Turning Savings into income – How much Income can your savings Generate?

Most retirement calculators project your “nest egg” (or your lump-sum savings).

However, increasingly the focus is more on the goal that really matters: whether your current savings can provide you with the annual “paycheck” you want in retirement.

 

It is possible to estimate how much your current savings will generate as an annual lifetime income. Conversely, it is possible to calculate how much is needed to be saved (Wealth) to reach a certain level of annual lifetime income when turning 65. These calculations can be undertaken for a range of ages e.g. from 55 to 74.

 

Traditionally saving for retirement means saving as much as you can (lump-sum) and trying to make your savings last a lifetime.

Yet, the biggest question, and one of the hardest to answer, has been what level of retirement income will my lump sum deliver over my retirement?

A good estimate to this question can be determined.

 

For example, there are number of Indices that can calculate the estimated lifetime annual income given someone’s age and size of nest-egg.

These Indices are better than vague rules of thumb, they are not magic, it’s just math.

More importantly, they are practical and the underlying investment strategy can be easily implemented.

 

Although these Indices are for US based investors, they are worth understanding given the underlying concepts and approaches.

Following these concepts and approaches will enhance the likelihood of reaching a desired standard of living in retirement.

Hopefully such indices/calculations will be more readily available for New Zealand investors in time.

 

Such indices are widely available overseas. By way of example are the BlackRock CoRI and EDHEC-Princeton Retirement Goal Price Index series.

Both of these Indices aim to help investors estimate how much their current savings will generate in annual lifetime income when they turn 65.

EDHEC-Princeton have also developed an Index that measures the performance of a portfolio invested in a goal-based investment strategy, Goal-Based Investing Index Series (See below).

 

By using these Indices, a quick and simple calculation can be undertaken to understand how much retirement income a lump-sum will likely generate.

Therefore, they are a great tool to start a conversation with your financial advisor i.e. discuss any changes you may need to make in your savings or investment strategy to help meet your retirement income goals.

How these Indices work is outlined below.

 

In closing, it is encouraging that KiwiSaver providers are required to include retirement savings and income projections in annual statements sent to KiwiSaver members from 2020 onwards.

This is a good start. The investment knowledge is available now to deliver a stable and almost secure level of income in retirement. Such investment strategies are aligned with the KiwiSaver income projection initiative instigated by the Financial Markets Conduct Amendment Regulations.

The OECD encourages the retirement objective is to be the generation of income in retirement and for there to be coherency between the accumulation and pay-out phase of retirement.

Currently most investment products are poorly positioned to meet these objectives.

Therefore, the retirement investment solution needs be customised to the individual and there needs to be a greater focus on generating a sufficient and stable stream of replacement income in retirement.  A regular Pay-check!

 

Happy investing.

Please see my Disclosure Statement

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

 

BlackRock CoRI

Black Rock CoRI Indexes aim to help investors estimate how much their current savings will generate in annual lifetime income when they turn 65.

The CoRI Indexes are a series of age-based U.S Fixed Income indexes. Each CoRI Index seeks to track the estimated cost of annual retirement income beginning at age 65.

By way of example, if the Index Value is 23.47, a US investor aged 65, and have a US$1,000,000 nest-egg, would generate an estimated annual retirement income of US$42,608.

Estimations based on a range of ages can be undertaken.

Access to the CoRi calculations is here. Remember this is for a US is based Investor, but a quick use of the tool will display its power.

The calculations depend on a number of assumptions, including number of years until you reach age 65, current interest rates, life expectancy, and inflation expectations.

The calculations are similar to those relied on by sophisticated pension plans and insurers. They include cash-flow modelling and actuarial practices to estimate the cost of annual retirement income, coupled with liability-driven investment techniques, to build a fixed income portfolio.

Greater detail on the CoRi methodology is available here.

 

EDHEC-Princeton Goal-Based Investing Index Series

The EDHEC-Princeton Goal-Based Investing Index Series is a joint initiative of EDHEC-Risk Institute and the Operations Research and Financial Engineering (ORFE) Department of Princeton University.

Research efforts undertaken towards the design of more meaningful retirement solutions, with the support of Bank of America’s Merrill Lynch Global Wealth Management group, led to the design of the EDHEC-Princeton Retirement Goal-Based Investing Index Series.

Through the Indices they aim to promote the use of state-of-the-art goal-based investing principles in retirement investing.

“At the root of this initiative is the recognition that none of the existing “retirement products” provides a completely satisfying answer to the threefold need for security, flexibility and upside potential. Annuities offer security, but at the cost of fees and surrender charges. Target date funds have more moderate costs and they have growth potential, but they offer no guarantee in terms of wealth at the horizon or in terms of replacement income.”

 

There are two Indices.

The first is the EDHEC-Princeton Retirement Goal-Price Index series.

The Goal Price Index series has been introduced as the appropriate tool to measure the purchasing power of retirement savings in terms of replacement income.

This Index, represents the price of $1 of retirement wealth or $1 of replacement income per year.

There are Retirement Wealth Indices as well.

Both indices can be adjusted for the cost of living or not.

The Indices, which are available for a range of retirement dates, can be used to evaluate the purchasing power of savings in terms of retirement wealth or retirement income and answer the question: are my savings sufficient to secure my wealth or income objective?

This is similar in application as the BlackRock CoRI Indices outlined above.

 

The second Index is the Retirement Goal-Based Investing Index series. This represents the performance of improved forms of Target Date Funds (TDF) invested in a goal-hedging portfolio (GHP) and a performance seeking portfolio (PSP).

Therefore, it is an enhancement on the Income Indices outlined above.

