Goal Based Investing

Generating stable and sustainable investment income

/ Kiwi Investor / 1 Comment

I would like to share this blog post by AMP Capital New Zealand, Four pillars for generating income | AMP Capital, which looks at the four main pillars of an investment framework to deliver a stable and sustainable level of income over time.

The Post challenges some of the conventional wisdoms underpinning the management of traditional portfolios.

The basis of the framework is a goal orientated investment approach.

For those wishing to understand more around Goal Based Investing, this Wikipedia page, which I have contributed to, Goal-based investing may be of interest. The Wikipedia page includes:

  • A description of Goal Based Investing (GBI)
  • A comparison of GBI to traditional portfolio theory
  • History and development of GBI
  • GBI in principle
  • GBI for the retirement problem

Pease read my Disclosure Statement

 

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

Investment Framework for a Rising Interest Rates Environment

/ Kiwi Investor / Leave a comment

Amongst the strategies to employ for the current interest rate environment is a Liability Driven Investment (LDI) approach. 

LDI provides a framework for managing retirement income outcomes in what is likely to be a rising interest rate environment over the years ahead. 

LDI places retirement planning goals at the centre of the investment approach leading to several key benefits:

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

Under LDI a more customised investment solution can be developed.

Conversely, if an investor runs with a Cash strategy, where the goal is primarily capital preservation, they will likely need additional precautionary savings to meet their income requirements over retirement.

Therefore, while an LDI strategy increases the likelihood of reaching the retirement income objectives, it also achieves this with a more efficient allocation of investment capital.

The additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.

Accordingly, LDI potentially provides a better framework in which to evaluate the risk of meeting your retirement income goals in a rising interest rate environment.

Retirement Planning (mis) focus

Arguably the primary goal of retirement planning is to provide a stable and secure stream of income in retirement – income to support a desired standard of living in retirement.

However, retirement planning investment approaches often focus too heavily on accumulated wealth e.g. how much do I need to save to retire on?

This could potentially result in the wrong focus.  For example, if a New Zealander retired in 2008 with a million dollars, their annual income would have been around $80k by investing in retail term deposits.  Their income would have dramatically dropped in 2009 to approximately $35k.  That is a big drop in income!  But interest rates have fallen further, currently (Feb 2021) a million dollars invested in New Zealand Term deposits will generate around $10k.

As a result, the focus should not necessarily be on the size of the account value e.g. KiwiSaver account balance.

This reflects that volatility of capital and investment returns are not a true measure of a retiree’s investment risk.

Investment strategies that focus on capital preservation, such as holding high levels of cash and short-term fixed income strategies, are riskier and more volatile relative to the investment goal of generating a stable and secure stream of income in retirement.

Redefining the Retirement Goal

Those planning for retirement seek to secure essential (sufficient income) and aspirational goals (additional wealth accumulation) with a high probability of achieving them.

Accordingly, the goal for retirement can be split between retirement income (essential goals) and wealth accumulation (aspirational goals). 

Those saving for retirement should be focusing on more than accumulated wealth alone. Other key considerations may include a desired level of retirement spending, meeting children’s education costs, healthcare costs, and a legacy.  These can be considered as future liabilities that need to be met.

Consequently, a better measure of a retiree’s investment risk becomes uncertainty around how much spending can be sustained in retirement.

Liability Driven Investing

Liability-driven investment (LDI) strategies, otherwise known as asset-liability management (ALM), take a complete and holistic approach.

LDI explicitly includes an investor’s current and future liabilities e.g., essential and aspirational goals.

The traditional way of building portfolios focusses more on risk tolerance, return expectations, and accumulated wealth rather than achieving the investment goals outlined above.

LDI creates better portfolios, particularly when it comes to retirement needs.  A more robust portfolio is generated, and the focus is on the key investment risk; failure to meet your investment objectives.

Obviously most financial planning processes take into consideration investment and retirement goals. Nevertheless, LDI makes retirement goals the central piece of constructing a portfolio. With LDI, portfolio allocations and management of risks are relative to meeting retirement objectives.

A more customised investment solution is developed.

See here for more on LDI.

