Target Date Funds

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

/ Kiwi Investor / 2 Comments

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.

 

Target Date Fund’s popularity set to Grow

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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.

Financial Climate Change – And the Risks are with You!

/ Kiwi Investor / 6 Comments

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

/ 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

One Year Anniversary

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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.

 

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.

 

Flexicurity in Retirement Income Solutions – making finance useful again

/ Kiwi Investor / 9 Comments

Flexicurity is the concept that individuals need both security and flexibility when approaching retirement investment decisions.  See EDHEC-Risk Institute.

 

Annuities, although providing security, can be costly, they represent an irreversible investment decision, and often cannot contribute to inheritance and endowment objectives. Also, Annuities do not provide any upside potential.

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.  In short, as outlined by EDHEC-Risk, modern day Target Date Funds “provide flexibility but no security because of their lack of focus on generating minimum levels of 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 do.

 

EDHEC offers a number enhancements to improve the outcomes of current investment products.

 

One such approach, and central to improving investment outcomes for the current generic Target Date Funds (TDF), is designing a more suitable investment solution in relation to the conservative allocation (e.g. cash and fixed income) within a TDF.  Such an enhancement would also eliminate the need for an annuity in the earlier years of retirement.

 

From this perspective, the conservative allocations within a TDF 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 with a TDF can be improved by being employed to better 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

The techniques and approaches are available and should be more readily used in developing a second generation of TDF (which can be accessed in some jurisdictions already).

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

 

For a better understanding of current crisis of global pension industry and introduction to Flexicure see this short EDHEC video and their very accessible research paper introducing_flexicure_gbi_retirement_solutions_1.

 

This is my last Post of the year.

Flexicure, is my word of the year! Hopefully, we will hear this being used further in relation to more Robust Investment Portfolios, particularly those promoted as Retirement Solutions.

As you know, my blog this year has had a heavy focus on retirement solutions and has drawn upon the analysis and framework of EDHEC-Risk Institute.

In addition, the thoughts of Professor Robert Merton have been important, particularly around placing a greater emphasis on replacement income in retirement as an investment objective and that volatility of replacement income is a better measure for investment risk for those investing for retirement.

I have also noted the limitation of Target Date Funds and how these can be improved e.g. with the introduction of Alternatives.

Nevertheless, the greatest enhancement would come from implementing a more targeted cashflow and income matching portfolio within the conservative allocations as discussed above.

 

Wishing you all the best for the festive season and a prosperous New Year.

 

 

Happy investing.

 

#MakeFinanceUsefulAgain

#flexicure

#goalbasedinvesting

 

Please see my Disclosure Statement

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

 

 

 

For those with a real focus on retirement income solutions

/ Kiwi Investor / 1 Comment

Great to see EDHEC pick up on my recent post on Target Date Funds (Life Cycle Funds).  Monkey Claw – be careful what you wish for.

I have considerable appreciation for EDHEC’s approach to applying goal-based investing principles to the retirement problem.  This makes a lot of sense given my insurance (liability backing) investing background.

Their focus on the need for more robust retirement solutions based on Goal Based Investing is so critical.

 

EDHEC’s and the thoughts of Professor Robert Merton, as outlined in my previous Posts of focusing on income and the volatility of income, are important concepts that will have an immediate and lasting contribution and impact on the ongoing shape of retirement solutions.

As EDHEC outlines, we need investment solutions that provide the certainty of Annuities but with more flexibility.  This is the industry challenge.  

 

EDHEC’s and Merton’s work, analysis, and insights have an important and fundamental contribution to the building of more robust retirement solutions that should be considered by anyone working in this area.

 

Happy investing.

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

 

Please see my Disclosure Statement

 

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

/ Kiwi Investor / 6 Comments

I have written previously about the short comings of Target Date Funds (TDF). They would certainly benefit from the inclusion of Alternative investment strategies.

