Liability Driven Investing (LDI) New Zealand

Technology focus that will transform the Wealth Management Industry – Robo Advice alone won’t be enough

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The Professional Wealth Magazine (PWM) argues that Private Banks must take “goaled-based tech to heart”.

In their recent article they see technology assisting Wealth Managers in the following areas:

  1. Customer facing;
  2. Client relationship management; and
  3. Goals-Based wealth management Investment Solutions.

The first two are well known, the third, as PWM note, is flying under the radar. Combined they are the future of a successful wealth management business.

Quite obviously Robo Advice models use technology. Nevertheless, Goals-Based wealth management provides the opportunity for greater customisation and a more robust investment solution that better meets the needs of the customer.

Therefore, technology will play a major role in delivering more customised Investment Solutions to a wider range of people.

 

Technology is going to play a major role in the industry’s transformation.

As has been argued: “In order to be part of the fourth industrial revolution, the people-centric industry of wealth management must transform the production, customisation and distribution of retirement solutions, …..”

(See my first Kiwi Investor Blog Post, Advancements in Portfolio Management, for an article written by Lionel Martellini, of EDHEC Risk Institute, that appeared in the Journal of Investment Management in 2016: 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.)

 

The PWM article covered a recent symposium held in Paris focusing on fintech, quantitative management and big data, the technologically-led trends transforming the global industry.

The participants at the symposium gathered to consider: what should be the role of technology in client acquisition and servicing, data analysis, and portfolio management?

With regards to technology in general PWM note, “Private banks need to put technological solutions at the heart of their operations if they are to meet the demands raised by clients and relationship managers, though there will always be a need for human interaction”

However, having acknowledged that technology is critical for a successful Wealth Management business of the future, it appears to be a difficult issue to address. PWM “calculate that of the 150 global private banks we monitor closely for technological, business, customer-facing and portfolio management trends, less than one third have implemented a serious technological solution to the challenges encountered by their clients and relationship managers.”

“Many have only devised client-interfaces such as online forms, apps and screens allowing choices of services. But a handful have gone much further…….”

 

Under the radar

PWM noted that “…there is probably one technology-led sphere which is totally under-appreciated by the industry, which was highlighted at the summit. This is that of goals-driven wealth management (GDWM), ….”

 

Goals-Based investing is an improvement on the generic industry approach. Rather than viewing your investments as one single diversified portfolio, where the allocations are primarily based on your risk tolerance and the concept of risk is measured by volatility or standard deviation of returns, Goals-Based investing creates distinct milestones (goals) that are closely aligned with the priorities in your life.

Goals-Based investing closely matches your investment assets with your unique goals and objectives (customisation). It is the Wealth Management counterpart to Liability Driven Investing (LDI), which is implemented by pensions and insurance companies where their investment problems are reflected in the terms of their future liabilities (expected future insurance claims), much like a Wealth Management client’s future priorities (goals). LDI is also implemented by Pension Funds, particularly those with Defined Benefits, which are known future liabilities/cashflows.

Goals-Based Investing offers a more robust investment solution, provides a closer alignment of retirement goals and investment assets. It will also help investors avoid some common behavioural biases, such as regret and hindsight bias.

The benefits of Goals-Based Investing are a:

  1. More stable level of income in retirement;
  2. More efficient use of capital – potentially need less retirement savings;
  3. Better framework to make trade-off between allocations to equities and fixed income; and
  4. Improved likelihood of reaching desired standard of living in retirement.

In summary, a Goals-Based investment strategy increases the likelihood of reaching a customer’s retirement income objectives. It can also achieve this with a more efficient allocation of capital. This additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.

 

As the PWM article points out, technology is allowing “wealth managers to use institutional tools, helping clients to prepare for key life events….. Length of investment terms, risk tolerances, prices, taxes, depreciation levels can all be plugged into a model by relationship managers. Optimal asset allocations can then be arrived at and modified to plan for specific goals.“

“While few private banks currently approach this topic seriously, it surely must become the wealth management paradigm for the future. It will still require human wealth managers to advise clients and shepherd them through the process, but it will put an algorithmic system at the centre of the asset allocation decision. There is no substitute for this and it will most likely steal the very soul of wealth management.”

The Bold is mine, LDI is an institutional tool implemented to meet specific goals.

 

This is beyond a straight forward Robo Advice model and the filling out of a generic risk profile questionnaire. Technology is being applied to determine more customised investment solutions, taking into consideration a greater array of personal information and then implementing an investment solution using more advanced portfolio techniques, such as LDI.

 

The article covers other technology related issues in relation to wealth management, such as increasing competition from the likes of Google, Facebook, Alibabas and Tencents.

Importantly, PWM see room for a human element in all of this.

 

PWM conclude we are at the beginning of the industry’s “revolution”, technology will play a part in the success of the modern wealth manager and in capturing the next generation of investors:

“The battle for the hearts and minds of the next generation and for the soul of wealth management has yet to be fought and won. But the opening salvos have been fired.”

