Month: January 2020

More needs to be done to address the post-retirement challenges

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The next generation to retire is likely to have much lower retirement savings. Those aged 40 to 55 are effectively a lost generation.

They have limited defined benefit (DB) pensions as many occupational schemes closed early on in their careers and it took the government many years to develop and implement auto-enrolment.

These are some of the underlying themes of the 2019 UK Defined Contribution (DC) Investment Forum (DCIF) report.  A summary and discussion of this report was recently published in an IPE Article.

The key findings of the DCIF Report:

  • Members are sleepwalking into retirement and choosing the path of least resistance
  • The industry has been slow to address the challenges posed by pension freedoms
  • The best approach is seen as income drawdown in earlier years and longevity protection later in retirement
  • Further policy initiatives are required to build consensus and provide clarity

 

In summary, “The DC industry needs to do more to address post-retirement challenges”.

 

There are obviously issues specific to the UK market e.g. it has been five years since pensioners in the UK gained greater freedom to use their defined contribution (DC) pots.

Nevertheless, retirement issues are universal and key learnings can be gained from individual markets.

 

The IPE article outlined the key challenge facing providers: “how do you ensure members retain flexibility and choice, while ensuring those members can manage both the investment and longevity risk over decades of retirement?”

 

Overall, the UK industry response has been slow. It appears “Pension providers have been focused on designing the best default fund with little energy spent on the post-retirement phase.”

Interestingly, research in the UK by Nest, a €8.3bn auto-enrolment provider, found most members expect their pension pot to pay an income automatically on retirement.

Members are also surprised by the level of complexity involved in draw down products.

 

Post Retirement Investment Solution Framework

Despite the lack of innovation to date there appears to be a consensus about the shape of the post-retirement investment solution.

An appropriate Post-Retirement Investment Strategy would allow retirees to have decent levels of income during the first two active decades of retirement and longevity protection for after 80.

“Not only does this remove the burden of an unskilled person having to manage both investment and longevity risk, but it also prevents members from either underspending or overspending their pots”.

The idea is to turn a DC pension pot into an income stream with minimal interaction from the scheme member.

 

This is consistent with the vision expressed by Professor Robert Merton in 2012, see this Kiwi Investor Blog Post: Designing a new Retirement System for more detail.

 

As the IPE article highlights, it is important retirees are provided guidance to ensure they understand their choices.

Albeit, a core offering will deliver a sustainable income.  This is potentially a default solution which can be opted out of at any stage.

Some even argue that the “trustees would then make a judgement about what a sustainable income level would be for each member and then devise a product to pay this out.”

“In addition, this product could also provide a small pot of cash for members to take tax-free on retirement as well buying later-life protection. This could take the form of deferred annuities or even a mortality pool.”

 

Early Product Development in the UK

The IPE article outlines several approaches to assist those entering retirement.

By way of example, Legal & General Investment Management have developed a retirement framework which they call ‘four pots for your retirement’.”

  • First pot is to fund the early years of retirement – assuming retirees will spend the first 15 years wanting to enjoy no longer working; they will travel and be active.
  • Second pot provides a level of certainty to ensure retirees do not outlive their savings, this may include an annuity type product.
  • Third pot is a rainy-day pot for one-off expenses.
  • Final pot is for inheritance.

 

Greater Policy Direction

Unsurprisingly, there is a call for clearer policy direction from Government. Particularly in relation to adequacy, and the relation between adequacy and retirement products.

Unlike a greater consensus around what an investment solution might look like, consensus around the regulatory environment will be harder to achieve.

This may slow investment solution innovation to the detriment of retirees.

 

Concluding remarks

The following point is made within the IPE article: “While pension providers in both the US and Australia have come to the same conclusions as the UK about the way to address the retirement market, no-one in these markets has yet developed a viable product.”

As the IPE article note “It is likely the industry will be pushing at an open door if it develops a product that provides an income in retirement.”

This is a significant opportunity for the industry.

 

Interestingly, the investment knowledge is available now to meet the Post Retirement challenge. Also, Post-Retirement Investment solutions are increasingly being developed and are available. It is going to take a change in industry mind-set before they are universally accepted.

 

The foundations of the investment knowledge for the Post-Retirement Investment solution as outlined above have regularly been posted on Kiwi Investor Blog.

For those wanting more information, see the following links:

 

There will be change, a paradigm shift is already occurring internationally, and those savings for retirement need a greater awareness of these developments and the likely Investment Solution options available, so that they are not “sleepwalking into retirement and choosing the path of least resistance”.

