Behavioural Drivers of Wealth Management

Underpinning The Regret Proof Portfolio and Best Portfolio Does not Mean Optimal Portfolio is, amongst a number of things, Behavioural Economics.

 

A recent paper A New Approach to Goals-Based Wealth Management published in the Journal of Investment Management (JOIM), provides a very comprehensive framework for a Goals-Based Wealth Management approach.

 

Behavioural Economics forms the foundations of Goals-Based Wealth Management.

 

As the JOIM Paper notes “Traditionally, the financial industry, financial advisors, and academics in finance have associated the notion of “risk” with the standard deviation of an investor’s portfolio. Investors, on the other hand, typically associate “risk” with the likelihood of not attaining their goals.”

This is important from the perspective of client communications: “In traditional financial planning, advisors look to understand what an investor’s goals are, then they ask questions designed to determine the investor’s tolerance for portfolio standard deviation, which leads to advising the investor to adopt a portfolio that has a mean and standard deviation corresponding to the investor’s risk appetite”

Goals-Based Wealth Management is defined “as a process that focuses on helping investors realize their goals, both short-term and long-term,..”

Behavioural Economics comes into play by “using language and ideas that are more natural for investors” in determining appropriate investment goals.

 

Behavioural Economics Foundations

The JOIM Paper provides a very good overview of the behavioural economics that forms the foundations of their Goals-Based Wealth Management Investment solution.

Inputs comes from the:

  1. pioneering and very influential academic literature on Behavioural Economics
  2. growing practitioner literature on goals-based wealth management

 

Richard Thaler’s work, who is a 2017 Nobel prize winner for his contribution to Behavioural Economics, provides a central pillar to the Goals-Based Wealth Management solution outlined in the JOIM Paper.

Thaler’s worked on the “endowment effect”, which is the asymmetric valuation of assets by individuals.  Namely, individuals value items more when they own them as opposed to when they do not.

This is related to loss aversion in Prospect Theory. Loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains.  Some studies have suggested that losses are twice as powerful, psychologically, as gains.  Loss aversion was first identified by Amos Tversky and Daniel Kahneman.

 

Mental accounting theory is also a significant contribution from Thaler and it is also an essential foundation for Goals-Based Wealth Management.

Mental accounting is where people treat money with different risk-return preference, depending on what use the money is to be put to. It is a way of keeping track of our money related transactions.

From a practical perspective, mental accounting helps elicit investors goals, and is “facilitated by breaking down overall portfolio goals into sub-portfolio goals using the ideas of mental accounts, where different goals are managed in different accounts, each aggregating into the overall portfolio.”

 

Lastly the JOIM Paper notes the work undertaken that developed Behavioural Portfolio Theory.  This theory postulates that investors behave as if they have multiple mental accounts. “Each mental account portfolio has varying levels of aspiration, depending on the goals for the mental account.  These ideas naturally lead to portfolio optimization where investors are goal-seeking (aspirational), while remaining concerned about downside risk in the light of their goals. Rather than trade-off risk versus return, investors trade off goals versus safety…”.

 

Practitioner’s Perspective

The JOIM Paper also notes the growing practitioner literature on goals-based wealth management.

Specifically, they reference three major contributions:

Nevins advocates a goal-orientated approach to help investors deal with biases such as overconfidence, hindsight bias, and overreaction.   Nevins’ work extended the mental accounting approach. He also argues that traditional investment planning fails to recognize investor’s behavioural preferences and biases.

Contributions by Zwecher, complements Nevins, he argues that risk management can be “done more actively and efficiently by demonstrating how a retirement portfolio that provides income, generates growth, and protects assets from disasters, can be created by adopting a bucketing (mental accounting) approach.”

Research undertaken by Brunel discussed the equal importance of two goals for an investor: being able to avoid nightmares while realizing dreams. “Brunel’s work focussed on demonstrating how goals-based wealth management can be achieved across multiple time horizons for multiple life goals. He also suggested how to map the language customers use in describing the importance of dreams or the severity of nightmares into acceptable probabilities that the investor will realize such dreams or avoid such nightmares.”

 

In short, Practitioners have recognized the need for a goals-based approach.

The premise is, if customers can better articulate and discuss their goals, including safety, then they are able to work with Practitioners to build more robust investment solutions that are better designed to meet their aspirations and investment objectives.

 

Happy investing.

 

Please see my Disclosure Statement

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

One Year Anniversary

Kiwi Investor Blog is one year old.

My top three articles for the year would be:

Investment Fees and Investing like an Endowment – Part 2

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

 

A Robust Framework for generating Retirement Income

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

 

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

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

 

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

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

 

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

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

Flexicure is my word of 2018.

 

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

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

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

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Best Portfolio Does Not Mean Optimal Portfolio

The best portfolio is not necessarily the optimal portfolio.

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

 

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

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

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

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

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

It is also more consistent with a behavioural bias approach.

 

As the paper concludes:

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

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

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

 

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

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

 

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

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

 

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

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

 

Happy investing.