The Benefits of LDI

Dimensional Funds Advisors (DFA) undertook analysis comparing two investment strategies relative to the goal of generating a stable and secure level of income in retirement:

  1. Goals based strategy that looks to generate sufficient income in retirement to match expected spending (consumption). This is the LDI strategy.
  2. Capital preservation strategy that is invested in Cash to manage the volatility of the account balance.

The following conclusions can be drawn from the DFA analysis:

  • The LDI strategy provides a more stable stream of income in retirement;
  • The LDI strategy provides greater clarity and confidence to plan for retirement; and
  • The Cash strategy results in a high level of volatility relative to the goal of generating a stable level of income in retirement.

See here for a detailed review of the DFA Research. 

In simple terms, the LDI strategy is a long-term bond portfolio that matches the expected retirement spending/consumption goal. Effectively, the LDI strategy generates cashflows to match future expected spending.

This reduces volatility relative to retirement spending goals.

Insurance Company’s implement a similar approach in meeting (paying out) future expected liabilities (insurance claims).

DFA conclude that “any strategy that attempts to reduce volatility using short- to intermediate-term fixed income, when the goal is a long-term liability like retirement consumption, will not be as effective as the LDI strategy.”

Although cash is perceived as low risk, it is not low risk when it comes to generating a steady and secure stream of income in retirement. Likewise, short term fixed income securities, while appropriate for capital preservation, are risky if the goal is to meet future spending/consumption in retirement.

In summary a LDI strategy provides the following benefits:

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

If an investor runs with a Cash strategy, where the goal is primarily capital preservation, they will likely need additional precautionary savings to meet their retirement income requirements.

Therefore, while an LDI strategy increases the likelihood of reaching the retirement income objectives, it also achieves this with a more efficient allocation of capital.

This additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.

Accordingly, LDI potentially provides a better framework in which to assess the risk of meeting your retirement income goals in a rising interest rate environment.

LDI Investment Framework for Individuals

Under the LDI model there are two portfolios: the liability portfolio and a return seeking portfolio. Most investment products offered today are return seeking portfolios with some dampening down of risk (measured by volatility of returns).

LDI is used by pension funds and insurance companies where their investment objectives and portfolios are primarily reflected in the terms of their future liabilities.

“Institutional” investment approaches such as LDI, Two-portfolio separation, and being more dynamic, are finding their way into wealth management solutions.

Goals-Based Investing is the wealth management counterpart to LDI. By way of example is EDHEC Risk Institute Goal-Based Investing Approach.

EDHEC suggest investors should maintain two portfolios:

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

And, over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting retirement income levels.

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

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

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

See here for more on the EDHEC Goals Based Investment approach.

Please read my Disclosure Statement

 

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

Coronavirus – Financial Planning Challenges

/ Kiwi Investor / Leave a comment

For those near retirement this year’s global pandemic has thrown up new challenges for them and their Financial Advisor.

Early retirement due to losing a job, the running down of emergency funds, and a low interest rate environment are new challenges facing those about to retire.

Events this year are likely to have significant repercussions for how individuals conduct their financial planning.  Specifically, how they approach spending and saving goals.

The pandemic will likely have lasting implications for how people think about creating their financial and investment plans, and therefore raises new challenges for the Advisors who assist them.

These are the key issues and conclusions outlined by Christine Benz, director of personal finance for Morningstar, in her article, What the Coronavirus Means for the Future of Financial Planning.

In relation to the key issues identified above, Benz writes “All of these trends have implications for the way households—and the advisors who assist them—manage their finances. While the COVID-19 crisis has brought these topics to the forefront, their importance is likely to persist post-pandemic as well.”

Although the article is US centric, there are some key learnings, which are covered below.

How the Pandemic Has Impacted Financial Planning for Emergencies

The Pandemic has highlighted the importance of emergency funds as part of a sound financial plan and the difficulties that many individuals and households face in amassing these “rainy-day funds.”

Lower income families are more at-risk during times of financial emergencies.  Research in the US found that only 23% of lower-income households had emergency funds sufficient to see them through three months of unemployment.  This rises to 52% for middle income households.

It is advisable to have emergency funds outside of super.

