How much Income do you need in Retirement?
The focus is often on accumulated wealth e.g. how much do you need to save to retire on?
This could potentially result in the wrong focus. For example if a New Zealander retired in 2008 with a million dollars, their annual income would have been around $80k by investing in retail term deposits, furthermore their income would have dramatically dropped in 2009. Current income on a million dollars would be approximately $35k. That’s a big drop in income! This also does not take into account the erosion of buying power from inflation. [Note: this Post was written in 2018, the current income on $1m in February 2021 is less than $10k.]
Of course, retirees can draw down capital, the rules of thumb are, ………… well, ………..less than robust.
The wrong focus on wealth accumulation can potentially lead to yield chasing in retirement which leads to unintended risks within investment portfolios.
More robust approaches are being developed
The global retirement challenge is leading to new Goal Based Investing solutions. Goal-based investing is the counterpart to Liability Driven Investing (LDI), which is used by pensions and insurance companies where their investment objectives are reflected in the terms of their future liabilities.
Arguably the main challenge facing retirees is to have a sufficient and stable stream of replacement income.
An innovative, rigorous, and robust investment framework for solving the retirement challenge is being developed by EDHEC, along with the Operations Research and Financial Engineering Department at Princeton University, and supported by Merrill Lynch.
The framework being developed has some practical applications. The EDHEC-Princeton Framework:
Defines the Retirement goal
The goal for retirement can be split between wealth and replacement income.
Those planning for retirement seek to secure essential (sufficient income) and aspirational goals (additional wealth accumulation) with high probabilities.
Different Risk Focus
The retirement framework results in a different focus on risk.
Instead of worrying about fluctuations in capital, investors investing for retirement should worry about fluctuations in potential income in retirement.
With regards to capital specifically, the focus should be on avoiding permanent loss of capital, rather than fluctuations in capital.
Therefore, the real risk is about not achieving the investment goal. Risk is not fluctuations of returns or underperforming a market index, but instead the true investment risk is failure to achieve investment goals. This is how investment outcomes should be measured and reported against.
Investment Management Attributes
With the EDHEC-Princeton framework the following portfolio management processes can be adjusted to increase the probability of meeting the investment goals:
- Hedging – this is the least risky portfolio that matches future income requirements
- Diversification – this is the most efficient way to achieve returns relative to goals
- Insurance – this is a dynamic interplay between hedging and return seeking portfolio in the context of what is the worst case scenario in pursuing the investment goals. The trade-off is between downside protection and upside participation. The measure of risk is underachieving the investment goals.
From this framework, EDHEC argue investors should maintain two portfolios:
- Goal-hedging portfolio – this replicates future replacement income goals
- Performance-seeking portfolio – this portfolio seeks returns and is efficiently diversified across the different risk premia – disaggregation of investment returns
Over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting replacement income levels.
The Goal-hedging portfolio is a sophisticated fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities. Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit, they are made with the view to match future replacement income requirements, matching of future cashflows. This is akin to what Insurance companies do to match their future liabilities.
EDHEC-Princeton Retirement Goal-Based Investing Indices
To reflect this retirement investment solution framework EDHEC and Princeton University have developed the EDHEC-Princeton Retirement Goal-Based Investing Indices.
The EDHEC-Princeton Retirement Goal-Based Investing Indices represents the value of a dynamic strategy that aims to offer high probabilities of reaching attractive levels of replacement income for 20 years in retirement while securing, on an annual basis, 80% of the purchasing power in terms of retirement income of each dollar invested.
This is the strategy of investing into a goal-hedging portfolio, that delivers stable replacement income in retirement, and the performance-seeking portfolio, which offer the upside potential needed to reach higher income levels with high probabilities, as outlined above
It will be really interesting to follow how these indices perform.
The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge. There are a some investment solutions currently available in the Target Date/Life Cycle options that are aligned with the above investment approach, as there are many that don’t.
These solutions are better than many of the Target Date Funds that have a number of short comings.
The EDHEC framework is a more efficient framework than the rule of thumbs that reduce the growth allocations towards defensive/income and where the income component is invested into market replicating cash and fixed income portfolios.
Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the right goal, replacement income in retirement.
In summary, the retirement investment solution needs to focus on generating a sufficient and stable stream of replacement income. This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI), much like an insurance company does in undertaking a liability driven investing approach. Focusing purely on an accumulated capital value and management of market risk alone may lead to insufficient replacement income in retirement, or inefficient trade-offs are made prior to and in retirement.
Importantly the investment management focus is not on beating a market index, arguing about fees (albeit they are important), the focus is on how the Investment Solution is tracking relative to the retirement goals.
Please see my Disclosure Statement
Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.