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

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

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

 

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

 

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

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

A good estimate to this question can be determined.

 

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

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

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

 

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

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

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

 

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

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

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

 

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

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

How these Indices work is outlined below.

 

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

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

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

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

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

 

Happy investing.

Please see my Disclosure Statement

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

 

BlackRock CoRI

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

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

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

Estimations based on a range of ages can be undertaken.

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

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

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

Greater detail on the CoRi methodology is available here.

 

EDHEC-Princeton Goal-Based Investing Index Series

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

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

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

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

 

There are two Indices.

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

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

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

There are Retirement Wealth Indices as well.

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

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

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

 

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

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

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

 

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

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

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

 

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

 

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

 

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

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

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

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

 

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

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

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

 

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

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

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

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

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

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

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

 

Retirement Goal

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

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

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

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

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

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

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

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

 

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

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

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

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

 

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

 

The death of the Policy Portfolio

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

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

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

It is a single Portfolio solution.

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

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

 

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

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

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

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

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

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

 

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

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

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

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

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

 

Evolution of Wealth Management – the new Paradigm

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

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

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

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

 

Goal-Based Investing

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

As explained by EDHEC Risk Goal-Based Investing involves:

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

 

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

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

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

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

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

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

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

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

 

Industry Challenge

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

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

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

 

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

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

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

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

 

Conclusion

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

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

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

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

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

 

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

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

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Financial Climate Change – And the Risks are with You!

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

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

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

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

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

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

 

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

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

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

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

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

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

 

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

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

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

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

 

But wait, there is more!

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

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

The Second and Third Pillars are as follows.

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

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

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

As EDHEC highlight:

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

 

The Solution

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

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

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

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

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

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

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

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

 

Happy investing.

 

Please see my Disclosure Statement

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

 

 

One Year Anniversary

Kiwi Investor Blog is one year old.

My top three articles for the year would be:

Investment Fees and Investing like an Endowment – Part 2

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

 

A Robust Framework for generating Retirement Income

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

 

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

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

 

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

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

 

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

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

Flexicure is my word of 2018.

 

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

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

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

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Flexicurity in Retirement Income Solutions – making finance useful again

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.

 

 

 

Future trends in ETFs are rather daunting. Are you prepared?

The recent survey by EDHEC-Risk Institute (EDHEC) of European professional investors into their practices, perceptions and future plans for investing into Exchange Trade Funds (ETF) is of interest and well worth reading.

The survey gathered information from 163 European investment professionals. Respondents to the survey were high-ranking professionals within their respective organisations, representing firms with large assets under management (36% of respondents represent firms with assets under management exceeding €10bn). Respondents to the survey are from the United Kingdom, European Union, Switzerland, and a small sample from other countries outside the European Union.

 

What is the dominant purpose of ETF usage?

The survey results clearly indicate that the current usage of ETFs is dominated by a truly passive investment approach. “Despite the possibilities that ETFs offer – due to their liquidity – for implementing tactical changes, they are mainly used for long-term exposure.”

Gaining broad market exposure remains the main focus of ETF users – 71% of respondents use ETFs to gain broad market exposure, versus 45% who use ETFs to obtain specific sub-segment exposure (sector, style).

“In line with this expression of conservatism in their use of ETFs, which is mainly focused on traditional passive management, it can also be noted that investors are largely satisfied by ETFs in traditional asset classes but more reserved about ETFs for alternative asset classes”

 

What are the future growth drivers?

The European ETF market has seen tremendous growth over the past decade or so. At the end of December 2017, the assets under management (AUM) within the 1,610 ETFs constituting the European industry stood at $762bn, compared with 273 ETFs amounting to $94bn at the end of December 2006 (ETFGI, 2017).

“A remarkable finding from our survey is that a high percentage of investors (50%) still plan to increase their use of ETFs in the future, despite the already high maturity of this market and high current adoption rates.”

