interest-rate environment

Documeent title on one or two

lines in Gustan Book 24pt

Lifecycle Funds in a rising

interest-rate environment

Elina Steinberg Director,

Client Portfolio Management TIAA-CREF Asset Management Stephen MacDonald, CFA Managing Director, Client Portfolio Management TIAA-CREF Asset Management

Favorable product design, fixed-income asset class

characteristics and macro factors may mitigate

the impact of a rise in rates.

Amid an improving U.S. economy and the Federal Reserve’s focus on transitioning away from stimulative monetary policies that have helped keep interest rates at historic lows, TIAA-CREF Lifecycle Funds investors may be wondering how a rise in rates could affect their Fund performance.

This question is particularly relevant for investors who are nearing retirement and whose Lifecycle Fund portfolios, by virtue of their glidepath design, have become more conservatively positioned over time through increased allocations to fixed income. Of concern is that exposure to fixed income—the asset class most sensitive to interest-rate changes—is increasing for participants approaching retirement just as rates are poised to begin rising. While interest-rate risk is always a consideration in fixed-income investing, there are four key factors that may help buffer the impact of a potential rate increase on TIAA-CREF Lifecycle Funds investors.

WDiversification matters. Maintaining diversified fixed-income exposure can help mitigate

interest-rate risk, as different sectors and security types tend to respond differently to changing rates. Moreover, because highly rate-sensitive U.S. Treasuries make up the largest component of the Barclays U.S. Aggregate Bond Index, investors may be better served by active management, with greater exposure to out-of-benchmark, potentially less rate-sensitive securities, than by indexed or other benchmark-centric approaches. This is particularly true if they choose a seasoned manager such as TIAA-CREF, whose fixed-income expertise is well represented in our Lifecycle Funds.

WInterest-rate increases may be limited by macro factors. In our view, current macroeconomic

conditions will likely limit the scope of a prospective rate increase. In addition, history suggests the impact of rising rates on fixed-income market performance may be less severe than is commonly feared.

WTIAA-CREF’s Lifecycle glidepath maintains a higher allocation to equities. Although our

Lifecycle Funds, like others, increase their fixed-income exposure over time, relative to peers they tend to maintain a higher allocation to equities all along the glidepath—and thus may be better positioned for a rising rate environment.

WTactical asset allocation is built into our Lifecycle Funds. In addition to relying on the strategic

glidepath, TIAA-CREF’s Lifecycle Funds team is able to use tactical positioning to adjust fixed-income allocations in line with the team’s short- and medium-term market views. In the pages that follow, we examine these factors in greater detail, with the goal of providing Lifecycle Funds investors with an informed perspective on the prospect of rising

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1. Diversification matters.

Different types of fixed-income securities respond differently to rising rates.

Sensitivity to interest-rate movements can differ substantially based on duration, credit quality and type of security. In general, corporate bonds (both investment-grade and high-yield), floating-rate notes, emerging-market debt, shorter-term issues, and certain types of structured securities may provide greater protection from losses during periods of rising rates.

For example, in 2009, interest rates increased sharply, with the yield on the bellwether 10-year Treasury note climbing from 2.46% to 3.85%. As shown in Exhibit 1, longer-term, higher-rated bond sectors tended to lag during this period, while shorter-term, lower-rated, and securitized assets outperformed. In some cases, the disparity in performance among categories was dramatic, underscoring the value of diversification.

A more recent example came in 2013, when credit spreads were much tighter than in 2009. The 10-year yield began 2013 at 1.78% and finished the year at 3.04%. Again, returns for fixed-income sectors varied widely in this rising rate environment, albeit somewhat differently than in 2009. Nonetheless, with returns ranging from -12.66% for long-term U.S. Treasuries to 0.23% for commercial mortgage-backed securities to 7.44% for high-yield corporate bonds, the rationale for diversifying across sectors held true.

Exhibit 1: Fixed-income performance may vary when interest rates rise. In 2009, as interest rates rose…

Source: Barclays. Total returns for all categories shown are based on the respective components of the Barclays U.S. Aggregate Bond Index except as follows: U.S. floating-rate notes (Barclays U.S. Floating Rate Notes Index); global emerging markets (Barclays Global Emerging Markets Index); and high yield (Barclays U.S. High Yield Index). It is not possible to invest in an index. Index performance does not reflect investment fees or transaction costs.