The Morningstar article highlights “Withdrawing from retirement accounts is suboptimal because those withdrawn funds can’t benefit from market appreciation—imagine, for example, the worker who liquidated stocks from a retirement account in late March 2020, only to miss the subsequent recovery.”

An emergency fund helps boost peace of mind and provides a buffer and the confidence to maintain longer-term retirement goals.

Financial Advisors can assist clients in setting saving goals to amass an emergency fund, which is specific to their employment situation, and how best to invest these funds so they are there for a rainy day.

From an industry and Policymaker perspective, and reflecting many households struggle to accumulate emergency reserves, Morningstar raised the prospect of “sidecar” funds as potentially part of the solution.

Sidecars “would be for employees to contribute aftertax dollars automatically to an emergency fund. Once cash builds up to the employee’s own target, he could direct future pretax contributions to long-term retirement savings. Automating these contributions through payroll deductions may make it easier for individuals to save than when they’re saving on a purely discretionary basis.”

The concept of sidecar funds has recently been discussed in New Zealand.

Financial Planning for Early Retirement

The prospect of premature retirement will pose an urgent challenge for some clients. 

Although those newly unemployed will consider looking for a new job some may also consider whether early retirement is an option.

The US experience, to date, has been that those workers 55 and older have been one of groups most impacted by job losses.

Morningstar highlight that early retirement is not always in an individual’s best interest, actually, working a few years longer than age 65 can be “hugely beneficial to the health of a retirement plan,”….

They note the following challenges in early retirement:

  • Lost opportunity of additional retirement fund contributions and potential for further compound returns; and
  • Earlier withdrawals could result in a lower withdrawal rate or reduce the probability the funds lasting through the retirement period. 

Financial Advisors can help clients understand the trade-offs associated with early retirement and the impacts on their financial plans.  Often the decision to retire is about more than money.

Individual circumstances in relation to access to benefits, pensions, health insurance, and tax need to be taken into consideration.  Given this, a tailored financial plan, including the modelling of retirement cashflows on a year-to-year basis would be of considerable value.

Accommodating Low Yields in a Financial Plan

The low interest rate (yield) environment is a challenge for all investors. 

Nevertheless, for those in retirement or nearing retirement is it a more immediate challenge.

Return expectations from fixed income securities (longer dated (maturity) securities) are very low.  Amongst the best predictor of future returns from longer dated fixed income securities, such as a 10-year Government Bonds, is the current yield.

In the US, the current yield on the US Government 10-year Treasury Bond is not much over 1%, in New Zealand the 10-Year Government Bond yields less than 1%.  Expected returns on higher quality corporate bonds are not that much more enticing.

As Morningstar note, “These low yields constrain the return potential of portfolios that have an allocation to bonds and cash, at least for the next decade.“

The low yield and return environment have implications as to the sustainability of investment portfolios to support clients throughout their retirement.

The impact of low interest rates on “withdrawal rates” is highlighted in the graph below, which was provided by Morningstar in a separate article, The Math for Retirement Income Keeps Getting Worse, Revisiting the 4% withdrawal rule. 

The 4% withdrawal rate 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.

For illustrative purposes, the Morningstar article compares a 100% fixed income portfolio from 2013 and 2020 to reflect the impact of changes in interest rates on the sustainability of investment portfolios assuming a 4% withdrawal rate. 

As Morningstar note, since 2013 investment conditions have changed dramatically. When they published a study in 2013 the 30-year Treasury yield was 3.61% and expected inflation was 2.32%. Investors therefore received a real expected payout of 1.29%.

When they refreshed the study in 2020, those figures are 1.42% and 1.76%, respectively.  This implies a negative expected return after inflation.

The graph below tracks the projected value of $1 million dollars invested in 2013 and 2020.  The prevailing 30-year Treasury yields for July 2013 and October 2020, as outlined above, are used to estimate income for each portfolio, respectively, over time.  A “real” 4% withdrawal rate is assumed i.e. the first years $40k withdrawal grows with the inflation rates outlined above.

As can be seen, the 2013 Portfolio lasts up to 30 years, the 2020 Portfolio only 24 years, highlighting the impact of lower interest rates on the sustainability of an investment portfolio.