The role of the GHP is to replicate changes in the price of retirement wealth or replacement income (i.e. to replicate the performance of a Goal Price Index above).

 

The EDHEC-Princeton indices are based on the application of goal-based investing principles.

EDHEC argue that the index series answers two important questions from a retirement investing standpoint:

  • “How much replacement income can be acquired from a given level of retirement savings? Given that income, and not wealth, is what matters in retirement, the ability to translate wealth into replacement income is critically important in assessing individual portfolios’ adequacy with respect to retirement needs. The Goal Price Index series has been introduced as the appropriate tool to measure the purchasing power of retirement savings in terms of replacement income.”
  • “How does one generate the kind of upside potential that is needed to achieve target levels of replacement income while securing minimum consumption levels in retirement? Dynamic allocation to two suitably designed “safe” and “risky” building blocks (namely the retirement goal-hedging portfolio and the performance-seeking portfolio), is required to achieve this dual objective. The Goal-Based Investing Index Series has been introduced to provide a benchmark for such dynamic retirement solutions, which can be regarded as improved, risk-managed forms of target-date funds.”

 

For those wanting more detail on the EDHEC Goals Based Investment approach see my previous Post: A more Robust Retirement Income Solution.

 

The values of the indices are published on the EDHEC-Risk Institute website.

 

KiwiSaver and OECD Pension Scheme Recommendations

The OECD has identified for some time the growing importance of Defined Contribution (DC) pension schemes.

There has been a major shift globally away from Defined Benefit (DB) schemes to DC, such as KiwiSaver here in New Zealand.

As a result, the individual has become increasingly responsible for investment decisions, for which they are generally not well equipped to make.   This has been likened to a “financial climate change” by the World Economic Forum

The OECD has undertaken a review of DC potential drawbacks and how to incorporate them into regulatory frameworks to protect members. This led to the formation of a Core Principles of Private Pension Regulation.

In addition, the OECD Roadmap for the Good Design of DC Pension Plan made several recommendations.

 

Off interest to me, from the perspective of designing investment solutions, were the following:

  • Ensure the design of DC pension plans is internally coherent between the accumulation and pay-out phases and with the overall pension system. 

 

  • Consider establishing default life-cycle investment strategies as a default option to protect people close to retirement against extreme negative outcomes. 

 

  • For the pay-out phase, encourage annuitisation as a protection against longevity risk.

 

The OECD made a number of other recommendations which also have merit and they are provided below.

 

The OECD Core Principles of Private Pension Regulation emphasised that the objective is to generate retirement income.

Importantly, investment strategies should be aligned with this objective and implement sound risk management practices such as diversification and asset-liability matching.

“These should be appropriately employed in order to achieve the best outcome for the plan members and beneficiaries” (Guidelines 4.1).

Interestingly, these principles should apply not only to KiwiSaver, but to any forms of voluntary savings plans and mandatory arrangements.

 

The emphasis on generating retirement income and coherency between accumulation and pay-out phase (de-cumulation) are important concepts.

 

In my mind, a greater focus should be placed on generating income in retirement at the later stages of the retirement accumulation phase i.e. at least 10-15 years out from retirement. This is achieved by using asset-liability matching techniques as recommended by the OECD. The investment knowledge is available now to achieve this.

This reflects that the goal of most modern investment Products is to accumulate wealth and risk is defined as volatility of capital. Although these are important concepts, and depending on the size of the Pool, the focus on accumulated wealth my not lead to the generation of a stable and sufficient level of income in retirement.

This is a key learning out of Australia as they near the end of the “accumulation” phase of their superannuation system.

The central point is, without a greater focus on generating Income in retirement during the accumulation phase the variation of income in retirement will likely be higher.

 

Therefore, it is important to have coherency between the accumulation and pay-out phase of retirement.

 

I have Posted previously on the concept of placing a greater focus on retirement income as the investment goal (as recommended by the OECD). The argument for such a goal is well presented by Noble Memorial Prize in Economic Sciences Professor Robert Merton.

Professor Merton highlights that for retirement, income matters, and not the value of Accumulated Wealth.

He also argues that variability of retirement income is a better measure of risk rather than variability of capital.

 

It is appropriate to consider the OCED recommendations at a time that the New Zealand Government are reviewing the Kiwisaver Default Provider arrangements.

This Review is being undertaken by the Ministry of Business, Innovation & Employment (MBIE) and submissions are due 18 September 2019.

This GoodReturns article provides some context.

 

It is also important to note that there is a paradigm shift underway within the wealth management industry. The industry is evolving, new and improved products are being introduced to the markets in other jurisdictions.

New and innovative financial products are disrupting traditional markets by offering alternative ways to receive retirement income. The new approaches combine existing products in new and different ways. While they do not always provide guaranteed lifetime income, the innovations nevertheless can give savers options and features that annuities do not provide.

For example, Managed Payout Funds in the USA are a major alternative to an annuity. These Funds are designed to produce a relatively consistent level of annual income but that does not guarantee that outcome. They are similar in some respects to Target Date Funds (TDFs) but have a different objective.

 

More robust investment solutions are being developed to meet the retirement income challenge, they also display Flexicurity.   EDHEC Risk Institute provides a sound framework for the development of Robust Investment Solution and the need for more appropriate investment solutions.

Increasingly the robust solution is a Goal-Based investment solution coupled with longevity annuities that begin to make payments when the owner reaches an advanced age (e.g. 80) as a means to manage longevity risk.

 

The future also entails an increasing level of customisation. This reflects that saving for retirement is an individual experience requiring much more tailoring of the investment solution than is commonly available now. Different investors have different goals.