“Private banks have interesting weapons in their armouries. Some still need to be modernised for effectiveness. But at the moment, those that appear to be vital for future success appear to be GDWM (goals-driven wealth management) tools, networking apps and screens for impact and ethics.“

“The private bank of the future will manage, introduce and evaluate, as well as working closely with the next generation. These disciplines require a raft of technological systems and an army of relationship managers, not just to operate them, but to take the output which they deliver and use this to help build a long-term relationship with families of the future.”

Again bold is mine.

 

The future, according to PWM, is a raft of technology solutions with Goals-Based investing as the underlying investment solution.

The appropriate use of technology and the mass production of customised investment solutions will be the Uber moment for the Wealth Management industry. The technology and investment knowledge is available now.

The customisation of investment solutions involves a Goals-Based investment approach, based on the principles of LDI.

A winning outcome will be the combination of smart technology and the mass production of customised investment solutions that more directly meet the needs of the customer in achieving their 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

/ Kiwi Investor / 7 Comments

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

Best Portfolio Does Not Mean Optimal Portfolio

/ Kiwi Investor / 1 Comment

The best portfolio is not necessarily the optimal portfolio.

As this thought-provoking article by Joachim Klement, CFA, highlights, “In theory, the optimal portfolio is the best portfolio, but in reality, the optimal is often far from the best for any given investor. Or to recall a quote variously attributed to Albert Einstein, Yogi Berra, and Richard Feynman, among others: “In theory, there is no difference between theory and practice, while in practice there is.””

The article highlights the shortcomings of a portfolio optimisation approach. No surprises there!

Nevertheless, a key point made in the article is that many people in a Trustee or Fiduciary role see the portfolio optimisation process as a black-box exercise which is full of assumptions.

If true, this can be a challenge, particularly for those presenting the results and “the client never understands how these assumptions lead to the proposed allocation”.

I am sure this occurs to varying degrees and as a result there is a real risk that there is not a good understanding of the purpose of each investment allocation within the portfolio.

This often leads to the most pertinent point made in the article:

“But since clients do not grasp the purpose of each investment in the context of the overall portfolio, they are more likely to give up on the portfolio, or parts of it, in times of trouble. As a result, the best portfolio is not the optimal portfolio, but rather the one that the client can stick with through the market’s ups and downs. This means reframing the role of different asset classes or funds relative to the investor’s goals and sophistication rather than to volatility and return.”

 

Exactly. Reframing the role of the different asset classes can be achieved by taking the discussion away from the largely two-dimensional world of an optimal portfolio, market risk and return, and focusing instead on how the allocations will help meet a client’s investment goals over time.

Therefore, we can move beyond the Markowitz portfolio (the basis of Modern Portfolio and the “Optimal” Portfolio).  This is not to diminish the Markowitz optimal portfolio and the benefits of diversification, the closest thing to a free lunch in investing. Markowitz also placed a number on risk through the variance of returns.

Nevertheless, variance of return may not be an appropriate measure of risk. Other measures of volatility can be used, just as more sophisticated portfolio optimisation approaches can be implemented. Neither of which would address the key issues of the article as outlined above. In fact, they may compound the issues, particularly the black-box nature of the process.

Other measures of risk should be considered, the most important risk being failure to meet one’s investment objectives.

If your investment goal is to optimise risk and return the “optimal” portfolio is likely to be the “best” portfolio. Albeit, I am not sure this is the primary objective for most individuals and companies. For example, other investment objectives may include liquidity, income/cashflow generation, endowments. (I also don’t think the most optimal equities portfolio is the best portfolio, there are other risks to consider e.g. liquidity and concentration risk which would mean moving away from the optimal portfolio.)

There are personal and aspiration risks to take into consideration e.g. ability to weather large loses. There could be investment goals with different time periods – the optimal portfolio is generally for a single period, not multi-periods.

This is not to say don’t use an optimisation approach, it is a good starting point. Albeit, the portfolio allocation will likely need to be adjusted to take into consideration a wider set of investment objectives, risk tolerances, and behavioural factors. I would have thought this is standard practice.

 

Expanding the discussion with the client will help identify a more robust portfolio and increase the understanding of the role of each allocation within the Portfolio.

In effect, a more customising investment solution will be generated, rather than a mass-produced product.

As noted in the article, reframing the role of different asset classes within a portfolio relative to the investor’s goals and the sophistication of the client rather than to volatility and return will likely result in better outcomes for clients.

Such an approach is consistent with Liability Driven Investment (LDI), where the liabilities are matched with predictable cashflows and the excess capital is invested in a growth/return seeking portfolio, which would include the likes of equities.

Such an approach is also consistent with a Goal Based Investing approach for individuals.

It is also more consistent with a behavioural bias approach.