Financial Advisors can help in determining the appropriate withdrawal rates from an investment portfolio and the trade-offs involved.  They may also be able to suggest different investment strategies to maintain a higher withdrawal rate and the risks associated with this.

This may also include the purchase of annuities, to manage longevity risk (the risk of running out of money in retirement) rather than from the perspective of boosting current portfolio income.

Morningstar suggests that new retirees “should be conservative on the withdrawal rate front, especially because the much-cited “4% guideline” for portfolio withdrawal rates is based on market history that has never featured the current combination of low yields and not-inexpensive equity valuations.”

The 4% withdrawal rate is an industry “rule of thumb”.  Further discussion on the sustainability of the 4% withdrawal rate can be found here.

I have posted extensively about the low expected return environment and the challenges this creates for the Traditional Portfolio of 60% Equities and 40% Fixed Income.

The following Post on what investors should consider doing in the current market environment may be of interest. This Post outlines some investment strategies which may help in maintaining a higher withdrawal rate from an investment portfolio.

Likewise, this Post on how greater customisation of the client’s invest solution is required and who would benefit most from targeted investment advice may also be of interest.

Lastly, Wealth Management.com covers Benz’ article in Retirement Planning in a Pandemic.

Please read my Disclosure Statement

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

The Traditional Diversified Fund is outdated – greater customisation of the client’s investment solution is required

/ Kiwi Investor / 4 Comments

Although it has been evident for several years, the current investment environment highlights the shortcomings of the one size fits all multi-asset portfolio (commonly known as Diversified Funds such as Conservative, Balanced, and Growth Funds, which maintain static Strategic Asset Allocations, arising to the reference of the “Policy Portfolio”).

The mass-produced Diversified Funds downplay the importance of customisation by assuming investment problems can be portrayed within a simple risk and return framework.

However, saving for retirement is an individual experience requiring tailoring of the investment solution.   Different investors have different goals and circumstances.  This cannot be easily achieved within a one size fits all Diversified Fund.

Modern-day investment solutions involve greater customisation.  This is particularly true for those near or in retirement.

A massive step toward offering increased customisation of the Wealth Management investment solution is the framework of two distinctive “reference” portfolios: A Return Seeking Portfolio; and Liability-Hedging (Capital Protected) Portfolio.

Details and implementation of this framework are provided in the next section.  The benefits of the framework include:

  • A better assessment of the risks needed to be taken to reach a client’s essential goals and how much more risk is involved in potentially attaining aspirational goals;
  • An approach that will help facilitate 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 helps in assessing what is the best course of action and trade-offs involved; and
  • A more efficient use of invested capital.  This is a very attractive attribute in the current low interest rate environment.  The framework will be more responsive to changing interest rates in the future.

These benefits cannot be efficiently and effectively achieved within the traditional Diversified Fund one size fits all framework; greater customisation of the investment solution is required.

With modern-day technology greater customisation of the investment solution can easily be achieved.

The technology solution is enhanced with an appropriate investment framework also in place.

Implementation of the Modern-Day Wealth Management Investment Solution

The reasons for the death of the Policy Portfolio (Diversified Fund) and rationale for the modern-day Wealth Management investment solution are provided below.

Modern-day investment solutions have two specific investment portfolios:  

  • Return seeking Portfolio that is a truly diversified growth portfolio, owning a wide array of different return seeking investment strategies; and
  • Capital Protected (Liability) Portfolio, is more complex, particularly in the current investment environment.  See comments below.

The allocations between the Return Seeking portfolio and Capital Protected portfolio would be different depending on the client’s individual circumstances.  Importantly, consideration is given to a greater array of client specific factors than just risk appetite and risk and return outcomes e.g. other sources of income, assets outside super.

Although the return seeking portfolio can be the same for all clients, the Capital Protected (Liability) portfolio should be tailored to the client’s needs and objectives, being very responsive to their future cashflow/income needs, it needs to be more “custom-made”.

The solution also involves a dynamic approach to allocate between the two portfolios depending on market conditions and the client’s situation in relation to the likelihood of them meeting their investment objectives.  This is a more practical and customer centric approach relative to undertaking tactical allocations in relation to a Policy Portfolio.