The investment techniques and approaches are available now to better customise investment solutions in relation to the conservative allocations within ones portfolio so as to generate a level of income to meet retirement goals.

Likewise, the allocation to risky assets (e.g. equities) should also be based on individual goals and circumstances.

The risky asset allocation should not be based on age alone, other factors such as assets outside of Super, other forms of income, and tolerance for risk in meeting aspiration retirement goals for example should also be considered.

 

In summary, the retirement investment solution needs be customised and 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). Focusing purely on an accumulated capital value and management of market risk alone may lead to insufficient replacement of income in retirement, greater variation of income in retirement, and/or other inefficient trade-offs are made during 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 “individuals” retirement goals.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

The OECD also recommends:

  1. Encourage people to enrol, to contribute and contribute for long periods.
  2. Improve the design of incentives to save for retirement, particularly where participation and contributions to DC pension plans are voluntary.
  3. Promote low-cost retirement savings instruments.
  4. Establish appropriate default investment strategies, while also providing choice between investment options with different risk profile and investment horizon.
  5. Promote the supply of annuities and cost-efficient competition in the annuity market.
  6. Develop appropriate information and risk-hedging instruments to facilitate dealing with longevity risk.
  7. Ensure effective communication and address financial illiteracy and lack of awareness.

 

 

Evolution within the Wealth Management Industry, the death of the Policy Portfolio

There has been a profound shift in the savings and investment industry over the last 15-20 years.

Changes to accounting rules and regulations have resulted in a large number of corporates closing their defined benefit (DB) pension schemes.

This has resulted in a major shift globally away from DB schemes and to defined contribution (DC) schemes, such as KiwiSaver here in New Zealand.

 

As a result, the individual has become increasingly responsible for investment decisions, for which they are generally not well equipped to make.

This has been likened to a “financial climate change” by the World Economic Forum.

Couple with an aging population, growing life expectations, and strains on Government sponsored pension/superannuation schemes there is an increasing need for well-designed retirement investment solution.

 

Overarching the above dynamics is the shortcomings of many financial products currently available.

Many Products currently do not provide a stable stream of income in retirement, or if they do, they lack flexibility.

As expressed by EDHEC Risk Institute robust investment solution need to display Flexicurity.

Flexicurity is the concept that individuals need both security and flexibility when approaching retirement investment decisions.

Annuities, although providing security, do not provide any potential upside. They can also be costly, represent an irreversible investment decision, and rarely are able to contribute to inheritance and endowment objectives.

Likewise, modern day investment products, from which there are many to choose from, provide flexibility yet not the security of replacement income in retirement. Often these Products focus solely on managing capital risk at the expense of the objective of generating replacement income in retirement.

Therefore, a flexicure retirement solution is one that provides greater flexibility than an annuity and increased security in generating appropriate levels of replacement income in retirement than many modern day investment products.

 

Retirement Goal

The most natural way to frame an investor’s retirement goal is in terms of how much lifetime replacement income they can afford in retirement.

The goal of most modern investment Products is to accumulate wealth, with the management of market volatility, where risk is defined as volatility of capital. Although these are important concepts, and depending on the size of the Pool, the focus on accumulated wealth my not provide a sufficient level of income in retirement.

This is a key learning from Australia as they near the end of the “accumulation” phase of their superannuation system. After a long period of accumulating capital a growing number of people are now entering retirement and “de-cumulating” their retirement savings.

A simple example of why there should be a greater focus on generating retirement income in the accumulation phase of saving for retirement is as follows:

A New Zealander who retired in 2008 with a million dollars, would have been able to generate an annual income of $80k by investing in retail term deposits. Current income on a million dollars would be approximately $32k if they had remained invested in term deposits. That’s a big drop in income, and it will continue to fall as the Reserve Bank undertakes further interest rate reductions over the course of 2019.

This also does not take into account the erosion of buying power from inflation.

Of course, retirees can draw down capital, the rules of thumb are, ………… well, ………..less than robust.

The central point, without a greater focus on generating Income in retirement during the accumulation phase there will likely be a higher level of variation of Income in retirement.

 

The concept of placing a greater focus on retirement income as the investment goal is well presented by Noble Memorial Prize in Economic Sciences Professor Robert Merton  in this Posdcast with Steve Chen, of NewRetirement.

Professor Merton highlights that for retirement, income matters, and not the value of Accumulated Wealth.

He also argues that variability of retirement income is a better measure of risk rather than variability of capital.

More robust investment solutions are being developed to address these issues.

 

Lastly, it is encouraging that KiwiSaver providers are required to include retirement savings and income projections in annual statements sent to KiwiSaver members from 2020 onwards.

 

The death of the Policy Portfolio

Another important consideration is that investment practices and approaches are evolving. Modern Portfolio Theory (MPT), the bedrock of most current portfolios, was developed in the 1950s. It is no longer that modern!

Although key learnings can be taken from MPT, particularly the benefits of diversification, enhancements can be made based on the ongoing academic and practitioner research into building more robust investment solutions.

The momentous shift is the move away from the old paradigm of the Policy Portfolio. The Policy Portfolio is the strategic asset allocation of a portfolio to several different asset classes deemed to be most appropriate for the investor.

It is a single Portfolio solution.

Over the last 15-20 years there has been several potential enhancements to the Policy Portfolio approach, including the move away from asset classes and greater focus on underlying “factors” that drive investment returns (Although a separate Post will be published on this development, an introduction to factor investing and its implementation have been covered in previous Posts).

This interview with Andrew Ang on Factor Investing might also be of interest.