 

As the paper concludes:

“In my experience, such behavioral approaches to portfolio construction work much better in practice than black box “optimal portfolios.”

“Consultants, portfolio managers, and wealth managers who take their fiduciary duty seriously should seriously consider ditching their “optimal portfolios” in favor of these theoretically less optimal but practically more robust solutions.”

“Because you are not acting in the client’s best interest if you build them a portfolio that they won’t stick with over the long term.”

 

The above would resonate with most investment professionals I know, yet strangely it does not appear to be “conventional” wisdom. Perhaps ditch is to stronger a word, too provocative.

It would be hard to argue with implementing a more practical and robust solutions aligned with a wider set of investment objectives is not in the best interest of clients, particularly if they are able to stay with the investment strategy over the longer term.

 

Referenced in the article is the work undertaken by Ashvin Chhabra, Beyond Markowitz. This work is well worth reading. Essentially he frames the investor’s risks as being:

  • Personal Risk – e.g. the risk of not losing too much that would impact on life style, this supports the safety first type portfolio
  • Market Risk – e.g. risk within the investment
  • Aspirational risk – e.g. taking risks to achieve a higher standard of living

 

This would is a great framework for a Wealth Management / Financial Planning process. Of note, market risk is only one component.

Lastly, the concept of a single Optimal Portfolio is far from the likely solution under this framework.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

The Regret Proof Portfolio

/ Kiwi Investor / 9 Comments

Based on analysis involving the input of 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.

Insurance companies regularly implement a two-portfolio approach as part of their Liability Driven Investment (LDI) program: a liability matching portfolio and a return seeking portfolio.

It is also consistent with a Goal Based Investing approach for an individual: Goal-hedging portfolio and a performance seeking portfolio. #EDHEC

Although there is much more to it than outlined by the article below, I find it interesting the solution of two portfolios came from the angle of behavioural economics.

I also think it is an interesting concept given recent market volatility, but also for the longer-term.

 

Background Discussion

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

“The idea that we had was to develop what we called a ‘regret-proof policy,’” Kahneman explained. “Even when things go badly, they are not going to rush to change their mind or change and to start over,”.

According to Kahneman, the optimal allocation for someone that is prone to regret and the optimal allocation for somebody that is not prone to regret are “really not the same.”

In developing a “regret-proof policy” or “regret minimization” Portfolio allows advisors to bring up “things that people may not be thinking of, including the possibility of regret, including the possibility of them wanting to change their mind, which is a bad idea generally.”

 

In developing a regret proof portfolio, they asked people to imagine various scenarios, generally bad scenarios, and asked at what point do you want to bail out or change your mind.

Kahneman, noted that most people — even the very wealthy people — are extremely loss averse.

“There is a limit to how much money they’re willing to put at risk,” Kahneman said. “You ask, ‘How much fortune are you willing to lose?’ Quite frequently you get something on the order of 10%.”

 

Investment Solution

The investment solution is for people to “have two portfolios — one is the risky portfolio and one is a much safer portfolio,” Kahneman explained. The two portfolios are managed separately, and people get results on each of the portfolios separately.

“That was a way that we thought we could help people be comfortable with the amount of risk that they are taking,” he said.

In effect this places a barrier between the money that the client wants to protect and the money the client is willing to take risk on.

Kahneman added that one of the portfolios will always be doing better than market — either the safer one or the risky one.

“[That] gives some people sense of accomplishment there,” he said. “But mainly it’s this idea of using risk to the level you’re comfortable. That turns out to not be a lot, even for very wealthy people.”

 

I would note a few important points:

  1. The allocation between the safe and return seeking portfolio should not be determined by risk profile and age alone. By way of example, the allocation should be based primarily on investment goals and the client’s other assets/source of income.
  2. The allocation over time between the two portfolios should not be changed based on a naïve glide path.
  3. There is an ability to tactically allocate between the two portfolios. This should be done to take advantage of market conditions and within a framework of increasing the probability of meeting a Client’s investment objectives / goals.
  4. The “safer portfolio” should look more like an annuity. This means it should be invested along the lines that it will likely meet an individual’s cashflow / income replacement objectives in retirement e.g. a portfolio of cash is not a safe portfolio in the context of delivering sufficient replacement income in retirement.

 

Robust investment solutions, particularly those designed as retirement solutions need to display Flexicurity.   They need to provide security in generating sufficient replacement income in retirement and yet offer flexibility in meeting other investment objectives e.g. bequests.  They also need to be cost effective.

The concepts and approaches outlined above need to be considered and implemented in any modern-day investment solution that assists clients in achieving their investment goals.

Such consideration will assist in reducing the risk of clients adjusting their investment strategies at inappropriate times because of regret and the increased fear that comes with market volatility.

