects thatinclude optimal glide path design, portfolio analysis, thefoundation of actuarial science. Dimitry’s articles have beenpublished in Pensions & Investments, Contingencies, GlobalPensions, Risks & Rewards, Pension Forum and otherpublications.

Dimitry is a Member of the American Academy of Actuaries.He holds Ph.D. in Mathematics from the Academy of Sciencesof USSR.

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WHY IS PARIS UPSIDE DOWN?

• “Why is Paris Upside Down?”, The Morningstar Magazine, 2016.

• 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.

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GLIDE PATH DESIGN INDUSTRY

• Increasingly popular products

• Rapidly growing AUM

• Shaky foundation

• Lots of confusion

• Some of the most fundamental issues are unresolved.

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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 2015.

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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.

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http://www.reuters.com/article/2014/10/10/us-funds-target-stocks-insight-idUSKCN0HZ09Q20141010http://phx.corporate-ir.net/phoenix.zhtml?c=119943&p=irol-newsArticle&ID=1931430http://www.edhec-risk.com/about_us/Press Releases/RISKArticle1048860368688218576/attachments/Press_release_EDHEC_MLWM_research_chair.pdfhttp://www.imca.org/sites/default/files/current-issues/JIC MastersInterviews/JIC141_MastersSeriesMerton.pdf

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• “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. manypractitioners don’t know why glide paths should evolve; most of those that thinkthey do, do so for the wrong reasons.

• Paul Samuelson (discussing the history of the calculus of variations): "All this isgood enough for the brilliant eighteenth century. But by the nineteenth it was ascandal that a rigorous mathematical theory was still not known."(Emphasis added).Samuelson, P. What Makes for a Beautiful Problem in Science? Journal ofPolitical Economy, December 1970, p. 1372-1377.

• In the spirit of this quote, Glide Path 1.0 is a major scandal.

• “The ridiculous”: plenty.

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THE GOOD, THE BAD AND THE RIDICULOUS OF GLIDE PATHS

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THE BIGGEST MONEY MISTAKE?

WSJ (10/26/16): The Biggest Money Mistakes We Make—Decade by Decade

20s: Playing it too safeThe 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 AnalystsJournal, July/August 2016, p.18-19.

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http://www.wsj.com/articles/the-biggest-money-mistakes-we-makedecade-by-decade-1477275181?tesla=y

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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

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http://www.cdiadvisors.com/papers/CDITheEquityHump.pdf

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• 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.”

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“GOOD,” “BAD” AND “RIDICULOUS” ASSUMPTIONS

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• Commitment-Inflow

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FUNDING COMMITMENTS

1

0 1 1

1

n

n k k k n n n

k

FV A R R CI CO R R CI CO

0 0

11 1

nk k

kn k

CI COFVPV A A RA

R R R R

1 1

nk k

k k

CO CIRA

R R

• Commitment-Outflow

• Portfolio Return

• Portfolio Return Factor 1k kR r

krkCO

kCI

• Existing Assets 0A

• Future Value

• Present Value

• Required Assets

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THE PRIMARY OBJECTIVE

0FV

0 0PV A RA

0

1 11 1

n nk k

k kk k

CO CIRA A

R R R R

• Future Value is non-negative

• Present Value is non-negative

• Required Assets is no greater than the existing asset value

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THE PRIMARY RISK – THE SHORTFALL EVENT

0FV

0 0PV A RA

0

1 11 1

n nk k

k kk k

CO CIRA A

R R R R

• Future Value is negative

• Present Value is negative

• Required Assets is greater than the existing asset value

• To manage the shortfall event, it must be measured. Useful measurementsinclude, but are not limited to, shortfall probability, size, and volatility as well asrisk adjusted expected FV and PV.

• The “elevator” of the transition from Glide Path 1.0 to 2.0 is simulation-freestochastic analysis of funding commitments.

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EXAMPLE: SHORTFALL PROBABILITY

0 01 11 1

Pr Pr %n n

k k

k kk k

CO CIRA A A Q

R R R R

• Probability that Required Assets is greater than the existing asset value

• A0 is the (1 - Q)th %ile of RA.

• Problem A: Given commitment-inflows and Q, maximize commitment-outflowssuch that A0 is the (1 - Q)th %ile of RA.

• Problem B: Given commitment-outflows and Q, minimize commitment-inflows suchthat A0 is the (1 - Q)th %ile of RA.

• Problem C: Given commitment-inflows and -outflows, minimize Q.

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THE FUNDING TRIANGLE

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Given two corners, optimize the third.

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PFAU-KITCES (2014)

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Pfau, W., Kitces, M. (2014) Reducing Retirement Risk with a Rising Equity Glidepath, Journal of Financial Planning 27 (1): 38–45.

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30-80 OPTIMAL?

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Same methodology, 15 years later

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THE “INVESTOR COHORT”

time

A “strategic game”:• players – the investor and his ageing “clones”;• actions – portfolio selections;• preferences – higher safety, lower risk and required contributions.

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.

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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.

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“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

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GLIDE PATH 1.0 VS. 2.0

Glide Path 1.0 Glide Path 2.0

ObjectiveTo construct professionally

diversified portfolios(Vanguard)

To optimize outcomes (CDI)

Glide Path is anInput

Disclosure

OutputIndispensable part of

portfolio selection

Methodology HeuristicsQuantitative

optimization and valuation

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THE IMPORTANCE OF TRUST

Robert C. Merton:

“Suppose you need surgery. The process can be made more transparent by showing youall of the scientific studies, a list of all the tools to be used, and the step-by-step surgicalprocedure. 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.18-19.

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PRODUCTS, SOLUTIONS, MYTHS

Andrew W. Lo:“Investors are not looking for products; they are looking for solutions. Few people in financethink in those terms, at least not yet, and it will be a sign of maturity when we startdeveloping solutions.”(Emphasis added)

Jeremy Siegel:“… the current incarnations of target date funds … are based on a variety of different mythsabout how much you should have in equity and fixed income as you get closer to someprojected 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.18-19.

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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 thestandard of living in retirement for a DC plan participant (given saving rate and risktolerance). CDI minimizes the required contribution rate of a DB plan (given the benefitstream 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 thedevelopment 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 PathsMindlin, 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"

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http://www.cdiadvisors.com/papers/CDI_Mindlin_Tale_Of_Three_Epiphanies.pdfhttp://www.cdiadvisors.com/papers/CDIOptimalGlidepathPrinciples.pdfhttp://www.cdiadvisors.com/papers/CDIEssentials.pdfhttp://www.cdiadvisors.com/papers/CDITheCaseForBuy-And-Hold.pdfhttp://www.cdiadvisors.com/papers/CDIWhyGlidePathsEvolve.pdfhttp://www.cdiadvisors.com/papers/CDIWhyGlidePathsEvolveII.pdfhttp://www.cdiadvisors.com/papers/CDITheEquityHump.pdf

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CDI ANALYTICAL TOOLBOX

• The analytics for optimal portfolio and glide path selection developed at CDIAdvisors is applicable to DB, DC, 529 plans, foundations/endowments and others.

• The CDI methodology of stochastic analysis is simulation-free. Monte-Carlosimulations 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 andfuture 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 investmentprograms given economic and demographic data. For a DC plan participant, forexample, the calculator estimates the stochastic properties of the variables ofinterest (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 anextensive and expensive computational infrastructure.

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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.

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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 LLCgives no representations or warranties as to the accuracy of such information, and accepts no responsibilityor liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracyin 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 disclosedand/or claimed in U.S. Patent No. 8,396,775. Information and opinions are as of the date indicated, and aresubject to change without notice.

November 15, 2016