0 1 2 3 4 5 6 7% Baa A Aa Aaa To ta l r et ur n ( %) To ta l r et ur n ( %)

...lower-rated credits outperformed ...short- and intermediate-term categories beat longer maturities

10 Yrs or higher 7-10 Yrs 5-7 Yrs 3-5 Yrs 1-3 Yrs U.S. Aggregate 2.91 8.09 15.21 27.49 5.01 6.00 5.82 6.14 0.08 0 5 10 15 20 25 30% Treasuries (20+ yrs)

Treasuries Agencies Mortgage-backed Floating-rate Corporate Global emerging High yield -12.92 -3.57 1.95 5.89 8.79 18.68 26.93 58.21

...high-yield, emerging-market and investment-grade corporate bonds dominated other sectors

-20 -10 0 10 20 30 40 50 60% To ta l r et ur n ( %) T:1 1”

The role of diversification takes on greater significance in light of changes that have occurred in the composition of the fixed-income market over the past five years, as public debt has crowded out private debt. For bond indexing strategies, the result has been much greater representation of Treasury securities, a longer duration profile, and heightened sensitivity to interest rates. As shown in Exhibit 2, since the “Great Recession,” the Treasury sector weighting in the Barclays U.S. Aggregate Bond Index grew from 25.1% to 35.5%—largely due to increased issuance by the U.S. Treasury based on our large fiscal deficits over that period. Corporate bonds have also grown as a share of the index (albeit to a lesser degree), with companies taking advantage of low rates to refinance debt, extend maturities and change their debt mix to reduce their cost of capital.

Exhibit 2: Benchmark composition has changed

Sector weightings in Barclays U.S. Aggregate Bond Index show growth in Treasuries

as of 12/31/2008 25.07% 35.54% 23.23% 31.53% 9.70% 17.67% 43.72% 13.54% as of 9/30/2014 W Treasury W Corporate

W Securitized (MBS, CMBS, ABS, other)

W Other

Source: Barclays

These market dynamics have resulted in steadily growing demand for a shrinking supply of “spread sector” products (higher-yielding, non-Treasury debt instruments), as fixed-income investors seek securities that represent compelling relative value, generate sustainable income, and are likely to be more resilient under a range of economic circumstances. Identifying such opportunities requires a careful, discriminating approach to security selection—which tends to favor active managers. Compared with indexed portfolios, actively managed portfolios have greater flexibility to avoid the increased exposure to interest-rate risk currently reflected in broader market indexes. Accordingly, fixed-income investors may be better served by choosing active portfolios with a proven record of diversified sector allocation and effective security selection. As an experienced asset manager whose fixed-income capabilities encompass long-tenured investment professionals and distinctive sector expertise, along with significant scale and presence in the market, TIAA-CREF offers diversification and active management benefits that can serve Lifecycle Funds investors well.

2. Interest-rate increases may be limited by macro factors. History offers perspective on interest rates and market performance.

While fixed-income losses due to rising interest rates present a risk, corresponding market fears may be disproportionate to the severity and lasting impact of the losses actually incurred. Such fears are based partly on exaggerated expectations for the scope of future rate increases. After months of market anxiety, varying interpretations of Fed guidance and a 2013 “taper tantrum,” it now appears that the end of quantitative easing (QE)—along with TIAA-CREF fixed-income

management

W13 portfolio managers

with average experience of 25 years

W34 senior research

analysts with average experience of 15 years, supported by 16 research generalists

WMore than $250 billion in

fixed-income assets under management,* including the fixed-income funds in which our Lifecycle portfolios invest

WActively managed

fixed-income funds that combine the team’s fundamental credit analysis with their views of the interest-rate environment and the ability to adjust duration accordingly

*As of 9/30/14.

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An increase of 1% to 2% in the 10-year Treasury yield, for example, would represent our base case scenario, occurring gradually between 2015 and 2016. In our view, the U.S. economy is far enough along in its recovery to withstand such a move. However, we also recognize that some risks to the recovery remain—including markedly slower growth in Europe and China, which, combined with a stronger U.S. dollar, could dampen global demand for U.S. exports.

Decelerating growth outside of the U.S. has already influenced the global interest-rate environment, which currently looks different than what we have seen in previous cycles. Ten-year yields are now higher in the U.S. than in Europe and most other developed markets. This could help mute the scope of coming rate rises in the U.S.