Being more goal focussed, rather than return focused, will help in getting investors through the ups and downs of market cycles. A two-portfolio investment approach may well assist in this regard as well.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

What matters for Retirement is Income not the value of Accumulated Wealth

/ Kiwi Investor / 11 Comments

This is the first of two Posts on why a greater focus should be placed on generating a level of income in retirement as an investment goal.

This Post outlines why income matters as an investment goal and the second Post covers why variability of retirement income is a better measure of risk rather than variability of capital.

A greater focus on income is different to the current industry approach, where accumulation of wealth has a higher priority. This is important of course. Yet a greater focus on generating income as an investment goal is not that radical. It is consistent with the age of the Defined Benefit investment solution. Therefore, it is not a new concept.

The rationale for the focus on income is provided below.

The inspiration and material for these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Nobel Prize winner Professor Robert Merton. The Podcast is 90 minutes in length, full of great conversation about retirement income, and well worth listening to.

 

During the Podcast discussion on why the focus should be on income and not accumulated wealth a definition of the standard of living in retirement needed to be determined.

From this perspective, Merton argues a standard of living in retirement is better defined as an amount of income, not a pot of money (accumulated wealth).

He argues the focus on income is consistent with what the Government provides you in retirement, a level of income. It is also much like a Defined Benefit where a level of income is provided and not a pot of money.

Also, the concept of income is easier to understand. You can see how rich I am with X amount of capital, but when converted to income that can be generated from that capital one can quickly see that the amount of capital may not be sufficient to support a desired standard of living in retirement. This is a key point.

Merton makes a strong case income is what matters in retirement and not how big your pot of money is.

As he says, people say, “If I have enough money, I’ll get the income. It will be fine.”

This may be true for the super wealthy but is not reality for many people facing the prospect of retirement.

Merton provides an example: twelve years ago in the US, if you had a million dollars you could generate $50k in interest, three years ago you could get a tenth of 1%, an income of $1k per million.

You’ve lost 98% of your income. As Merton says, what would you do if I lost 98% of your wealth!

The point being, knowing you had a million dollars did not tell you about a lifestyle that could be supported in retirement.

Merton is more direct with the following: “Let’s be clear the goal, the purpose for retirement. Not for the silly other things but for retirement is a stream of income sufficient to sustain a standard living and that standard of living is measured by income.”

“Just knowing the amount of money you have doesn’t tell you how you can live. That’s the message and we have to get that clear both so that savers and people in plans are trying to figure out how they’re doing. We need to tell them the amount they can buy as an indicator of how close to where they are.”

What Merton is saying here, is we should let people know what level of income can be generated from their pot of money. This provides a better measure and insight as to how they are placed for retirement.

Further to this point, volatility of accumulated wealth is not a good measure of how well we are doing.

More importantly, we should focus on the volatility of expected income in retirement, not current volatility of capital. This is covered in the next Post – What matters for retirement is income not the value of Accumulated Wealth – Focus on likely variability of Income not variability of Capital

For the time being: “What matters for retirement is income not the value of the pot of money” Merton.

The investment knowledge is currently available to design investment solutions that can better meet client’s income requirements in retirement to support the standard of living they wish to attain. It will result in the implementation of different investment strategies based in Liability Driven Investing (Goal Based Investing). A more Robust Retirement Income Solution is required.

The benefit being, there will be an increased likelihood that investment outcomes are more consistent with Client’s retirement objectives.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Is the 4% rule dead? – Approaches to Generating Retirement Income

/ Kiwi Investor / 6 Comments

The 4% rule of thumb equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.

Bill Bengen developed this rule in 1994.

There have been numerous other studies since and the rule has gained wide acceptance.

Essential to these studies is the expected returns from markets. By and large previous studies have been undertaken using US Equity market data.

Nevertheless, this raises several key questions: are returns from the US representative of other country’s expected equity market returns? and will the historical returns generated in the US be delivered in the future?

 

The 4% rule has been challenged in a recent article by Wade Pfau.

Pfau has expanded the research to include other developed nations (17 in total) and lengthening the analysis to 30 – 40 years.

Pfau concluded:

  • the 4% real withdrawal rule has simply not been safe;
  • even with perfect foresight, only 4 of 17 countries had a safe withdrawal rate above 4%; and
  • a 50/50 allocation to bonds and stocks had zero successes for the 17 countries.

 

At a minimum, investment outcomes can be improved from:

  • Increasing levels of portfolio diversification e.g. the use of alternatives;
  • A dynamic asset allocation approach that adjusts withdrawals to market conditions; and
  • An appropriate rebalancing strategy.

 

Pfau’s article is well worth reading, he concludes “It may be tempting to hope that asset returns in the twenty-first century United States will continue to be as spectacular as in the last century, but Bogle (2009) cautions his readers, “Please, please please: Don’t count on it” (page 60).”

 

The most insightful observation

In my mind the most important insight from Pfau’s study was that safety of generating retirement income does not come “from conservative asset allocations, and the findings from this figure suggest that from an international perspective, stock allocations of at least 50 percent during retirement should be given careful consideration.”