The framework easily allows for the inclusion of a diverse range of individual investment strategies.  Ideally a menu offering an array of investment strategies can be accessed allowing the customisation of the investment solution for the client by the investment adviser.

Implementation is key, which involves identifying and combining different investment strategies to build customised robust investment solutions for clients.

The death of the Policy Portfolio

Modern Portfolio Theory (MPT), the bedrock of most current portfolios, including the Policy Portfolio, was developed in the 1950s.

Although key learnings can be taken from MPT, particularly the benefits of diversification, enhancements have been made based on the ongoing academic and practitioner research into building more robust investment solutions.  See here for a background discussion.

The Policy Portfolio is the strategic asset allocation (SAA) of a portfolio to several different asset classes deemed to be most appropriate for the investor e.g. Diversified Funds

It is a single Portfolio solution.

A key industry development, and the main driver of the move away from the old paradigm, is the realisation that investment solutions should not be framed in terms of one all-encompassing Policy Portfolio but instead should be framed in terms of two distinct reference Portfolios.

A very good example of the two portfolios framework is provided by EDHEC-Risk Institute and is explained in the context of a Wealth Management solution.  They describe the two reference portfolios framework involving:

  1. Liability-hedging portfolio, this is a portfolio that seeks to match future income requirements of the individual in retirement, and
  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 to finance studies from the 1950s on fund separation theorems (which is an area of research separate to the MPT).

The concept of two portfolios has also been 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 discusses the idea of a “regret-proof policy” here.

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

Reasons for the death of Policy Portfolio include:

  • there is no such thing as a meaningful Policy Portfolio. Individual circumstances are different.
  • 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.

Many institutional investors have moved toward liability driven investment (LDI) solutions, separating out the hedging of future liabilities and building another portfolio component that is return seeking.  More can be found on LDI here.

These “institutional” investment approaches, LDI, portfolio separation, and being more dynamic are finding their way into Wealth Management solutions around the world.

Evolution of Wealth Management – Implementation of the new Paradigm

In relation to Wealth Management, the new paradigm has led to Goal-Based investing (GBI) for individuals. GBI focuses is on meeting investor’s goals along similar lines that LDI does 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 the two portfolios approach, fund separation, LDI, 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 retirement income requirements. It is typically dominated by longer dated high quality fixed income securities, including inflation linked securities.  It does not have a high exposure to cash. In the context of meeting future cashflow requirements in retirement Cash is the riskiest asset, unless the cashflows need are to be met in the immediate future.  For further discussion on the riskiness of cash in the context of retirement portfolios see here.

The second portfolio is the return seeking portfolio or growth 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 the 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.

This will 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.

For those wanting a greater appreciation of EDHEC’s framework please see their 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.

Please see my Disclosure Statement

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

Tailored Investment solutions boost superannuation outcomes – Lifecycle Funds outperform Balanced Funds

/ Kiwi Investor / 1 Comment

A greater level of customisation leads to better investment outcomes for investors.

For example, Multifactor Lifecycle Funds that focus on age and size of account balances are best placed to last the distance as we live for longer in retirement, compared to a Balanced Fund and Lifecycle Funds that focus on age alone.

Multifactor Lifecycle Funds:

  1. Generate higher expected lifetime income relative to a Balanced Fund (70% equities and 30% Fixed Income and Cash); and
  2. Outperform a Balanced Fund over 90% of the time based on a numerous number of different market and economic scenarios.

These are the key findings of the Rice Warner’s research paper: Lifecycle Design – To and Through Retirement.

Lifecycle Funds, also referred to as Glide Path Funds, Target Date Funds, or Lifestages Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor approaches retirement.

 

Rice Warner found that somebody aged 30 with an opening balance of $26,000 and invested in a Multifactor Lifecycle Fund had a 91.8% chance of outperforming a Balanced Fund by the time of retirement at age 63.

Their research also found that by investing in a Multifactor Lifecycle Fund the expected retirement income is up to 35% higher than that expected from a Balanced Fund (Source: Australian AFR The product that can boost super by 35pc).

