High cash holdings a scandalous investment for someone in retirement

Arguably a primary goal of retirement planning is to provide a stable and secure stream of replacement income in retirement. Such income should be sufficient to support a desired standard of living in retirement.

Therefore a key risk is uncertainty about how much spending (consumption) can be sustained in retirement.

Fundamental to this approach is measuring risk relative to the spending/consumption goals. As a result, the focus should not be on the size of the account value (Super pot). Nor is volatility of capital and returns a true measure of risk.

The size of the super pot, Kiwisaver account balance, does not tell someone the level of income that can be generated to support a desired standard of living in retirement.

As a result, strategies that focus on capital preservation, such as holding high levels of cash and short-term fixed income strategies, are more risky and volatile relative to the investment goal of generating a stable and secure stream of replacement income in retirement.

Therefore, holding high levels of cash at the time of retirement could potentially be a very poor investment decision, as is proposed by a number of Target Date / Life Stages investment products.


The Analysis

Dimensional Funds Advisors (DFA) undertook analysis comparing two investment strategies relative to the goal of generating a stable and secure level of income in retirement:

  1. Goals based strategy that looks to generate sufficient income in retirement to match expected spending (consumption). This is called a liability-driven investment strategy or “LDI”.
  2. Capital preservation strategy that is invested in Cash as a means to manage the volatility of the account balance.


The following conclusions can be drawn from the DFA analysis:

  • The LDI strategy provides a stable stream of replacement income in retirement
  • The LDI strategy provides greater clarity and confidence to plan for retirement
  • The Cash strategy results in a high level of volatility relative to the goal of generating a stable level of income


The DFA analysis highlight that, relative to the Income goal, the LDI’s estimated volatility relative to this goal was 2.9%, compared to 20.7% for Cash strategy.

As far as range of outcomes, DFA compared the LDI and Cash strategy over a number of 10-year periods between 1962 and 2015, 44 overlapping 10-year periods.

“The pattern was clear. In all 10-year periods, the LDI strategy is relatively stable”. Meanwhile the Cash strategy “is a rollercoaster”.

If we assume the Investment goal was to deliver $1 of income every year, the analysis showed that annual income from the LDI strategy ranged between $0.97 and $1.09.

Conversely, the Cash strategy generated retirement income outcomes from $0.35 to $2.09. The median outcome was $0.67, this is well below $1 desired and the $1.01 LDI median.



In simple terms, the LDI strategy is a long-term bond portfolio that matches the expected retirement spending/consumption goal. Effectively, the LDI strategy generates cashflows to match future expected spending. This reduces volatility relative to the retirement spending goals. This is exactly the same approach insurance company’s implement to pay out future expected liabilities (insurance claims).

DFA conclude that “any strategy that attempts to reduce volatility using short- to intermediate-term fixed income, when the goal is a long-term liability like retirement consumption, will not be as effective as the LDI strategy.”

Although cash is perceived as low risk, it is not low risk when it comes to generating a steady and secure stream of replacement income in retirement. Short term fixed income securities, while appropriate for capital preservation, are risky if the goal is meet future spending/consumption.


This is not a fantasy, the portfolio construction techniques are available today to implement LDI strategies, which should not be beyond the capability of any credible fixed interest team to implement.


Goals Based (LDI) Strategy Benefits

  1. More stable level of income in retirement
  2. More efficient use of capital – potentially need less retirement savings
  3. Better framework to make trade-off between allocation to equities and LDI fixed income portfolio in improving the likelihood of reaching desired standard of living in retirement.


If an investor runs with a Cash strategy, where the goal is primarily capital preservation, they will need additional precautionary savings to meet their retirement income requirements.


Therefore, an LDI strategy increases the likelihood of reaching the retirement income objectives. It also achieves this with a more efficient allocation of capital. This additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.


Lastly, the LDI strategy provides a better framework in which to access the risk of not meeting your retirement income goals.


Holding a large allocation to Cash does not tell you if you are able to generate a sufficient level of income to support a desired standard of living in retirement.


The approach outlined here is consistent with EDHEC Retirement Income Framework. Furthermore, such an approach applied to the Income assets of the Target Date Fund would greatly improve the efficiency and effectiveness of such products.