 

I don’t see enough of the Post Retirement Challenges being addressed in New Zealand by solution providers. More needs to be done, the focus in New Zealand has been on accumulation products and the default option as occurred in the UK.

The approach to date has been on building as big as possible retirement pot, this may work well for some, for others not so well.

Investment strategies can be developed that more efficiently uses the pool of capital accumulated – avoiding the dual risks of overspending or underspending in the early years of retirement and providing a greater level of flexibility compared to an annuity.

These strategies are better than Rules of Thumb, such as the 4% rule which has been found to fail in most markets.

More robust and innovative retirement solutions are required.

 

In New Zealand there needs to be a greater focus on decumulation, Post Retirement solutions, including a focus on generating a secure and stable level of income throughout retirement.

The investment knowledge is available now and being implemented overseas.

Let’s not leave it until it is too late before the longevity issues arise for those retiring today and the next generation, who are most at risk, begin to retire.

 

Happy investing.

 Please read my Disclosure Statement

 

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

Why is the Multi-Asset Portfolio so Popular?

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The rise of the Multi-Asset Portfolio can be traced back to the Global Financial Crisis (GFC) in 2008, when many investors “grew disenchanted with the long-time investment mantra that equities were the one true way to wealth. That smug bromide rang hollow when the financial crisis slashed many stock portfolios in half”, according to recent Chief Investment Office (CIO) article, How Multi-Asset Investing Became So Popular.

Following the GFC, the mantra became diversify your holdings. As a result, Multi-Asset Portfolios, which combine equities, fixed income, and an array of other assets, gained greater prominence.

Multi-Asset Portfolios grew more popular on promises of greater capital preservation and sometimes the delivery of superior returns.

As CIO note, the increased prominence of the Multi-Asset Portfolio can be attributed to David Swensen, Yale’s investment chief since 1986. Yale has generated an impressive performance record by investing outside of just equities and fixed income. Their portfolio has included high allocations to private equity, real estate, and other non-traditional assets. (For more on the success of the Endowment model and the fee debate please see this Post.)

 

The CIO article also noted that Multi-Asset Portfolios are most prominent among target-date funds (TDFs), which have become the default offering among 401(k) plans (e.g. US superannuation schemes such as KiwiSaver in New Zealand).

“TDFs have grown five-fold since the financial crisis, reaching $1.09 trillion in 2018, a Morningstar report concluded, with an estimated $40 billion added last year.”

 

The Concept: Absolute returns and better risk management

The Multi-Asset Portfolio is based on the concept of absolute returns, where the focus is on generating a more targeted and less volatile investment return outcome. There is a greater focus on risk management relative to that undertaken within a traditional portfolio. The intensity and sophistication of risk management employed depends on the type of absolute return strategy.

The absolute return universe is very broad, ranging from Multi-Asset Portfolios to those with a much greater focus on absolute returns such as the plethora of Hedge Fund strategies, including Risk Parity as discussed in the CIO article.

This contrasts with the traditional balanced fund, which are generally less diversified, portfolio risk is dominated by the equity exposures, and returns are much more subject to the vagaries of investment markets. The management of risk is more focused on relative returns i.e. how performance goes relative to a market benchmark, rather than returns relative to an absolute return outcome.

A Multi-Asset Portfolio generally has more of an absolute return focus than a Traditional Portfolio. It achieves this by having a more truly diversified portfolio, moving beyond the traditional Balanced Portfolio (60% equities and 40% Fixed Income), to incorporate a greater array of different investment strategies and risk management approaches within the portfolio.

As the CIO article comments, “There’s a strong argument for Swensen-like multi-asset funds that range beyond stocks and bonds, adding solid helpings of commodities, real estate and all kinds of other asset classes. With such an array, the thinking goes, you’re best protected when recessions thunder in.”

 

Return Expectations

The CIO article made the following observation, Multi-Assets Portfolios are “expected to return 4.5% annually through 2024, according to Casey Quirk, an arm of Deloitte Consulting. That isn’t a daunting growth rate, but the figure should have a decent chance of holding steady, while public markets lurch around, especially in the next recession.”

To put this into perspective, a recent CFA Institute article estimated that a Balanced Portfolio will return 3.1% over the next 10 years.

It is highly likely we are heading into a “Low Return Environment”.

 

As a result, a different investment approach to that which has been successful over the last 20-30 years is likely needed to invest successfully in what is expected to be a Challenging Investment Environment.

As the CIO article notes, “But multi-asset now goes far beyond the simple stock-bond duality, which seems insufficient to deliver the best diversification. The most salient problem with the basic pairing nowadays is that bonds are paying low interest rates. Their ability to score capital gains is limited because rates don’t have much left to fall before they hit zero. “These don’t work as well as they used to,” observed Deepak Puri, CIO Americas for Deutsche Bank Wealth Management.”