I say this given the sharp reduction in equities by many Target Date Funds and many Target Date Funds have limitations, see a recent post and another I posted earlier in the year.

 

More robust and innovative retirement solutions are required

We are living longer, and the concept of retirement is changing. New and more sophisticated investment solutions are required.

Thankfully the investment knowledge and approaches are available to provide a safer and sustainable level of retirement income.

These new strategies are based on Goal Based Investing, drawing on the insights of Liability Driven Investing (LDI) approaches employed by the likes of Insurance Companies and Defined Benefit plans.

The new generation of retirement investment solutions involve a more goal-based investment approach and something more akin Target Date Fund 2, which involves the adoption of a more sophisticated fixed interest solution.

 

EDHEC-Risk Institute

From this perspective I like the EDHEC-Risk Institute framework which places a greater emphasis on generating retirement income.

EDHEC argue investors should maintain two portfolios:

  1. Goal-hedging portfolio – this replicates future replacement income goals
  2. Performance-seeking portfolio – this portfolio seeks returns and is efficiently diversified across the different risk premia – disaggregation of investment returns

 

Over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting replacement income levels. There is no predetermined path. Investment decisions are made relative to increasing the probability of achieving a level of retirement income.

The Goal-hedging portfolio is a sophisticated fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities. Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit, they are made with the view to match future replacement requirements, matching of future cashflows. This is akin to what Insurance companies do to match their future liabilities (LDI).

The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge. It looks to address the shortcoming of many Target Date Funds.

 

The EDHEC framework is a more efficient framework than the rule of thumbs that reduce the growth allocations towards defensive/income, and the income component is invested into market replicating cash and fixed income portfolios.

Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the right goal, replacement income in retirement. The industry, by and large, has a too greater focus on accumulated wealth.

Accumulated wealth is important, but more importantly will it deliver the required replacement income in retirement.

 

In summary, the retirement investment solution needs to focus on generating a sufficient and stable stream of replacement income in retirement. This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI), much like an insurance company does in undertaking a liability driven investing approach. Focusing purely on an accumulated capital value and management of market risk alone like many of the current Target Date Funds may lead to insufficient replacement of income in retirement for some investors.

Lastly, and not least, a good advice model is vital and technology also has a big role to play in the successful implementation of these strategies.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Are Kiwi-saver investors too conservative?

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Fisher Funds recently released research suggesting those nearing retirement, and in retirement, should reduce their growth assets allocation more slowly than currently implemented in New Zealand (NZ) and that the NZ Funds Management industry should do more to help shake Kiwis out of their too conservative approach to investing.  As reported on Good Returns.

This is an interesting piece of research.  At the very least, credit where credit is due.

The NZ industry should be discussing these issues more broadly.

It is disappointing to see these discussions transcend into a debate over fees.  Fees are important.  So too is the appropriateness of the investment strategy being implemented.  And arguably, investment strategy is more important.  Investment strategy and fees can be debated independently.  Perhaps the comment by Fisher Funds, as reported by Good Returns, “too-conservative investment was a bigger concern than fees, which gets more attention”, was too much for some.

 

I’d imagine in some circumstances Fisher’s comment would be true, subject to the level of fees being paid and mismatch of investment strategy relative to a Client’s investment objectives.

And that is where I would like to jump in.  The focus on the growth / income split and rule of thumb of reducing the growth allocations with age is potentially misleading.

The investment strategy is obviously subject to the individual’s circumstances, including age, level of current income, other assets, risk appetite, risk tolerance, planned retirement age to name a few, but most important is required level of replacement income in retirement and any aspirational goals e.g. legacies.

Therefore, the investment strategy should focus not only on wealth accumulation but also the level of replacement income in retirement.

Many of the Life Cycle Funds based on cohorts of age and only managing market risk (through the reductions in growth assets) have a number of shortcomings.  e.g. many are not managing inflation risk and longevity risk.  Lastly, most Life Cycle Funds don’t make revisions to asset allocations due to market conditions, it is a naïve glide path.

More importantly, the vast majority of the Life Cycle Funds, particularly in Australasia, are not focusing on generating or hedging replacement income in retirement.

The New Zealand industry is behind global developments in this area, more robust approaches are being developed.

Globally the retirement income challenge is leading to new Goal Based Investing solutions.  Goal-based investing is the counterpart to Liability Driven Investing (LDI), which is used by pensions and insurance companies where their investment objectives are reflected in the terms of their future liabilities.  See my post A more Robust Retirement Income Solution

 

Arguably the main challenge facing retirees is to have a sufficient and stable stream of replacement income.

A good advice model recognises this issue.