Assuming at least a mild to moderate increase is on the horizon, it’s natural to try to anticipate its likely impact. We can look to history to see how fixed-income markets have performed when rates were rising, recognizing that the past may provide useful context but is not a predictor of future outcomes, as economic and market conditions are never identical. Indeed, the lack of historical precedent for the degree of market support that has been provided through the Fed’s QE programs—and uncertainty as to how credit markets may respond now that this support has been withdrawn—make it particularly challenging to gauge the likely impact of forthcoming interest-rate changes.

With that cautionary note in mind, our analysis shows that bond markets have tended to be resilient, bouncing back after initially incurring losses during rising rate environments. For example, based on previous periods when the 10-year Treasury yield was low (less than 3.5%) but increasing, intermediate-term government bonds realized losses of 1%-3% over one-year time frames. As illustrated in Exhibit 3, however, these short-term losses reversed over medium-term time frames. In fact, average annualized returns for intermediate-term U.S. government bonds have been positive for all rolling three-year periods since 1926.

Exhibit 3: Bond markets have shown resilience following rate increases. Intermediate-term government bonds

1-year and rolling 3-year total returns since 1926

_W

_W

What happens when rates rise sharply from low levels? Since 1926, there have been three years—1931, 1958, and 2009—in which long-term interest rates started below 3.5% and jumped by at least 50 basis points (0.50%) over the course of the year. In those years, intermediate-term government bonds posted losses of -2.32%, -1.29% and -2.40%, respectively. However, those one-year losses reversed relatively quickly. Three-year returns (encompassing the current year and the subsequent two years) for 1931, 1958 and 2009, were 2.67%, 3.19% and 4.60%, respectively. In fact, as shown in this graph, despite 10 instances of negative one-year returns since 1926, average annualized returns for intermediate-term U.S. government bonds have been positive over all rolling 3-year periods. Of course, past performance is no guarantee of future results, and there is no assurance that bonds will perform similarly if interest rates rise sharply from current levels.

Source: Ibbotson Associates.

Performance reflects the Ibbotson Associates Stocks, Bonds, Bills, and Inflation (SBBI) US Intermediate-Term Government Total Return USD index. It is not possible to invest in an index. Index performance does

-10 -5 0 5 10 15 20 25 30% 2013 2010 2006 2002 1998 1994 1990 1986 1982 1978 1974 1970 1966 1962 1958 1954 1950 1946 1942 1938 1934 1930 1926 T:1 1”

There is no guarantee that fixed-income markets will repeat this pattern of short-term reversals in the next interest-rate cycle. Nonetheless, in the long run, the risk of being underexposed to fixed income due to market timing may outweigh the risk of exposure to rising interest rates. Investors who maintain a longer-term focus, consistent with the Lifecycle Funds’ objective, and resist the impulse to react to short-term volatility are more likely to benefit from the positive returns of fixed-income assets over time.

3. Our Lifecycle glidepath maintains a higher allocation to equities.

Greater exposure to equities may position the Lifecycle Funds better than peers when rates increase.

The glidepath of TIAA-CREF’s Lifecycle Funds is designed to accommodate the growing life expectancy of the U.S. population, requiring a balance between longevity risk and market risk. As a result, our Lifecycle Funds tend to have a higher allocation to equities along the glidepath, relative to many of our peers.

At an investor’s target retirement date, assuming an age of 65, TIAA-CREF’s Lifecycle Funds are allocated evenly between equities and fixed income, thus offering balanced exposure (i.e., without an overweight to fixed income). This design is intended to give investors the continued ability to participate appropriately in equity markets over a potentially extended retirement period.

Our Lifecycle Funds’ final allocation, reached 10 years after retirement (at an assumed age of 75), is 60% fixed income and 40% equities—a notably higher allocation to equities than the 30% to 35% weighting used by most of our peers. Our final allocation is a long-term strategic decision for our glidepath and not a temporary move in anticipation of higher interest rates. It reflects our belief that we must prepare our participants for a potentially longer retirement period with the ability to draw down savings gradually. However, it also positions our funds well for a rising rate environment in which fixed income would be expected to underperform equities.