Nevertheless, this is not to dismiss them. TDF have some notable advantages e.g. they have an inbuilt advice model. TDF automatically de-risk the portfolio with the age of the investor by down weighting the equity allocation and increasing the allocation to cash and fixed interest. This is attractive to those who are unable to afford investment advice or are not interested in seeking investment advice.

Nevertheless, it is important to understand their short comings 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.”

Locally, TDF have also been raised as a possible addition to the KiwiSaver landscape as a Default Fund option. They are very much part of the investment landscape in Australia.

 

In my mind TDF don’t address the inherit weaknesses of current investment products that overly simplify the retirement investment solution by focusing on:

  • Accumulated wealth as the primary goal; and a
  • Formulaic (prescribed) approach of adjusting allocations to equities over the period up to retirement based on age.

 

TDF may not be the investment solution that addresses key retirement issues, just as Annuities are also not the solution.   Arguably, TDF don’t have an investment objective.

A more goal orientated investment approach is required.

Improvements in the investment solution and a more robust portfolio can be developed by engaging in a more goal orientated investment approach that:

  • Has a focus on the generation of retirement income as an investment goal; and
  • Employs a more sophisticated cash and fixed interest solution that generates a more stable level of retirement income (much like insurance companies employ to meet future liabilities (insurance claims).

 

The investment knowledge is available now to implement these investment solution enhancements.

This new approach will bring more rigor to the investment strategy and a move away from rules of thumbs such as the 4% Rule and adjusting the equity allocation based on age alone.

 

At the centre of a more robust approach is the focussing on the generation of retirement income.

Accumulated wealth is important, you can say you are rich with a million-dollar investment portfolio.

However, this million-dollars does not tell you the standard of living you may be able to support in retirement. Some may well say a very good one! And that may well depend on whether you live in Auckland or Gore.

How about the volatility of income in retirement?

By way of example, prior to the Global Financial Crisis (GFC) a New Zealand investor could get 7-8% on cash at the bank, lets say $70k in income on your million dollar investment.

Current term deposit rates are around 3.5%, that’s a 50% fall in income!! And interest rates have been at these levels for some time and if the Reserve Bank of New Zealand is right they will continue to remain at these levels for some time.

 

Of course, these issues are not the concern of the ultra-wealthy. They are nevertheless vitally important for the less wealthy. They could have a detrimental impact on the standard of living in retirement for many people.

Furthermore, with an income focus, as interest rates rise (they will some day!) more informed investment decisions can be made and importantly investment strategies can be undertaken to help minimise the volatility of income in retirement.

 

Therefore, we should not just focus on the generation of retirement income as the investment goal but also consider how we can manage the volatility of income in retirement. As I say, the knowledge to do this is already available.

 

I have recently written a Post on why focus on Income and one on why focus on the volatility of Income.

 

This FT article on the short comings of TDF may be of interest.

 

The article highlights the risk to the industry.

 

The following section of the FT article is most relevant to the discussion above:

…….. “This underscores the importance of crafting investment products that generate sustained income for retirees, says Lionel Martellini, a professor at Edhec currently seconded to Princeton.

Prof Martellini says the key shortcoming with target date funds the group has identified is the fact that the bond allocation, intended to be the safe portion of the portfolio, is often risky. This risk hinges on the fact that bond portfolios offer — but do not guarantee — income, according to the researchers.

The fixed income allocation should look more like an annuity, Prof Martellini says, a financial product that pays a steady stream of income to the holder. But it must avoid the pitfalls of annuities, namely a lack of flexibility that means they cannot be passed on to a next of kin, for example.

“That’s what we’re talking about — a bond portfolio that is a good proxy for the cash flow that people need. Such a simple move will add a large benefit to how much replacement income you can generate,” Prof Martellini says. Critics say target date funds fail to achieve this because their fixed income portfolios are composed of short-term bonds that are beholden to market risks and do not take into account retirees’ different income expectations.” ………………..

 

The final comments are consistent with the point made above with having a more sophisticated cash and fixed interest investment solution.

 

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