Why? lowering investment cost is the primary driver behind investors’ future adoption of ETFs for 86% of respondents in 2018 (which is an increase from 70% in 2014).

Interestingly, EDHEC find investors are not only planning to increase their ETF allocation to replace active managers (70% of respondents in 2018), but are also seeking to replace other passive investing products through ETFs (45% of respondents in 2018).

 

How do investors select ETFs?

Cost and quality of replication. Both of which are more easy to identify from a quantitative perspective.

EDHEC argue” Given that the key decision criteria are more product-specific and are actually “hard” measurable criteria, while “soft” criteria that may be more provider-specific have less importance, competition for offering the best products can be expected to remain strong in the ETF market. This implies that it will be difficult to build barriers of entry for existing providers unless they are related to hurdles associated with an ability to offer products with low cost and high replication quality.”

 

A section I found more interesting:

What are the Key Objectives Driving the Use of Smart Beta and Factor Investing Strategies?

EDHEC find that “the quest for outperformance is the main driver of interest in smart beta and factor investing. In fact, 73% of respondents agree that smart beta and factor investing indices offers significant potential for outperformance”

The most important motivation behind adopting such strategies is to improve performance.

Interestingly they find that the actual implementation of such strategies is still at an early stage

EDHEC found that among those respondents who have made investments in smart beta and factor investing strategies, these investments typically made up only a small fraction of portfolio holdings.

“More than four-fifths of respondents (83%) invest less than 20% of their total investments in smart beta and factor investing strategies and only 11% of respondents invest more than 40% of their total investments in smart beta and factor investing strategies”

As they say, ”It is perhaps surprising that almost a decade after the influential report on Norway’s Sovereign Wealth Fund (see Ang, Goetzmann and Schaefer, 2009), which emphasised the benefits of factor investing for investors, adoption of such an approach remains partial at best.

 

Not surprisingly, those that use factor strategies, the use of them is not related to factor timing and more to extracting the long term premia from the factors.

 

In relation to fixed interest, “17% of the whole sample of respondents already use smart beta and factor investing for fixed-income. Some 80% of this sub-sample of respondents invest less than 20% of their total investment in smart beta and factor investing for fixed-income.”

It appears that respondents show a significant interest for smart beta and factor investing for fixed-income. The interest appears to be there, but likelihood of implementation not so much.

Interestingly, from responses “it thus appears that investors are doubtful that research on factor investing in fixed-income is sufficiently mature at this stage. Given the strong interest in such strategies indicated by investors, furthering research in fixed-income factor investing is a promising venture for the industry.”

 

The survey looked into a number of other areas, for example do investors have the necessary information to evaluate smart beta and factor investing strategies? What requirements do investors have about smart beta and factor investing strategy factors?

 

Future Developments

What are investor expectations for further development of ETF products?

The following areas where identified as potential are of further ETF product development:

  • Ethical/Socially Responsible Investing (SRI) ETFs,
  • emerging market equity ETFs and emerging market bond ETFs,
  • ETF indices based on smart beta and on multi-factor indices, EDHEC note that more than two-fifths of the respondents want further developments in at least one of the categories related to smart beta equity or factor indices. “This shows that the development of ETFs based on advanced forms of equity indices is now by far the highest priority for respondents.”……… “We also note that additional demand for ETFs based on smart bond indices is not so far behind”…..

 

Fixed Income and Alternatives

The survey results indicate that respondents desire further development in the area of fixed income and alternative asset classes.

Also there is an increased interest in integration of ESG in smart beta and factor investing, and strategies in alternative asset classes.

“So, there is still a lack of products when it comes to asset classes other than equity, and this lack is particularly critical for the fixed-income asset class, which is largely used by investors.”… “It is likely that the development of new products corresponding to these demands may lead to an even wider adoption of smart beta and factor investing solutions.”

  

 

Happy investing.

 

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

 

Please see my Disclosure Statement

For those with a real focus on retirement income solutions

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)

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

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?

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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