 

The focus of this Post, and probably the most significant shift away from the old paradigm, is the realisation that investments should not be framed in terms of one all-encompassing Policy Portfolio, but instead in terms of two distinct reference Portfolios.

The two portfolios as expressed by EDHEC-Risk Institute and explained in the context of a wealth Management solution are:

  1. Liability-hedging portfolio, this is a portfolio of fixed interest securities, that seeks to match future income requirements of the individual in retirement
  2. Performance Seeking Portfolio, this is a portfolio that seeks growth in asset value.

The concept of two separate portfolios is not new, it dates back to finance studies in the 1950s on fund separation theorems (which is an area of research separate to the MPT).

The idea of two portfolios was also recently endorsed by Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.

Kahneman, discussed the idea of a “regret-proof policy” at a recent Morningstar Investment Conference in Chicago.

 

The death of the Policy Portfolio was first raised by Peter Bernstein in 2003.

Reasons for the death of Policy Portfolio include that there is no such thing as a meaningful Policy Portfolio. Individual circumstances are different.

Furthermore, Investors should be dynamic, they need to react to changing market conditions and the likelihood of meeting their investment goals – a portfolio should not be held constant for a long period of time.

Therefore, institutional investors are moving toward more liability driven investment solutions, separating out the hedging of future liabilities and building another portfolio component that is return seeking.

The allocation between the two portfolios is seen as a dynamic process, which responds to the market environment and the changing likelihood of meeting investment goals.

 

Evolution of Wealth Management – the new Paradigm

These “institutional” investment approaches, liability driven investing, portfolio separation, and being more dynamic are finding their way into wealth management solutions.

Likewise, there is a growing acceptance the goal, as outlined above, is to focus on delivering income in retirement. Certainly a greater emphasis should be place on Retirement Income than previously.

Specifically, the goal is to meet with a high level of probability consumption goals in the first instance, and then aspirational goals, including healthcare, old age care and/or bequests.

Therefore, the investment solution should be designed to meet investment goals, as opposed to purely focusing on market risks as a whole, as is the case with the Policy Portfolio.

 

Goal-Based Investing

This new paradigm has led to Goal-Based investing (GBI) for individuals. Under GBI the focus is on meeting investor’s goals, much like liability-driven investing (LDI) is for institutional investors.

As explained by EDHEC Risk Goal-Based Investing involves:

  1. Disaggregation of investor preferences into a hierarchical list of goals, with a key distinction between essential and aspirational goals, and the mapping of these groups to hedging portfolios possessing corresponding risk characteristics (Liability Hedging Portfolio).
  2. On the other hand it involves an efficient dynamic allocation to these dedicated hedging portfolios and a common performance seeking portfolio.

 

GBI is consistent with two portfolio approach, fund separation, liability driven investing, and undertaking a dynamic investment approach.

The first portfolio is the Liability Hedging Portfolio to meet future income requirements, encompassing all essential goals.

The objective of this Portfolio is to secure with some certainty future income requirements. It is typically made up of longer dated high quality fixed income securities, including inflation linked securities.

The second portfolio is the Growth portfolio, or return seeking portfolio. This is used to attain aspirational goals, objectives above essential goals. It is also required if the investor needs to take on more risk to achieve their essential goals in retirement i.e. a younger investor would have a higher allocation to the Return Seeking Portfolio.

The Growth Portfolio would be exposed to a diversified array of risk exposures, including equities, developed and emerging markets, factor exposures, and unlisted assets e.g. unlisted infrastructure, direct property and Private Equity.

Allocations between Hedging Portfolio and the Growth Portfolio would depend on an individual’s circumstances e.g. how far away they are from reaching their desired standard of living in retirement.

This provides a fantastic framework for determining the level of risk to take in meeting essential goals and how much risk is involved in potentially attaining aspirational goals. It will lead to a more efficient use of invested capital and a better assessment of the investment risks involved.

Importantly, the framework will help facilitate a more meaningful dialogue between the investor and his/her Advisor. Discussions can be had on how the individual’s portfolios are tracking relative to their retirement goals and if there are any expected shortfalls. If there are expected shortfalls, the framework also helps in assessing what is the best course of action and trade-offs involved.

 

Industry Challenge

The Industry challenge, as so eloquently defined by EDHEC Risk, as a means to address the Pension Crisis as outlined at the beginning of this Post:

“investment managers must focus on the launch of meaningful mass-customized retirement solutions with a focus on generating replacement income in retirement, as opposed to keeping busy with launching financial products ill-suited to the problem at hand”

“……..The true challenge is indeed to find a way to provide a large number of individual investors with meaningful dedicated investment solutions.”

 

As expressed above, saving for retirement is an individual experience requiring much more tailoring of the investment solution than is commonly available now. Different investors have different goals.

Mass-production of Products, rather than Mass-Customisation of Investment Solutions, has been around for many years with the introduction of Unit Trusts/Mutual Funds, and more recently Exchange Traded Funds (ETFs).

Mass-production, and MPT, down play the importance of customisation by assuming investment problems can be portrayed within a simple risk and return framework.

Although the Growth Portfolio would be the same for all investors, the Liability Hedge Portfolio requires a greater level of customisation, it needs to be more “custom-made”.

 

Conclusion

Encouragingly, the limitation of “one size fits all” approach has been known for some time. The investment techniques and approaches are available now to better customise investment solutions.

The challenge, is scalability, and the good news is advancements have been made in this area as well.

This is leading to changes within funds management organisations involving the greater use of technology and new and improved risk management techniques.  New skills sets have been developed.

The important point is that the knowledge is available now and it is expected that such investment solutions will be a growing presence on the investment landscape.

This will lead to better investment outcomes for many and have a very real social benefit.