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Moreover, TIAA-CREF Lifecycle Funds are rebalanced on a monthly basis. Rebalancing— which individual investors are less likely to do when attempting to manage asset allocations in their retirement savings on their own—helps ensure the intended allocations to equity and fixed income are maintained along the entire glidepath. In addition to keeping asset allocation on track, rebalancing may enhance return potential. For example, during periods in which interest rates are rising and equities are outperforming fixed income, rebalancing entails selling stocks at higher prices (thus taking profits) and buying bonds at lower prices. This process allows our Lifecycle Funds to replace older, lower-yielding fixed-income securities with newer issues offering higher yields. (Price and yield move in opposite directions.)

4. Tactical asset allocation is built into our Lifecycle Funds.

Temporary allocation decisions that vary from the strategic glidepath may add value. Short- and intermediate-term market events are inevitable over the course of a portfolio’s lifespan. TIAA-CREF’s Lifecycle Funds team has the ability to use tactical positioning to adjust the funds’ asset allocations to address such events, in line with the team’s short- and medium-term market views. Tactical asset allocation decisions, which are guided by our Asset Allocation Committee, may vary by as much as +/-5% of the strategic market sector allocations.

Exhibit 4: TIAA-CREF Lifecycle Index Funds glidepath maintains higher allocation to equities

W

_W

_W

_W

_W

Represents significant change to the glidepath

U.S. Equity Russell 3000® Index

International Equity MSCI ACWI ex-USA Index

Fixed Income Barclays U.S. Aggregate Bond Index

Short-Term Fixed Income Barclays 1-5 Year U.S. Government/Credit Index

Inflation-Protected Assets Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index (Series–L)

Source: TIAA-CREF Asset Management. The above chart represents the strategic asset allocation progression of one of a series of multi-asset class portfolios with target retirement dates at 5-year intervals. Asset allocations represent the exposures sought at the given number of years before the maturity of the fund and are not actual mutual fund exposures. Allocations are presented for information only and may not represent the actual allocation at the time of investment.

-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 Years to Retirement 100 80 60 40 20 0 A llo ca ti o ns %

1 _{Lifetime income is a guarantee subject to the claims-paying ability of the annuity issuer.}

You should consider the investment objectives, risks, charges and expenses carefully before investing. Please call 877 518-9161 or log on to tiaa-cref.org for product and fund prospectuses that contain this and other information. Please read the prospectuses carefully before investing. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income.

Please note: The target date for Lifecycle Funds is the approximate date when investors plan to start withdrawing their money. The principal value of the fund(s) is not guaranteed at any time, including at the target date.

TIAA-CREF products may be subject to market and other risk factors. See the applicable product literature, or visit tiaa-cref.org for details.

An example of a hypothetical tactical decision that could be made in the face of rising interest rates is an underweight in longer-duration fixed-income funds in which the Lifecycle Funds invest (such as the TIAA-CREF Inflation-Linked Bond Fund and TIAA-CREF Bond Fund), with a corresponding overweight, relative to the glidepath, in shorter-duration fixed-income funds (such as the TIAA-CREF Short-Term Bond Fund and TIAA-CREF Money Market Fund). Another potential tactical decision might be to temporarily underweight fixed income relative to equities at specific points along the glidepath. Such tactical moves, when made, are temporary in nature and do not fundamentally alter the Lifecycle Funds’ optimal strategic glidepath.

Professional advice in conjunction with Lifecycle Funds

We recommend that individuals nearing or already in retirement take advantage of TIAA-CREF’s advice offering. An advice session with a financial advisor offers professional guidance in evaluating different options based on an investor’s specific return objectives, income needs, and risk considerations. Consulting with a TIAA-CREF financial advisor may be especially helpful for investors considering the purchase of an annuity to convert the assets accumulated in a Lifecycle Fund during their working years into a vehicle that provides lifetime income in retirement.1

Conclusion

Although the prospect of higher interest rates in today’s environment is real, we think the actively managed, diversified fixed-income exposure provided through the TIAA-CREF Lifecycle Funds remains a prudent strategic allocation for our participants. Our unique glidepath design, along with the potential benefits of tactical positioning and regular rebalancing, lends further support to the Lifecycle Funds’ ability to navigate a rising interest-rate environment. Moreover, TIAA-CREF offers additional investor resources, including opportunities to meet with a financial advisor, which may complement the use of Lifecycle Funds to help plan for and enjoy successful retirement outcomes.

For more information about TIAA-CREF’s Lifecycle Funds, asset management capabilities, and market perspectives, visit tiaa-cref.org.