For somebody aged 60 with an account balance of $118,300, a Multifactor Lifecycle Fund had a 72.4 per cent chance of outperforming a Balanced Fund.

Lastly, Second Generation Lifecycle Funds, which reduce their growth allocation later, outperformed a Balanced Fund 91.2% of the time. A Multifactor Lifecycle Fund outperforms a Second Generation Lifecycle Fund 84.6% of the time.

 

A key conclusion from the Rice Warner research is that Lifecycle strategies that use factors in addition to age, such as superannuation account balance size, provide the ability to better tailor a portfolio to enhance outcomes for those saving for retirement. Therefore, they often outperform other investment strategies.

 

They achieve this by adopting a more growth-oriented stance while an investor has a long investment horizon and shifting to defensive assets when the investor’s investment horizon grows short.

Importantly, an individual’s investment horizon is a function of not only age but also the size of their superannuation account. This is an important concept, the rationale is provided in the section below – The Benefits of a Multifactor Lifecycle Fund.

 

A summary of the Rice Warner analysis is provided below, along with key Conclusions and Implications for those aged 30 and 60.

A copy of the Rice Warner analysis can be found here.

 

To my mind, there is going to be an increased customisation of investment solutions available for those saving for retirement that will consider factors beyond age e.g. account size, salary, and assets outside of Super.  Some are available already.

Technology will enable this, Microsoft and BlackRock are well advanced in collaborating, BlackRock and Microsoft want to make retirement investing as easy as ordering an Uber.

 

In relation to Lifecycle Funds, they are subject to wide spread criticism.

Some of this criticism is warranted, nevertheless, often the criticism is the result of the poor design of the Fund itself, rather than concept of a Lifecycle Fund itself. This is highlighted in the Rice Warner research, where the first Generation of Lifecycle Funds de-risk to early.

I covered the criticism of Lifecycle Funds in a previous Post, in the defence of Lifecycle Funds.

 

Lifecycle Funds can be improved upon. For example a more sophisticated approach to the management of the Cash and Fixed Interest allocation, this is well documented by the research undertaken by Dimensional Funds Advisors which I covered in a previous Post.

 

In my opinion, all investments strategies would benefit from a greater focus on tangible investment goals, this will lead to a more robust investment solution.

A Goals based investing approach is more robust than the application of “rule of thumbs”, such as the 4% rule and adjusting the growth allocation based purely as a function of age.

Goals based investing approaches provide a better framework in which to assess the risk of not meeting your retirement goals.

Greater levels of customisation are required, which is more relevant in the current investment environment.

 

 

Rice Warner – The benefits of Multifactor Lifecycle Funds

Investment literature indicates that an investor’s investment horizon is a key determinant of an appropriate investment strategy.

The consequence of longer investment horizons allows an investor to take on more risk because even if there is a severe market decline there is time to recover the losses.

Furthermore, and an important observation, Rice Warner’s analysis suggests that as we enter retirement investment horizon is a function of age and size of the superannuation account balance.

A retiree with a larger account balance has in effect a longer investment horizon. They are in a better position to weather any market volatility.

This reflects, that those with a small account size typically withdraw a greater proportion of their total assets each year, indicative of largely fixed minimum cost of living, resulting in a shorter investment horizon.

 

A very big implication of this analysis is that an investor’s investment horizon is “not bounded by the date that they choose to retire (though this point is relevant). This is as a member is likely to hold a substantial proportion of their superannuation well into the retirement phase, unless their balance is low.”

“One consequence of this is that investment strategies which consider this retirement investment horizon may deliver better outcomes for members – both to and through retirement. This is because as a member’s account balance grows, sequencing risk becomes less relevant allowing higher allocations to growth assets.”

For those wanting a better understanding of sequencing risk, please see my earlier Post.

 

Rice Warner conclude, Lifecycle strategies that use factors in addition to age, such as superannuation account balance size, provide the ability to better tailor a portfolio to provide enhanced outcomes for those saving for retirement. Therefore, they often outperform other investment strategies.

Thus, the title of their research Paper, Lifecycle Design – To and Through Retirement, more often than not investors should still hold a relatively high allocation to growth assets in retirement.  They should be held to the day of retirement and throughout retirement.