Dimensional conclude”

“If one of the primary goals of retirement savings is to provide for consumption in retirement, the investment approach should be aligned with the investment goals. This means that it is important to manage the risks that are relevant to the goal. In the case of retirement income, two primary risks are inflation and interest rate risk, both of which can be addressed with an LDI approach to risk management. Not having the right risk management in place leads to unnecessary uncertainty about how much income one can afford. Additionally, investors may sacrifice returns unnecessarily. As investors shift away from growth assets, they tradeoff some expected return to gain risk reduction. So, it’s imperative that the investments reduce the risks that matter to make this a good tradeoff. We show that a blended LDI and equity solution may be able to achieve a better balance of growth vs. risk reduction—…………………”


Happy investing.


Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Risk Measure of Wealth Management

Risk is not the volatility of your investment portfolio, or volatility of returns, risk is determined by your investment goals.

This is the view of Nobel laureate Professor Robert Merton. Such an assessment of risk also underpins many Goals-Based wealth management solutions.

More robust investment solutions are developed when the focus on risk moves beyond variations of returns and volatility of capital. The key risk is failure to meet your investment objectives.


The finance industry, many financial advisors and academics express risk as the variation in returns and capital, as measured by the standard deviation of returns, or variance.

Nevertheless, clients often see risk as the likelihood of not attaining their investment goals.

The traditional financial planning approach is to understand client’s goals, then ask questions to determine risk tolerance, which then leads to advising a client to adopt a portfolio that has a mean expected return and standard deviation corresponding to the Client’s risk appetite.  Standard deviation of returns, variation in capital, becomes the measure of risk.


Nevertheless, a different discussion with clients on their goals will likely result in a different investment solution. It will also improve the relationship between the Client and the Advisor.

Such a discussion will lead to more individualised advice and a better understanding of the choices being made. Clients will be in a better place to understand the impacts of their choices and the probability of achieving their goals. It will be more explicit to them in making trade-offs between playing it safe and taking risks to achieve their investment goals.

A goals based approach provides a more intuitive, transparent, and understandable planning approach.

Ultimately it leads to a more robust portfolio for the Client where information from the goals-based discussion can be mapped to a specific range of portfolios.

It is also a dynamic process, where portfolios can be updated and changed on new discussions and information. The process can adapt for multiple-goals over multiple time periods.

This is in stark contrast to the single period single objective, static portfolio traditionally implemented based on risk appetite.

There is also a strong foundation in Behaviour Economics supporting the Goals-Based investment approach.


I have covered Merton’s view in previous Posts, so please don’t accuse me of confirmation bias!

Merton’s views on risk is also well presented in a 2016 i3 Invest article in Australia, Risk is determined by Investment goal.

“Risk is not simply expressed as the volatility of your invested assets, but is determined by your ultimate goal, according to Nobel laureate Robert Merton.”


The i3 article provides an example on how your goal determines to a large degree what your risk-free asset is.

The goal provides a starting point for determining:

  • how far removed you are from achieving your objectives; and
  • importantly, how much risk you need to take to have a chance of meeting these objectives.


“If you had as your goal to pay your (Australian dollar) tax bill in a year from now, then what is the safe asset for you?”

“It would be an Australian dollar, one year, zero coupon, Australian Treasury Bill that matures in one year. That would be the sure thing.”


As the i3 article mentions Merton has criticised the idea that superannuation is a pot of money, instead of a basis for generating an income stream.

Merton argues that there should be greater focus on generating replacement income in retirement and we need to stop looking at account balances and variations in account balances. Instead, we should focus on the income that can potentially be generated in retirement from the investment portfolio, pot of money.


This is not a radical idea, this is looking at the system in the same way as Defined Benefit Funds did, the “old” style funds before the now “modern” defined contributions fund (where the individual takes on all the investment risk).  Defined contributions funds focus on the size of the pot.  The size of the superannuation pot (Kiwisaver account balance) does not necessarily tell you the standard of living that can be supported in retirement.  This is Merton’s critical point.


A greater focus on income is aligned with goals-based investment approach.

As Merton’s explains, if we accept we should focus on income, targeting sufficient replacement income in retirement, the development of a comprehensive income product in retirement is not difficult. He concludes, “This doesn’t require the smartest scientist in Australia to solve this problem. We know how to do it, we just need to go out and do it,”.


As noted above I have previously Posted on Merton’s retirement income views. The material from these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Professor Merton. The Podcast is 90 minutes in length and full of great conversation about retirement income. Well worth listening to.


For those wanting a greater understanding of Merton’s views and rationale please see:

  1. What matters for retirement is income not the value of Accumulated Wealth
  2. Is variability of retirement income a better measure of risk rather than variability of capital? – What matters for retirement is income not the value of Accumulated Wealth


Happy investing.


Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.


Behavioural Drivers of Wealth Management

Underpinning The Regret Proof Portfolio and Best Portfolio Does not Mean Optimal Portfolio is, amongst a number of things, Behavioural Economics.


A recent paper A New Approach to Goals-Based Wealth Management published in the Journal of Investment Management (JOIM), provides a very comprehensive framework for a Goals-Based Wealth Management approach.


Behavioural Economics forms the foundations of Goals-Based Wealth Management.


As the JOIM Paper notes “Traditionally, the financial industry, financial advisors, and academics in finance have associated the notion of “risk” with the standard deviation of an investor’s portfolio. Investors, on the other hand, typically associate “risk” with the likelihood of not attaining their goals.”

This is important from the perspective of client communications: “In traditional financial planning, advisors look to understand what an investor’s goals are, then they ask questions designed to determine the investor’s tolerance for portfolio standard deviation, which leads to advising the investor to adopt a portfolio that has a mean and standard deviation corresponding to the investor’s risk appetite”

Goals-Based Wealth Management is defined “as a process that focuses on helping investors realize their goals, both short-term and long-term,..”

Behavioural Economics comes into play by “using language and ideas that are more natural for investors” in determining appropriate investment goals.


Behavioural Economics Foundations

The JOIM Paper provides a very good overview of the behavioural economics that forms the foundations of their Goals-Based Wealth Management Investment solution.

Inputs comes from the:

  1. pioneering and very influential academic literature on Behavioural Economics
  2. growing practitioner literature on goals-based wealth management


Richard Thaler’s work, who is a 2017 Nobel prize winner for his contribution to Behavioural Economics, provides a central pillar to the Goals-Based Wealth Management solution outlined in the JOIM Paper.

Thaler’s worked on the “endowment effect”, which is the asymmetric valuation of assets by individuals.  Namely, individuals value items more when they own them as opposed to when they do not.

This is related to loss aversion in Prospect Theory. Loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains.  Some studies have suggested that losses are twice as powerful, psychologically, as gains.  Loss aversion was first identified by Amos Tversky and Daniel Kahneman.


Mental accounting theory is also a significant contribution from Thaler and it is also an essential foundation for Goals-Based Wealth Management.

Mental accounting is where people treat money with different risk-return preference, depending on what use the money is to be put to. It is a way of keeping track of our money related transactions.

From a practical perspective, mental accounting helps elicit investors goals, and is “facilitated by breaking down overall portfolio goals into sub-portfolio goals using the ideas of mental accounts, where different goals are managed in different accounts, each aggregating into the overall portfolio.”


Lastly the JOIM Paper notes the work undertaken that developed Behavioural Portfolio Theory.  This theory postulates that investors behave as if they have multiple mental accounts. “Each mental account portfolio has varying levels of aspiration, depending on the goals for the mental account.  These ideas naturally lead to portfolio optimization where investors are goal-seeking (aspirational), while remaining concerned about downside risk in the light of their goals. Rather than trade-off risk versus return, investors trade off goals versus safety…”.


Practitioner’s Perspective

The JOIM Paper also notes the growing practitioner literature on goals-based wealth management.

Specifically, they reference three major contributions:

Nevins advocates a goal-orientated approach to help investors deal with biases such as overconfidence, hindsight bias, and overreaction.   Nevins’ work extended the mental accounting approach. He also argues that traditional investment planning fails to recognize investor’s behavioural preferences and biases.

Contributions by Zwecher, complements Nevins, he argues that risk management can be “done more actively and efficiently by demonstrating how a retirement portfolio that provides income, generates growth, and protects assets from disasters, can be created by adopting a bucketing (mental accounting) approach.”

Research undertaken by Brunel discussed the equal importance of two goals for an investor: being able to avoid nightmares while realizing dreams. “Brunel’s work focussed on demonstrating how goals-based wealth management can be achieved across multiple time horizons for multiple life goals. He also suggested how to map the language customers use in describing the importance of dreams or the severity of nightmares into acceptable probabilities that the investor will realize such dreams or avoid such nightmares.”


In short, Practitioners have recognized the need for a goals-based approach.

The premise is, if customers can better articulate and discuss their goals, including safety, then they are able to work with Practitioners to build more robust investment solutions that are better designed to meet their aspirations and investment objectives.


Happy investing.


Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.