 

The inspiration for this Post comes from EDHEC Risks short paper: Mass Customization versus Mass Production – How An Industrial Revolution is about to Take Place in Money Management and Why it Involves a Shift from Investment Products to Investment Solutions  (see: EDHEC-Whitepaper-JOIM)

A more technical review of these issues has also been undertaken by EDHEC.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Target Date Fund’s popularity set to Grow

Target Date Funds are popular, particularly amongst Millennials, and this growth is expected to continue.

This is a key insight from a WealthManagement.com survey of 530 retirement plan advisors in the US. The survey was conducted in February 2019. (TDF Survey Feb 2019)

 

Target Date Funds (TDF), also referred to as Glide Path Funds or Life Cycle Funds, automatically reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

In previous posts I have highlighted it is important to understand the shortcomings of TDF given their growing dominance international. According to the FT “Assets held in US target date mutual funds now stand at $1.1tn, compared with $70bn in 2005, according to first-quarter data compiled by the Investment Company Institute, a trade body.

Encouragingly, the shortcomings of TDF can largely be overcome.

 

The WealthManagement.com survey highlighted that almost half of those surveyed expect to increase their use of TDF in the next two years.

From this perspective, the following insights are provided from the survey:

  • TDF are an important tool in many retirement plans: 61% of Advisors surveyed currently have clients invested in target date funds.
  • TDF also typically represent an important component of their retirement plan when used.
  • Many plan advisors expect the reliance on TDFs to increase in the coming years.

 

Risk Management and Glide Paths

Of the Advisors surveyed longevity and volatility where the top two risks.

“The popularity of TDF was partly attributed to their ability to help retirement plan advisors address two of the biggest risks to successful retirement: longevity and volatility risk.”

“These two risks line up well with the strengths of the glide path concept. In particular, the gradual reduction in equity exposure over time seeks to minimize volatility in retirement, while the exposure to the growth potential of equities beyond retirement hedges against longevity risk.”

 

It is also noted that Glide paths help manage other risks, such as behavioural risks – to guard against investors adjusting their investment allocations based on emotions.

 

Interestingly: Nearly two-thirds of plan advisors (63%) report favouring a “through” glide path for clients, over a “to” glide path (37%); the latter achieves and maintains a conservative allocation at the target date, while the former reduces its equity allocation gradually throughout retirement.

“Given that retirement can last for 30 years or more, and that more plan advisors prioritize longevity risk over volatility risk, a “through” glide path is logically the more attractive feature.”

 

Customisation

The report observes that one of the major appeals TDF is the ability to contribute money to an investment account that automatically shifts its asset allocation over time according to a pre-determined schedule.

Therefore, in evaluating TDF Advisors tend to focus on the mix of assets and allocation in the glide path and the glide path itself.

Although Fees are a consideration, it is worth emphasising the above two aspects are considered the most important by Advisors in determining which TDF to recommend to Clients.

 

Therefore, it is not too surprising that a greater degree of customisation would be attractive to Advisors so as to better meet Client’s investment objectives:

  • Most advisors surveyed (59%) believe that more customization versus off-the-shelf options would help make TDFs more useful and more attractive to clients.
  • In fact, the most commonly cited reason advisors say they don’t use TDFs in the plans they advise is the lack of customizability (33%).

 

Goals-based Investing

Further to the above customisation observations, the report notes that the popularity of TDF among retirement plan advisors may be linked to advisors’ tendency to take a goals-based investment approach:

  • Just over half of the plan advisors surveyed (51%) identified most strongly with a goals-based label, as compared to targeting outperformance against a benchmark (41%)

“It’s perhaps not surprising that a group that favors the use of TDFs would also favor an investment strategy built around a specific target or outcome. This trend suggests that if goals-based investing is in fact gaining broader popularity, TDFs may benefit from increased usage as well.”

 

Shortcomings of Target Date Funds

I have posted previously on the shortcomings of TDF.

Essentially, Target Date Funds have two main shortcomings:

  1. They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration future income requirements or likely endowments, current level of income to retirement, or risk profile.
    • They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
  2.  Additionally, the glide path does not take into account current market conditions.
    • Risky assets have historically shown mean reversion (i.e. asset returns eventually return back toward the mean or average return, prices display volatility to the upside and downside.

Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:

    • Delays in pace of transitioning from risky assets to safer assets
    • May require step off the glide path given extreme risk environments

 

I have advocated the customisation of the fixed income allocation within TDF would be a significant step toward addressing the shortcomings of many TDF. The inclusion of Alternative assets and the active management of the glide path would be further enhancements.

These shortcomings are consistent with the desire for a greater level of customisation from Advisors.  Although not explicitly addressing the shortcomings outlined above, the following commentary from the report is interesting:

“A comment from one retirement plan advisor with more than 25 years of experience in the industry hits on multiple suitability issues at once. “TDFs look only at age and not where we are in the interest rate cycle,” he says. “Retirement date is not a terminus date, and many clients still need growth well after their retirement date.”

While most TDFs do not explicitly factor the interest rate cycle into their glide paths, many do address the need to maintain exposure to growth beyond the target retirement date—particularly through the choice of a “through” glidepath, although perhaps not at the level advisors would like to see. “

 

This is a great insight and consistent with my previous posts where it has been highlighted that maintaining high levels of cash at time of retirement is scandalous. This is addressed by having an equity allocation at the time of retirement (through glide path) and a more customised fixed income allocation within the TDF.

 

Measuring success

Great to see:

“In keeping with the general tendency toward a goals-based approach identified earlier, however, it is noteworthy that advisors most commonly evaluate TDF performance relative to peer groups (40%) and not based on outperformance of a benchmark, whether an industry index (21%) or a custom benchmark (16%).”