The research clearly supports this, a higher growth asset allocations should be held to and through retirement.  In my mind this is going to be an increasingly topically issue given the current market environment.

 

 

Rice Warner Analysis

Rice Warner considered several investment strategies applied to various hypothetical members throughout their lifetime.

They assess the distribution of outcomes of the investment strategies to establish whether adjustments can be made to provide members with better outcomes overtime.

Rice Warner considered:

  1. Balanced Strategy which adopts a fixed 70% allocation to Growth assets.
  2. High Growth strategy which adopts a fixed 85% allocation to Growth assets.
  3. First-generation Lifecycle (Lifecycle 1 (Age)) with a focus on defensive assets and de-risking at young ages.
  4. Second-generation Lifecycle (Lifecycle 2 (Age)) with a focus on growth assets and de-risking at older ages.
  5. Multi-dimensional Lifecycle (Lifecycle (Age and Balance)) which adopts a high allocation to growth assets unless a member is at an advanced age and has a low balance.

Six member profiles selected to capture low, moderate, and high wealth members at ages 30 and 60.

Rice Warner then considered the distribution of expected lifetime income under a range of investment scenarios using a stochastic model.

This allowed for a comparison of the income provided to members under each strategy in a range of investment situations for comparative purposes.

 

Conclusions

Rice Warner Conclude:

  • Investment horizon is a critical driver in setting an appropriate investment strategy. Investment strategies should take into consideration a range of investment horizon, both before and after retirement.
  • Adopting high allocations to growth assets is not inherently a poor strategy, even in cases where members are approaching retirement. These portfolios will typically provide:
    • Improved outcomes in cases where members are young, or investment performance is strong;
    • Marginally weaker outcomes where members are older and investment performance is weak.
  • Second-generation Lifecycle investment strategies (focused on growth assets and late de-risking) will typically outperform first generation strategies (which are focused on defensive assets and de-risking when a member is young).
  • Growth-oriented constant strategies will typically outperform First-generation Lifecycle strategies, except where investment performance is poor.
  • Designing Lifecycle strategies that use further factors in addition to age (such as balance) provide the ability to better tailor a portfolio to provide enhanced outcomes by:
    • Adopting a more growth-oriented stance while a member has a long investment horizon.
    • Shifting to defensive assets when a member’s investment horizon grows short.

 

Implications

Overall the results, aged 30:

  • High Growth strategies can provide significant scope for outperformance with minimal risk of underperformance relative to a Balanced Fund due to the members’ long investment horizon.
  • First-generation Lifecycle strategies will typically underperform each of the other strategies considered except where investment outcomes are poor for a protracted period. This underperformance is a result of the defensive allocation of these strategies being compounded over the member’s long investment horizon.
  • Second-generation Lifecycle can mitigate the risk faced by the members over their lifetime, albeit at the cost of a reduced expected return on their portfolio relative to a portfolio with a higher constant allocation to growth assets.
  • Lifecycle strategies which adjust based on multiple factors are able to manage the risk and return trade-off inherent to investments in a more effective way than single strategies or Lifecycle strategies only based on age. This is a result of the increased tailoring allowing the portfolio to adopt a more aggressive stance when members are young and thereby accumulate a high balance and extend their investment horizon further. This leads to this portfolio often outperforming the other strategies considered.

 

For those aged 60

  • High Growth strategies can provide significant outperformance in strong investment conditions. This comes at the cost of a modest level of underperformance in a poor investment scenario (a reduction in total lifetime income for members ranging between 2% and 5% relative to a Balanced fund).
  • First-generation Lifecycle strategies will underperform in neutral or strong market conditions due to their lack of growth assets. In cases where investment performance is poor these strategies outperform the other strategies considered particularly for those with low levels of wealth (due to their short investment horizons).
  • Two-dimensional Lifecycles provide enhanced risk management (but not necessarily better expected performance) by providing:
    • Protection for members who are vulnerable to sequencing risk with short investment horizons (low and moderate wealth profiles) by adopting a Balanced stance.
    • High allocations to growth for members whose investment horizon is long (high wealth profiles).