 

I fear the lessons from the GFC and 2000 Tech Bubble are fading from the collective memory, as equity markets reach historical highs and investors chase income from within equity-income sectors of the sharemarket.

In addition, more advanced portfolio management approaches have been developed over the last 20 – 30 years.

It would seem crazy that these learnings are not reflected in modern day investment portfolios. In a previous Post: A Short History of Portfolio Diversification, it is not hard to see how the Multi-Asset Portfolio has developed over time and is preferred by many large institutional investors.

Meanwhile, this Post: What Portfolio Diversification looks like, compares a range of investment portfolios, including the KiwiSaver universe, to emphasis what a Multi-Asset Portfolio does look like.

 

Growth in Multi-Asset Portfolios to continue

Increasingly the Multi-Asset Portfolios are taking market share from traditional portfolios.

Institutional investors are increasingly adopting a more absolute return investing approach. This has witnessed an increased allocation, and growth in Funds Under Management, in underlying strategies, “such as private equity, hedge funds, real estate, natural resources, and other strategies whose assets aren’t publicly traded.”

 

An underlying theme of the CIO article is the Death of the Balance Portfolio, which I covered in a previous Post.

Personally, I think the death of 60/40 Portfolio is occurring for more fundamental reasons. The construction of portfolios has evolved, as noted above, more advanced approaches can be implemented. For those interested I covered this in more detail in a recent Post: Evolution within the Wealth Management Industry, the death of the Policy Portfolio. (The Policy Portfolio is the 60/40 Portfolio).

 

Concluding Remarks

The current market environment, of low expected returns, might quicken the evolution in portfolio construction toward greater adoption of Multi-Asset Portfolios and a more absolute return focus.

Therefore, the value is in implementation, identifying the suitable underlying investment strategies to construct a truly diversified portfolio, within an appropriate fee budget.

Wealth management practices need to be suitably aligned with this value adding activity.

 

Happy investing.

Please read my Disclosure Statement

 

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

Developing ETF Trends and Innovations – EDHEC Risk Research

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The most recent EDHEC Risk Institute’s European Exchange Trade Funds (ETF) survey* provides valuable insights into the developing trends and innovation in relation to the use of ETF in a diversified and robust portfolio.

The following Post outlines the key findings of the EDHEC ETF survey, which is well worth reading.

 

The changing Purpose of using ETFS

Increasingly ETFs are being used for tactical allocation purposes. Historically the dominant purpose of ETF usage has been to gain a truly passive investment, a long-term buy-and hold investment to gain broad market exposures via the major market indices.

Results by EDHEC indicate there is now a greater usage of ETFs for tactical allocations rather than their role for long-term positions (53% and 51% respectively).

The survey also noted:

  • Gaining broad market exposure remains the focus of ETF for 73% of users, compared with 52% of respondents using ETFs to obtain specific sub-segment exposure.

 

As EDHEC note, the increasing focus on sub-segment exposures can be linked to product development, “which has led to the introduction of new products for a multitude of sub-segments of the markets (sectors, styles etc.). It also correlates with the growing use of ETFs for tactical allocations, which tend to favour a more granular investment approach over broad exposures.”

 

ETF Use continues to Grow**

The adoption of ETF continues to grow, particularly for the traditional asset classes. “In 2019 91% of respondents used ETFs to invest in equities, compared with 45% in 2006. As for governments and corporate bonds, the result went from 13% and 6% in 2006, to 66% and 68%, respectively, in 2019…”

“Investors prefer ETFs for traditional asset classes over alternative asset classes in line with this expression of conservatism in their use of ETFs, which is mainly focused on gaining access to broad market exposure”….

The Survey recorded a high level of satisfaction by investors with ETF in the traditional asset classes.

The survey also notes:

  • A high percentage of investors (46%) still plan to increase their use of ETFs in the future, despite the already high maturity of this market and high current adoption rates
  • Lowering investment cost is the primary driver behind investors’ future adoption of ETFs (74% of respondents in 2019).
  • ETF investors are planning to increase their ETF allocation to replace active managers (71% of respondents in 2019) and replace other passive investing products through ETFs (42% of respondents in 2019)

 

Future Growth and ETF Innovation Drivers

“Ethical/SRI and smart beta equity / factor indices are the main expectations for further development of ETF products”

Further developments where called for in the following market segments:

  • 31% of respondents wished for further development of Ethical/Socially Responsible Investing (SRI) ETFs.
  • ETFs related to advanced forms of equity indices – namely those based on multi-factor and smart beta indices – 30% and 28% of respondents

 

In aggregate 45% of respondents would like further development in one of the following areas of either smart beta indices, single-factor indices, and multi-factor indices.