 

Happy investing.

 

Please see my Disclosure Statement

 

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

Impact Investing – a large and growing market

A recent Report by the Global Impact Investing Network (GIIN) estimated the size of the Global Impact Investing universe to be $502 billion (see: Sizing the Global Impact Investing Market).

It is important to note this is a separate measure “to estimates of the size of related markets (such as ESG or socially responsible investing). Neither, of course, are accurate or complete indicators of the current impact investing market size.”

 

The GINN report defines “impact investing as investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return. Impact investments are made in both emerging and developed markets as well as across all asset classes, including private and public markets.”

 

They also note that impact investing has gained significant momentum over the last decade “as both an investment strategy and an approach to addressing pressing social and environmental challenges. Through impact investments, investors seek to generate both a financial return and positive, measurable social and environmental impact.”

 

The Article provides a detailed explanation of their approach and types of organisations included in the analysis. There is also a section on how to interpret the results.

The database captures many types of organizations. Over 60% are asset managers. About one in five are foundations, and the rest include banks, development finance institutions, family offices, and institutional asset owners.

The database also includes a global group of investors. The majority are based in developed markets, including the U.S. and Canada (58%) and Western, Northern & Southern Europe (21%). It also includes investors based in regions like Sub-Saharan Africa, Latin America & the Caribbean, the Asia-Pacific, and the Middle East & North Africa.

 

 

Market Size

GIIN estimates the overall global impact investing industry AUM is USD 502 billion, as of the end of 2018.

They estimate that there is over 1,340 active impact investing organizations across the world.

They also estimate the median investor AUM is USD 29 million, the average is USD 452 million, indicating that while most organizations are relatively small, several investors manage very large impact investing portfolios.

Overall, asset managers account for about 50% of estimated AUM who typically channel capital via specialized managers.

Investments are across the board, including venture capital, private equity, fixed income, real assets, and public equities.

This is an important study, previously, as they noted in their article, a well-defined estimate of the size of the impacting market did not exist. This provides a benchmark to measure future industry growth.

 

Conclusions

The GIIN Report concludes as follows:

“Since the term ‘impact investing’ was formally coined in 2007, the industry has grown in leaps and bounds. With a growing recognition of the power of investment capital to address pressing social and environmental challenges, impact investing has attracted the attention of an increasing number of investors of all types and from all over the world. Indeed, over 50% of active impact investing organizations made their first investment in the past decade.

This research shows that there are over 1,340 active impact investing organizations across the world who collectively manage USD 502 billion in investments intended to bring about positive change. These figures are a snapshot as of the end of 2018, yet the market is quickly growing and will continue to do so. Indeed, it must: trillions of dollars are needed to effectively address the critical social and environmental challenges that face the world today, such as those outlined in the Sustainable Development Goals.

In order to meet global need, much more capital will need to be unlocked for impact investing — but there is good reason to be optimistic. One in four dollars of professionally managed assets (amounting to USD 13 trillion) now consider sustainability principles. There is great potential for these investors, who have already aligned their capital with their values, to more intentionally use their investments to fuel progress through impact investments. The growing consideration of social and environmental factors in investing is also a signal of a larger shift in the global financial markets — an increasing number of people are recognizing that their money should do more than just make more money. Their investments can — and should — also seek to fuel meaningful, sustainable social and environmental impact.”

 

 

This is a very interesting study and provides a benchmark to measure future growth of impact investing. Globally it is a large market and it is sure to grow further.

Likewise, impact investing is gaining a growing presence in New Zealand. Based on international evidence, there is a strong demand from investors for investments that generate positive, measurable social and environmental impact alongside financial returns.

Fort those wanting more background on Impact Investing this report posted by the Ākina Foundation maybe of interest (Ākina Foundation Impact Investing Sept 2017).

 

Happy investing.

 

Please see my Disclosure Statement

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

 

 

 

 

 

 

Financial Climate Change – And the Risks are with You!

The impending global pension crisis is well known, the numbers are staggering, and will worsen dramatically from here unless something is done.

Nevertheless, the well-known demographic problem is only one third of the story.

Increasingly the risks of the pension shortfall are residing squarely with the individual, who typically lack the time and expertise required to make such complex financial decisions. Furthermore, there is a lack of appropriate investment products to meet post-retirement challenges.

Addressing the retirement savings gap requires several responses. For the individual, more sophisticated and robust investment solutions and greater tailoring of the investment advice is required.

New Zealand is not immune from these global trends. Appropriately, the lack of post-retirement investment solutions in New Zealand has been identified and has had increased coverage recently.

To my mind, not just in New Zealand but globally, Goals Based Investment solutions with a focus on delivering a more stable level of income in retirement are a fundamental part of the retirement solution. Importantly, the investment knowledge and capabilities are available now to meet the challenges ahead.

 

The global savings gap is highlighted in the infographic from Raconteur, which illuminates a growing problem attached to an aging population.

As this article by Visual Capital highlights, the World Economic Forum (WEF) estimates that the combined retirement savings gap, for the following eight major countries: Canada, Australia, Netherlands, Japan, India, China, the United Kingdom, and the United States, is growing at $28 billion every 24 hours!

“The WEF says the deficit is growing by $28 billion every 24 hours – and if nothing is done to slow the growth rate, the deficit will reach $400 trillion by 2050…..”

The size of the global retirement savings gap is very well presented in the Raconteur infographic

As we know, we are all living longer, “life expectancy has risen by three years per decade since the 1940s”……. “The population of retirees globally is expected to grow from 1.5 billion to 2.1 billion between 2017-2050, while the number of workers for each retiree is expected to halve from eight to four over the same timeframe.”

