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.

 

Why?

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.