 

More specifically, the EDHEC Survey found that “respondents would like to see further development of smart beta and factor investing products in the area of fixed income”……“The integration of ESG into smart beta and factor investing, and strategies in alternative asset classes (currencies, commodities, etc.), closely follow.”

 

EDHEC conclude, “It is likely that the development of new products corresponding to these demands may lead to an even higher take-up of smart beta and factor investing solutions.”

 

Criteria for selecting ETF Providers

The two main drivers of selecting an ETF provider are Cost and the quality of Cost and Quality of Replication. These two criteria dominate the survey results.

The long-term commitment of the provider, range of solutions, and level of innovation also rank highly.

 

Smart Beta and Factor Investing

The EDHEC Risk Survey has a large section on the drivers of using Smart Beta and Factor Investing Strategies.

Motivation for Smart Beta and Factor investing strategies include improving performance and managing risk

Albeit, the adoption of these strategies is a small fraction of portfolio holdings.

 

Concluding Comments

EDHEC found that there was a preference for passive for open-ended passive funds to invest in equity products, and active solutions to invest in fixed income products.

In relation for smart beta and factor investing the “take-up remains partial despite more than a decade of discussion in the industry, with the vast majority of adopters investing less than 20 per cent of their portfolio in such approaches.”

They find that this is partly due to a lack of ‘transparency and difficulty in accessing information about such strategies”….“In the case of fixed income strategies, investors express doubts over the maturity of research results at this stage. They also see a need for further development of long/short equity strategies based on factors, strategies that address client-specific risk objectives, and strategies that integrate environmental, social and governance (ESG) considerations.”

Personally, I see an increasing demand for smart beta and factor investing within fixed income strategies. Whether this is within an ETF structure, time will tell.

 

Therefore, for product provides to capture the growth and innovation outlined above, as EDHEC highlight, there is work to be done “to improve their solutions for smart beta and factor investing strategies if they are to make it into the mainstream.”

This is an area of opportunity for ETF providers, particularly if it includes an ESG overlay.

 

Happy Investing

 

Please read my Disclosure Statement

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

 

* The 2019 EDHEC survey gathered information from 182 European investment professionals concerning their practices, perceptions and future plans. Respondents are high-ranking professionals within their organisations (34% belong to executive management and 42% are portfolio managers), with large assets under management (42% of respondents represent firms with assets under management exceeding €10bn). Respondents are distributed across different European countries, with 12% from the United Kingdom, 70% from other European Union member states, 14% from Switzerland and 4% from other countries outside the European Union.

* *  At the end of December 2018, the assets under management (AUM) within the 1,704 ETFs constituting the European industry stood at $726bn, compared with 273 ETFs amounting to $94bn at the end of December 2006 (ETFGI, 2018b).

Past Decade of strong returns unlikely to be repeated

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The current return assumption for the average US public pension fund is 7.25%, according to the National Association of State Retirement Administrators (NASRA), highlighted in a recent CFA Institute Blog: Global Pension Funds the Coming Storm.

This compares to the CFA Institute’s (CFA) article expected return for a Balanced Portfolio of 3.1% over the next 10 years.  A Balanced Portfolio is defined as 60% Equities and 40% Fixed Income.

Therefore, the article concludes that a 7.25% return assumption is “overly optimistic in a low return interest rate environment”.

The expected low return environment will place increasing pressure on growing pension liabilities and funding deficits. This is over and above the pressures of an aging population and the shift toward Defined Contribution (DC) superannuation schemes e.g. KiwiSaver.

This environment will likely require a different approach to the traditional portfolio in meeting the growing liabilities of Define Benefit (DB) Plans and in meeting investment return objectives for DC superannuation Funds such as KiwiSaver in New Zealand.

The value will be in identifying and implementing the appropriate underlying investment strategies.

 

Past Returns

For comparison purposes an International Balanced Portfolio, as defined above, has returned around 7.8% over the last 10 years, based on international fixed income and global sharemarket indices.

A New Zealand Balanced Portfolio has returned 10.3%, based on NZ capital market indices only.

New Zealand has had one of the best performing sharemarkets in the world over the last 10 years, returning 13.5% per annum (p.a.), this compares to the US +11.3% p.a. and China -0.7% p.a.. Collectively, global sharemarkets returned 10.2% p.a. in the 2010s.