 

The underlying investment solutions need to be more targeted in relations to investment objectives.  For example the “conservative” allocation (described by EDHEC-Risk as the Goal-hedging portfolio, see post above) is a fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities.  Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit.  Investment decisions are made with the view to match future income replacement requirements, matching of future cashflows and client liabilities.  This is akin to what Insurance companies do to match their future liabilities.

The investment strategy required to generate a stable stream of replacement income is much more sophisticated that a fixed interest laddered approach or investments into term deposits.  Particularly with retirement lasting for 20 – 25 years.  NZer’s are lucky, as they have had, at least historically, high real interest rates.

From this perspective, the Good Returns article noted that a Kiwi Fund providers Life Cycle Fund was invested 100% in Cash for those over 65, if this is true, this is a very risky investment solution for someone in retirement.  Let’s hope they are getting the appropriate level of  investment advice.

 

Of course this leads into the fee debate.  We all know a robust portfolio is broadly diversified across different risks and returns.   Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes.  True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta, smart beta, alternative and hedge fund risk premia.  And of course, true alpha from active management, returns that cannot be explained by the return sources outlined above.  There has been a disaggregation of returns.

Not all of these risk exposures can be accessed cheaply.

 

I’ll say it again, fees paid are important.  Nevertheless, the race to be the lowest cost provider may not be in the best interest of clients from the perspective of meeting their unique investment objectives.  Sophisticated investors such as endowments, insurance companies, pension funds, and Sovereign Wealth Funds, are taking a different perspective.  Albeit, their approach is not inconsistent with fees being an important “consideration” that should be managed, and managed appropriately.  They likely manage to a fee “budget”, as they manage to a risk budget.

 

A balanced and appropriate approach is required, with the focus always on achieving the investment objective.

 

So are Kiwi Saver investors invested too conservatively?  Quite likely.  Is the solution to have higher equity allocations? Not necessarily.

The answer is to have more goal orientated investment solutions with a focus on managing the biggest investment risk, failure to meet your investment objectives.  To achieve this, may require a higher level of fees than the lowest cost “products” in the market.  Lastly, the goal is not about beating markets, it’s about meeting investment objectives.  Risk is not solely measured by the level of equities you have in a portfolio.  Risk is the probability of meeting your investment objectives.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

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A Robust Framework for generating Retirement Income

/ Kiwi Investor / 25 Comments

How much Income do you need in Retirement?

The focus is often on accumulated wealth e.g. how much do you need to save to retire on?

This could potentially result in the wrong focus.  For example if a New Zealander retired in 2008 with a million dollars, their annual income would have been around $80k by investing in retail term deposits, furthermore their income would have dramatically dropped in 2009.  Current income on a million dollars would be approximately $35k.  That’s a big drop in income!  This also does not take into account the erosion of buying power from inflation. [Note: this Post was written in 2018, the current income on $1m in February 2021 is less than $10k.]

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

The wrong focus on wealth accumulation can potentially lead to yield chasing in retirement which leads to unintended risks within investment portfolios.

More robust approaches are being developed

The global retirement challenge is leading to new Goal Based Investing solutions.  Goal-based investing is the counterpart to Liability Driven Investing (LDI), which is used by pensions and insurance companies where their investment objectives are reflected in the terms of their future liabilities.

Arguably the main challenge facing retirees is to have a sufficient and stable stream of replacement income.

An innovative, rigorous, and robust investment framework for solving the retirement challenge is being developed by EDHEC, along with the Operations Research and Financial Engineering Department at Princeton University, and supported by Merrill Lynch.

The framework being developed has some practical applications.  The EDHEC-Princeton Framework:

Defines the Retirement goal

The goal for retirement can be split between wealth and replacement income.

Those planning for retirement seek to secure essential (sufficient income) and aspirational goals (additional wealth accumulation) with high probabilities.

Different Risk Focus

The retirement framework results in a different focus on risk.

Instead of worrying about fluctuations in capital, investors investing for retirement should worry about fluctuations in potential income in retirement.

With regards to capital specifically, the focus should be on avoiding permanent loss of capital, rather than fluctuations in capital.

Therefore, the real risk is about not achieving the investment goal.  Risk is not fluctuations of returns or underperforming a market index, but instead the true investment risk is failure to achieve investment goals.  This is how investment outcomes should be measured and reported against.

Investment Management Attributes

With the EDHEC-Princeton framework the following portfolio management processes can be adjusted to increase the probability of meeting the investment goals:

  1. Hedging – this is the least risky portfolio that matches future income requirements
  2. Diversification – this is the most efficient way to achieve returns relative to goals
  3. Insurance – this is a dynamic interplay between hedging and return seeking portfolio in the context of what is the worst case scenario in pursuing the investment goals. The trade-off is between downside protection and upside participation.  The measure of risk is underachieving the investment goals.

From this framework, EDHEC argue investors should maintain two portfolios:

  1. Goal-hedging portfolio – this replicates future replacement income goals
  2. Performance-seeking portfolio – this portfolio seeks returns and is efficiently diversified across the different risk premia – disaggregation of investment returns

Over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting replacement income levels.