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Kiwi Investor Blog achieves 100 not out

/ Kiwi Investor / 1 Comment

Kiwi Investor Blog achieves 100 Posts.

Thank you to those who have provided support, encouragement and feedback. It has been greatly appreciated.

 

Before I briefly outline some of the key topics covered to date by Kiwiinvestorblog.com, the “intellectual framework” for the Blog has largely come from EDHEC Risk Institute in relation to Goals-Based investing and how to improve the outcomes of Target Date Funds in providing a more robust investment solution.

Likewise, Noble Laureate Professor Robert Merton’s perspective on designing an appropriate retirement system has been influential. Regulators and retirement solution providers should take note of his and EDHEC’s work.

Combined, EDHEC and Professor Merton, are helping to make finance useful again.

Their analysis into more robust retirement solutions have the potential to deliver real welfare benefits for the many people that face a challenging retirement environment.

A Goals-Based approach also helps the super wealthy and the High Net worth in achieving their investment and hopefully philanthropic goals, resulting in the efficient allocation of capital.

The investment knowledge is available now to achieve this.

 

To summaries, the key topics of Kiwi investor blog:

 

  • Likewise, much ink has been spilt over Target Date Funds. I believe these are the vehicle to achieving the mass production of the customised investment solution. Furthermore, they are likely to be the solution to the KiwiSaver Default option. The current generation have many shortcomings and would benefit by the implementation of more advanced investment approaches such as Liability Driven Investing. This analysis highlights that Target Date Funds that are 100% invested in cash at time of retirement are scandalous.

 

 

  • The first kiwiinvestorblog Post was an article by EDHEC Risk Institute outlining the paradigm shift developing within the wealth management industry, including the death of the Policy Portfolio, the move toward Goals-Based Investing and the mass production of customised investment solutions. These themes have been developed upon within the Blog over the last 22 months.

I covered the EDHEC article in more depth recently.

 

 

  • The mass production of customised investment solutions has been a recurrent topic. Mass customisation enabled by technology will be the Uber Moment for the wealth management industry. Therefore, the development of BlackRock and Microsoft collaborating will be worth following.

 

 

 

  • Several Posts have been on Responsible Investing. I am in the process of writing a series of articles on Responsible Investing. The next will be on Impact Investing. The key concern, as a researcher, is identifying those managers that don’t Greenwash their investment approach and as a practitioner seeing consistency in terminology.  The evidence for Responsible Investing is compelling and there is a wide spectrum of approaches.

 

 

  • There has been a focus on the issues faced by those near or in Retirement, such as the Retirement Planning Death Zone. These discussions have led to conclusion that Warren Buffet could be wrong in recommending high allocations to a low cost index funds. Investment returns are greatly impacted by cashflows into and out of the retirement fund.

 

  • I don’t tend to Post around current market conditions; market views and analysis are readily available. I will cover a major market development, more to provide some historical context, for example the anatomy of sharemarket corrections, the interplay between economic recession and sharemarket returns, and lastly, I first covered the topic of inverted yield curves in 2018.  I provided an update more recently, Recessions, inverted yield curves, and Sharemarket returns.

 

My word for 2019 is Flexicure, as outlined in my last Post of 2018, Flexicurity in Retirement Income Solutions – making finance great again – which brings together many of the key topics outlined above.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

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.

 

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

/ Kiwi Investor / 11 Comments

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.

 

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

/ Kiwi Investor / Leave a comment

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

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

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

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

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

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

 

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

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

(See my first Kiwi Investor Blog Post, Advancements in Portfolio Management, for an article written by Lionel Martellini, of EDHEC Risk Institute, that appeared in the Journal of Investment Management in 2016: Mass Customization versus Mass Production – How an Industrial Revolution is about to take place in money management and why it involves a shift from investment products to investment solutions.)

 

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

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

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

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

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

 

Under the radar

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

 

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

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

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

The benefits of Goals-Based Investing are a:

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

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

 

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

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

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

 

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

 

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

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

 

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

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

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

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

Again bold is mine.

 

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

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

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

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

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Target Date Fund’s popularity set to Grow

/ Kiwi Investor / Leave a comment

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.