Similarly, the NZ fixed income markets, Government Bonds, returned 5.4% p.a. last decade. The NZ 5-year Government Bond fell 4.1% over the 10-year period, boosting the returns from fixed income. Interestingly, the US 5-year Bond is only 1% lower compared to what it was at the beginning of 2010.

 

It is worth noting that the US economy has not experienced a recession for over ten years and the last decade was the only decade in which the US sharemarket has not experienced a 20% or more decline. How good the last decade has been for the US sharemarket was covered in a previous Post.

 

In New Zealand, as with the rest of the world, a Balanced Portfolio has served investors well over the last ten or more years. This reflects the strong returns from both components of the portfolio, but more particularly, the fixed income component has benefited from the continue decline in interest rates over the last 30 years to historically low levels (5000 year lows on some measures!).

 

Future Return Expectations

Future returns from fixed income are unlikely to be as strong as experienced over the last decade. New Zealand interest rates are unlikely to fall another 4% over the next 10-years!

Likewise, returns from equities may struggle to deliver the same level of returns as generated over the last 10-years. Particularly the US and New Zealand, which on several measures look expensive. As a result, lower expected returns should be expected.

The lower expected return environment is highlighted in the CFA article, they provide market forecasts and consensus return expectations for a number of asset classes.

 

As the article rightly points out, one of the best estimates of future returns from fixed income is the current interest rate.

As the graph below from the article highlights, “the starting bond yield largely determines the nominal total return over the next decade. So what you see is what you get.”

 

US Bond Returns vs. US Starting Bond Yields

US Bond Returns vs US Starting Bond Yields

 

In fact, this relation has a score of 97% out of 100%, it is a pretty good predictor.

The current NZ 10 Government Bond yield is ~1.65%, the US 10-Year ~1.90%.

 

Predicting returns from equity markets is more difficult and comes with far less predictability.

Albeit, the article concludes “low returns for US equities over the next 10 years.”

 

Expected Returns from a Balanced Portfolio

The CFA Article determines the future returns from a Balance Portfolio “By combining the expected returns from equities and bonds based on historical data, we can create a return matrix for a traditional 60/40 portfolio. Our model anticipates an annualized return of 3.1% for the next 10 years. That is well below the 7.25% assumed rate of return and is awful news for US public pension funds.”

Subsequent 10-Year Annualized Return for Traditional 60/40 Equity/Bond Portfolio

Subsequent 10 years annualized Return for Traditional 60 40 Equity Bond Portfolio.png

 

This is a sobering outlook as we head into the new decade.

Over the last decade portfolio returns have primarily been driven by traditional market returns, equity and fixed income “beta“. This may not be the case when we look back in ten-years’ time.

 

This is a time to be cautious. Portfolio strategy will be important, nevertheless, implementation of the underlying strategies and manager selection will be vitally important, more so than the last decade. The management of portfolio costs will also be an essential consideration.

It is certainly not a set and forget environment. The challenging of current convention will likely not go unrewarded.

Forewarned is forearmed.

 

Global Pension Crisis

The Global Pension crisis is well documented. It has been described as a Financial Climate Crisis, the risks are increasingly with you, the individual, as I covered in a previous Post.

As the CFA article notes, the expected low return environment adds to this crisis, as a result deeper cuts to government pensions and greater increases in the retirement age are likely. This will led to greater in-equality.

 

This is a serious issue for society, luckily there is the investment knowledge available now to help increase the probability of attaining a desired standard of living in retirement.

However, it does require a shift in paradigm and a fresh approach to planning for retirement, but not a radical departure from current thinking and practices.

For those interested, I cover this topic in more depth in my post: Designing a New Retirement System. This post has been the most read Kiwi Investor Blog post. It covers a retirement system framework as proposed by Nobel Laureate Professor Robert Merton in his 2012 article: Funding Retirement: Next Generation Design.

 

Lastly, the above analysis is consistent with recent calls for the Death of the Balanced Portfolio, which I have also Blogged on.

Nevertheless, I think the Balanced Portfolio is being replaced due to the evolution within the wealth management industry globally, which I covered in a previous Post: Evolution within Wealth Management, the death of the Policy Portfolio. This covers the work by the EDHEC-Risk Institute on Goals-Based Investing.

 

In another Posts I have covered consensus expected returns, which are in line with those outlined in the CFA article and a low expected return environment.

In my Post, Investing in a Challenging Investment Environment, suggested changes to current investment approaches are covered.

Finally, Global Economic and Market outlook provides a shorter-to-medium term outlook for those interested.

 

Please note, I do not receive any payment or financial benefit from Kiwi Investor Blog, and a link to my Discloser Statement is provided below.

 

Happy investing.

Please read my Disclosure Statement

 

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