The Goal-hedging portfolio is a sophisticated fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities.  Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit, they are made with the view to match future replacement income requirements, matching of future cashflows.  This is akin to what Insurance companies do to match their future liabilities.

EDHEC-Princeton Retirement Goal-Based Investing Indices

To reflect this retirement investment solution framework EDHEC and Princeton University have developed the EDHEC-Princeton Retirement Goal-Based Investing Indices.

The EDHEC-Princeton Retirement Goal-Based Investing Indices represents the value of a dynamic strategy that aims to offer high probabilities of reaching attractive levels of replacement income for 20 years in retirement while securing, on an annual basis, 80% of the purchasing power in terms of retirement income of each dollar invested.

This is the strategy of investing into a goal-hedging portfolio, that delivers stable replacement income in retirement, and the performance-seeking portfolio, which offer the upside potential needed to reach higher income levels with high probabilities, as outlined above

It will be really interesting to follow how these indices perform.

The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge.  There are a some investment solutions currently available in the Target Date/Life Cycle options that are aligned with the above investment approach, as there are many that don’t.

These solutions are better than many of the Target Date Funds that have a number of short comings.

The EDHEC framework is a more efficient framework than the rule of thumbs that reduce the growth allocations towards defensive/income and where the income component is invested into market replicating cash and fixed income portfolios.

Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the right goal, replacement income in retirement.

In summary, the retirement investment solution needs to focus on generating a sufficient and stable stream of replacement income.  This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI), much like an insurance company does in undertaking a liability driven investing approach.  Focusing purely on an accumulated capital value and management of market risk alone may lead to insufficient replacement income in retirement, or inefficient trade-offs are made prior to and in retirement.

Importantly the investment management focus is not on beating a market index, arguing about fees (albeit they are important), the focus is on how the Investment Solution is tracking relative to the retirement goals.

Happy investing.

Please see my Disclosure Statement

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

Investment Fees and Investing like an Endowment – Part 2

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We all know a robust portfolio is broadly diversified across different risks and returns.

Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes.  This has diminishing diversification benefits e.g. adding global listed property or infrastructure to a multi-asset portfolio that includes global equities.

Why? True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, inflation, economic growth, low volatility, value, and growth.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta, smart beta, alternative and hedge fund risk premia.  And of course, true alpha from active management, returns that cannot be explained by the risk exposures outlined above.  There has been a disaggregation of returns.

Not all of these risk exposures can be accessed cheaply.

 

The US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification, along with the heavy investment into alternative investments and factor exposures.  They are a model of world best investment management practice.

Unlisted infrastructure, unlisted real estate, hedged funds, and private equity are amongst the favoured alternatives by Endowments, Sovereign Wealth Funds, and Superannuation Funds.

As reported by the New York Times recently “Yale continues to diversify its holdings into hedge funds, where it has 25 percent of its assets, and venture capital, with a 17 percent stake, in addition to foreign equity, leveraged buyouts and real estate, as well as some bonds and cash. That diversification strategy, which Mr. Swensen pioneered, is widely followed by larger institutions.”

Yale has approximately 20% allocated to listed equities, domestic and foreign combined, and seeks to allocate approximately one-half of the portfolio to the illiquid asset classes of leveraged buyouts, venture capital, real estate, and natural resources.

 

The Yale Endowment recently released its annual report which gained some publicity.

The following quote received a lot of press:  “In advocating the adoption of a passive indexing strategy, Buffett provides sound investment advice for the vast majority of individuals and institutions that are unable (or unwilling) to commit the resources (human and financial) necessary for active management success. Yet, Buffett’s advice is not appropriate for the cohort of endowments that possess the capabilities to pursue successful active management programs.”

The Yale report was published not long after the Buffet Bet concluded.

Buffet’s investment advice was highlighted further this week surrounding publicity of the Berkshire Hathaway Annual meeting.

 

At the centre of this exchange is investment management fees.

Don’t get me wrong, fees are important.  Yet smart investors are managing fees as part of a multi-dimensional investment puzzle that needs to be solved in meeting client investment objectives.  Other parts of the puzzle may include for example liquidity risk, risk appetite, risk tolerance, cashflow requirements, investing responsibly, and client future liabilities, to name a few.

This is more pressing currently, these issues need to be considered in light of the current market conditions of an aging US equity bull market and historically low interest rates and the growing array of different investment solutions that could potential play a part in a robust investment portfolio.

The debate on fees often misses the growing complexities faced in meeting specific investment objectives.  The debate becomes commoditised.  The true risk of investing, failure to meet your investment objectives, often gets pushed into the background.

 

The importance of this? EDHEC recently highlighted many of the current retirement products do not adequately address the true retirement savings goal – replacement income in retirement.