As noted in the article, the WEF has made clear that the situation is not trivial, likening the scenario to “financial climate change”

 

In short, this is a major issue that needs to be addressed, and with a high degree of urgency, otherwise the effects are likely to be overwhelming.

This is not just a global issue, but also here in New Zealand.

The range of initiatives include raising the retirement age and likely cuts to benefits.

Specially for the individual, more sophisticated and tailored investment solutions are required. Goals Based investment solutions to be specific.

 

But wait, there is more!

Research by EDHEC Risk Institute builds on the view provided above. As they note, the three pillars of the retirement savings system are under duress.

The first pillar is the State/Government pension, as noted above. Nevertheless, this is only a third of the story.

The Second and Third Pillars are as follows.

The Second Pillar is the shift globally from Defined Benefit (DB) schemes to Defined Contribution (DC) e.g. Super Funds, Retirement Accounts, KiwiSaver. This shift takes the risk of delivering retirement income from the employer to the employee. Under a DC scheme the investment decision has been squarely placed with the individual. A default option is often provided if no investment decision has been made.

The Third Pillar is the growth of private savings, given the erosion of the above two Pillars. This is for those that can make additional savings and for those in retirement. Quite obviously the investment decision(s) rest with the individual, who typically lack the time and expertise required to make such complex financial decisions.

The key point with the Third Pillar is the lack of investment solutions globally to appropriately provide a secure and sustainable level of replacement income in retirement.

As EDHEC highlight:

Insurance companies, asset managers and investment banks offer a variety of so-called retirement products such as annuities and target date funds, but they hardly provide a satisfactory answer to the need for retirement investment solutions. Annuities lack flexibility and have no upside potential, and target date funds have no focus on securing minimum levels of replacement income.

 

The Solution

Luckily, there are appropriate investment solutions to help address the growing retirement shortfall.

Goals Based Investment solutions can help address the shortcomings of both Pillar Two and Three.

This Blog is filled with Posts on Goals Based Investing and the short comings of many Target Date Funds. For New Zealand readers I have outlined what a Goals Based investment solution would look like as a Default Fund option within Kiwisaver.

To recap, the modern day investment solution requires “flexicurity”. This is an investment solution that provides greater flexibility than an annuity and increased security in generating appropriate levels replacement income in retirement than many modern day investment products.  #EDHEC

The focus on generating replacement income in retirement should be considered during the accumulation phase.

The concept of Goals Based Investment solution is not radical, the investment frameworks, techniques, and approaches are currently available. The implementation of which can be easily handled by any credible fixed interest team.

Goals Based Investment solutions have been shown to increase the likelihood of reaching retirement income objectives. They also achieve this with a more efficient allocation of capital. This additional capital could be used for current consumption or invested into growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.

Lastly, Goals-Based Investment strategies provides a better framework in which to access the risk of not meeting your retirement goals.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

 

Balance Funds are not on Target for Default KiwiSaver Investors

Personally I am not convinced with the suggestion of moving KiwiSaver Default Fund Investors into a Balance Fund is the right solution, as was recently promoted in a Stuff article.

It is certainly a bit of a stretch to claim it is a radical idea. Nor is it really something materially different, it is a variation on a current theme – what equity allocation should be targeted.

 

The Balance Fund solution would result in a higher equity allocation, which in theory, and observed in practice over the longer term, will “likely” result in higher savings account balances. This is not guaranteed of course.

On this basis, a higher allocation is more likely to be appropriate for some Default Fund investors but not all. Conceivably it may be more appropriate for more than is currently the case.

Albeit, it is far from an ideal solution.

As noted in the article, it would not be appropriate for those saving for a house deposit, a high equity allocation is not appropriate in this situation. Therefore, there is still a need to provide advice as suggested. Unfortunately, whether it is a Conservative or Balance Fund a level of advice will be required.

A higher equity allocation may not necessarily result in a better outcome for KiwiSaver investors, what happens if an investor switches out of the higher equity weighted fund just after a major market correction as they cannot tolerate the higher level of market volatility. It may take years to get back to their starting position. Over the longer term, they may have been better off sticking with a more Conservative Fund. This is a real risk given a lack of advice around KiwiSaver.

This is also a real risk currently given both the New Zealand and US sharemarket have not had a major correction in over 10 years and both are currently on one of their best performance periods in history.

A higher level of volatility may result in pressure on the Government to switch back to a more conservative portfolio at a later date. A variation on the above individual situation which would likely occur at exactly the wrong time to make such a change in an equity allocation.

 

A more robust investment solution is required.

 

A possible Solution?

Perhaps the solution, and some may argue a more radical and materially different approach, is to introduce Target Date Funds as the Default Fund KiwiSaver solution.

Target Date Funds, also referred to as Glide Path Funds or Life Cycle Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement. Administratively it is more complex for the Providers, as many different Funds are required, as is a higher level of oversight.

Target Date Funds adjust the equity allocation on the premise that as we get older we cannot recover from financial disaster because we are unable to rebuild savings through salary and wages. These Funds follow a rule of thumb that as you get closer to retirement an investor should be moved into a more conservative investment strategy. This is a generalisation and does not take into consideration the individual circumstances of the investor nor market conditions.

Target Date Funds are becoming increasingly popular overseas e.g. the US and Australia. Particularly in situations where the Investor does not want or cannot afford investment advice. The “Product” adjusts the investor’s investment strategy throughout the Life Cycle for them, no advice is provided.

 

All good in theory, nevertheless, these products have some limitations in their design which is increasingly being highlighted.

Essentially, Target Date Funds have two main short comings:

  1. They are not customised to an individual’s circumstances e.g. they do not take into consideration future income requirements, likely endowments, level of income generated up to retirement, or risk profile.
    • They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
  2. Additionally, the equity allocation glide path does not take into account current market conditions.
    • Risky assets have historically shown mean reversion i.e. asset returns eventually return back toward the mean or average return
    • Therefore, linear glide paths, as employed by most Target Date Funds, do not exploit mean reversion in assets prices which may require:
      • Delays in pace of transitioning from risky assets (equities) to safer assets (cash and fixed income);
      • Stepping off the glide path given extreme market risk environments

The failure to not make revisions to asset allocations due to market conditions is inconsistent with academic prescriptions and common sense, both suggest that the optimal strategy should display an element of dependence on the current state of the economy.

The optimal Target Date Fund asset allocation should be goal based and multi-period:

    • It requires customisation by goals, of human capital, and risk preferences
    • Some mechanism to exploit the possibility of mean reversion within markets

 

To achieve this the Investment Solution requires a more Liability Driven Investment approach: Goals Based Investing.

Furthermore, central to improving investment outcomes, particularly most current Target Date Funds and eliminating the need for an annuity in the earlier years of retirement, is designing a more suitable investment solution in relation to the conservative allocation (e.g. cash and fixed income) within a Target Date Fund.

From this perspective, the conservative allocations within a Target Date Fund are risky when it comes to generating a secure and stable level of replacement income in retirement. These risks are not widely understood nor managed appropriately.

The conservative allocations within most Target Date Funds can be improved by matching future cashflow and income requirements. While also focusing on reducing the risk of inflation eroding the purchasing power of future income.

This requires moving away from current market based shorter term investment portfolios and implementing a more customised investment solution.

The investment approach to do this is readily available now and is based on the concept of Liability Driven Investing applied by Insurance companies, called Goal Based Investing for investment retirement solutions. #Goalbasedinvesting

 

Many of the overseas Target Date Funds address the shortcomings outlined above, including the management of the equities allocation over the life cycle subject to market conditions.

This is relevant to improving the likely outcome for many in retirement. This knowledge is helping make finance more useful again, in providing very real welfare benefits to society. #MakeFinanceUsefulAgain

 

As we know, holding high Cash holdings at retirement is risky, if not scandalous.

We need to be weary of rules of thumb, such as the level of equity allocation based on age and the 4% rule (which has been found to be insufficient in most markets globally).

We also need to be weary of what we wish for and instead should actively seek more robust investment solutions that focus on meeting Clients investment objectives.

 

This requires a Goals Based Investment approach and an investment solution that displays “flexicurity”. This is an investment solution that provides greater flexibility than an annuity and increased security in generating appropriate levels replacement income in retirement than many modern day investment products.

This is not a radical concept, as discussed above the investment frameworks, techniques, and approaches are currently available to achieve better investment outcomes for Default KiwiSaver investors.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

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.

One Year Anniversary

Kiwi Investor Blog is one year old.

My top three articles for the year would be:

Investment Fees and Investing like an Endowment – Part 2

Endowments and Sovereign wealth Funds lead the way in building robust investment portfolios in meeting a wide range of challenging investment objectives.   This Post covers this and amongst other things, what true diversification is, it is not having more and more asset classes, a robust portfolio is broadly diversified across different risks and returns. A lot can be learnt from how Endowments construct portfolios, take a long term view, and seek to match their client’s liability profile. Although fees are important, an overriding focus on fees may be detrimental to building a robust portfolio and in meeting client investment objectives.

 

A Robust Framework for generating Retirement Income

This Post builds on the Post above and looks at an investment framework for individuals, developed by EDHEC-Risk Institute and their Partners. It is a Goal Based Investment framework with a focus on capital value but also delivering a secure and stable level of replacement income in retirement.

 

The monkey paw of Target Date Funds (be careful what you wish for)

This Post emphasises the need to focus on generating a stable and secure level of replacement income in retirement as an investment goal and highlights the approach that is required to achieve this. Such an approach would greatly enhance the outcomes of Target Date Funds. This Post also references the thoughts of Professor Robert Merton around having a greater focus on generating replacement income in retirement as an investment objective and that volatility of replacement income is a better measure of investment risk, as it is more aligned with investment objectives, unlike the volatility of capital or standard deviation of returns.

 

Kiwi Investor blog has covered many topics over the year, including the value of active management, the shocking state of the investment management industry globally, Responsible Investing, the high cost of index funds and being out of the market.

Of these, recent research into the failure of the 4% rule in almost all markets worldwide is well worth highlighting.

 

Kiwi Investor Blog has a primary focus on topics associated with building more robust portfolios and investment solutions.

The Blog has highlighted the research of EDHEC-Risk Institute throughout the year. EDHEC draw on the concept of Flexicurity. This is the concept that individuals need both security and flexibility when approaching investment decisions. This is surely a desirable goal and the hallmark of a robust investment portfolio. The knowledge is available to achieve this and the framework and rationale is covered in the Posts above.

Flexicure is my word of 2018.

 

I don’t think the Uber moment has been reached in the investment management industry yet. Technology will be very important, but so too will be the underlying investment solution. The investment solution needs to be more tailored to an individual’s investment objectives.

As outlined in the Posts highlighted above, the framework for the investment solution has emerging and is developing.

It is a goal based investment solution, more closely tailored to an individual’s investment aspirations, so as to provide a more secure and stable level of replacement income in retirement.

 

Happy investing.

 

Please see my Disclosure Statement

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