This is not addressed by many of the target date / life cycle funds, nor is it the role of the accumulation 60/40 (equities/bonds) Fund of your standard superannuation fund.  Life cycle funds predominately manage market risk, there are other risks that need to be managed, some of which are outlined above, replacement income in retirement should also be added.

As EDHEC further highlighted, this is a serious issue for the industry, and more so considering the world’s pension systems are under enormous stress due to underfunding and a rising demographic imbalance with an aging population.  Furthermore, globally, there has been a shift of managing retirement risk to the individual i.e. the move away from Defined Benefit to Defined Contribution.

 

As a result, a greater focus is needed on investment solutions in replacing income needs in retirement.  This requires a greater awareness and matching of people’s retirement liabilities, a Goal Based Investment solution (Liability Driven Investing).

The management of client liabilities, and the design of the customised investment solutions needs to be implemented prior to retirement.  As many are currently discovering, a portfolio of cash and fixed interest securities, no matter how cheaply it is provided, is not meeting retirement income needs.

The debate needs to move on from fees to the appropriateness of the investment solutions in meeting an individual’s retirement needs.

The advice model is critical.

This is a big challenge, and I’ll blog more on this over time.

 

I’ll say it again, fees paid are important.  Nevertheless, the race to be the lowest cost provider may not be in the best interest of clients from the perspective of meeting client investment objectives.  The focus and design of “products” is primarily on accumulated value, a greater focus is required on replacement income in retirement.

Sophisticated investors such as endowments, insurance companies, pension funds, and Sovereign Wealth Funds, are taking a different perspective to the commoditised retail market.  Albeit, their approach is not inconsistent with fees being an important “consideration” that should be managed, and managed appropriately.  They likely manage to a fee “budget”, as they manage to a risk budget.

 

It is very critical that the Endowments get it right.  Endowments are a crucial component of university budgets. During the global financial crisis of 2008 many endowments had to significantly cut back their spending due to the falling value of their Endowment Funds.  It is estimated that distributions from the Yale endowment to the operating budget of the University have increased at an annualized rate of 9.2 percent over the past 20 years.  The Endowment Fund is the university’s largest source of revenue.  The Fund is expected to contribute $1.3 billion to the University this year, this is equal to approximately 34% of the Yale’s operating budget.

Much can be learned from how endowments construct portfolios, take a long term view, and seek to match their client’s liability profile.  An overriding focus on fees will lead away from investing successfully in a similar fashion.

 

The endowment approach can be applied to an individual’s circumstances, particularly high net worth individuals.  The more complex the situation, the better, and the more value that can be added.

There will be a growing demand for more tailored investment solutions.

EDHEC argue an industrial revolution is about to take place in money management, this will involve a shift from investment products to investment solutions “While mass production has happened a long time ago in investment management through the introduction of mutual funds and more recently exchange traded funds, a new industrial revolution is currently under way, which involves mass customization, a production and distribution technique that will allow individual investors to gain access to scalable and cost-efficient forms of goal-based investing solutions.”

 

For the record, as reported by the Institutional Investor: For the 20-year period ending June 30, Yale’s endowment earned a 12.1 percent annualized return, beating its benchmark Wilshire 5000 stock index, which gained 7.5 percent. A passive portfolio with a 60 percent stock allocation and 40 percent in bonds, meanwhile, had a 20-year return of 6.9 percent.

 

Lastly, I am a very big fan of Buffet, and one should read the two books by the two key people who have reportedly had a big influence on him, number one is obvious, Benjamin Graham’s The Intelligence Investor, and the other Philip A Fisher, Common Stocks and Uncommon Profits.  I preferred the later to the former.

It is also well worth reading David Swensen’s book: Pioneering Portfolio Management. Yale has generated the highest returns among its peers over the last 20 years.

 

Build robust investment portfolios.  As Warren Buffet has said: “Predicting rain doesn’t count.  Building arks does.”

Invest for the long-term.

Happy investing.

 

Please see my Disclosure Statement

 

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Goal Based Investing – Retirement Solutions

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Goal based investing

 

EDHEC-Risk Institute, along with the Princeton Operations Research and Financial Engineering Department, are in the process of developing new indices to address the key problems in retirement:

  1. Level of replacement income in retirement
  2. Performance of investment strategy invested in a goal-hedging portfolio and performance seeking portfolio

These indices are based on the application of goal-based investing principles to help solve the key retirement problems.

 

EDHEC has undertaken this initiative because they argue “existing retirement products do not fit with an individual’s actual retirement needs and could be improved by applying Goal-Based Investing principles.”

I agree.  There is much work and improvement to be undertaken in this area.

This EDHEC work goes to the heart of my first post around Advancements in Portfolio Management, Mass Customisation 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, and Liability Driven Investing.

 

It is well worth keeping an eye on the EDHEC develops in this area and I hope to make this a continued focus of future blogs.

 

Happy Investing.

 

Please see my Disclosure Statement