 

Please see my Disclosure Statement

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

 

The Regret Proof Portfolio

Based on analysis involving the input of Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.

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

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

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

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

 

Background Discussion

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

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

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

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

 

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

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

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

 

Investment Solution

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

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

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

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

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

 

I would note a few important points:

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

 

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

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

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

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

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Flexicurity in Retirement Income Solutions – making finance useful again

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

 

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

Likewise, modern day investment products, from which there are many to choose from, provide flexibility yet not the security of replacement income in retirement.  Often these Products focus solely on managing capital risk at the expense of the objective of generating replacement income in retirement.  In short, as outlined by EDHEC-Risk, modern day Target Date Funds “provide flexibility but no security because of their lack of focus on generating minimum levels of replacement income in retirement.”

 

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

 

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

 

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

 

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

The conservative allocations with a TDF can be improved by being employed to better matching future cashflow and income requirements. While also focusing on reducing the risk of inflation eroding the purchasing power of future income.

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

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

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

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

 

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

 

This is my last Post of the year.

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

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

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

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

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

 

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

 

 

Happy investing.

 

#MakeFinanceUsefulAgain

#flexicure

#goalbasedinvesting

 

Please see my Disclosure Statement

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

 

 

 

For those with a real focus on retirement income solutions

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 variability of retirement income a better measure of risk rather than variability of capital?

This is the second Post on why a greater focus should be placed on generating a level of Income in retirement as an investment goal. The first Post outlines why income matters as an investment goal.

This Post covers why variability of retirement income is a better measure of risk rather than variability of capital.

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

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

 

To set the scene Merton discusses the difference between the high and low in longer term interest rates in the United States in the last 10 years, if you retired … with a given pot of money, if you retired and you got an income of a hundred, whatever that means, at the peak of interest rates, when they’re high, you get a hundred. At the trough, at the low end of interest rate, the same amount of money, you’d only get 74.

As he says, in other words your income will be 26% lower. “Think about that, 26% less of income, that’s a big hit especially for working middle class people but for any of us.”

 

You may well argue, that the last 10 years was an extraordinary period of time and corresponding fall in interest rates. Which would be correct.

Nevertheless, this does not detract from the point being made, how can we determine if a pot of money is enough to retire on? This can only be known by focusing on income generated from that pot of money.

Importantly, if you don’t monitor this risk, generating a stable level of income in retirement, you cannot manage it. And I would argue, such a focus will lead to you making better informed investment decisions that will likely result in a more stable and secure income in retirement.

This could well mean that as interest rates rise, you need a smaller pot and don’t need to take on as much risk as thought to support your life style in retirement.

 

Back to Merton, he uses another example, and highlights a number of times, the industry focuses on the wrong metric, the value of the pot (accumulated value).

If the value of the pot rises, we are happy, if the value declines, ‘you’re frowning’!

But, that’s not reality and in most cases it is not telling how you are going to go in retirement because you really want to know what income you are going to get in retirement.

Therefore, you should not be worried about the value of your pot, but what income the pot can generate in retirement.

That is the goal, and we should measure ourselves relative to that goal.

 

Defining risk around the risk of not being able to achieve income

Merton uses the following thought piece:

You’re 62, you’ve done well in your retirement account and I say to you, “Hey, you’ve got enough money to basically lock in your goal. I can buy you inflation protect, US Treasuries with funding that will take care of you throughout retirement guaranteed full faith and credit, the government protected for inflation at this level income, that’s your goal. Then I say, “You do want to increase your goal?” You said, “No, I’m happy with that, that’s my lifestyle. If I have some extra money, I’ll do something with it but basically, I’m happy with that. That’s what I want to live on and the safety and security, that is what matters to me.”

As Merton argues, in this situation the rationale thing to do would be to implement such an investment strategy. (This is Liability Driven Investing, or Goal Based Investing. Such investment approaches can be implemented now. Such approaches are aligned with how Insurance Companies and some Pension Funds implement.)

Such strategies as outlined above will closely match a desired level of income (subject to availability of appropriate securities – which is an area Government Policy could help in securing better retirement outcomes).

Under such an investment strategy retirement income is safe and largely predicable – reflecting the use of Government securities that are linked to inflation.

 

Nevertheless, while Income is stable, the value of the portfolio of fixed interest securities is not stable.

As interest rates rise, the price of bonds, fixed interest securities such as Government Bonds, fall.

However the Income from the bond does not change.

Using Merton’s example:

“Income is absolutely stable in a bond. Its value will fluctuate with interest rate. If interest rates, especially long-term bonds, which is what you would need for retirement, if the interest rates go up and let’s say your bonds go from 100 to 85 and I send you or put it on your account that your account has gone down 15% and you’re 62, you see that, you’ll go berserk. You’re going to say, “You told me you’re being safe for me and I’ve lost 15% of my retirement.”

“In fact, that’s not correct statement. Your retirement is defined by how much income you get for life. That hasn’t changed. The value of that has, that example is the problem at the core. It’s misinformation because we show them the wrong number”.

As Merton notes, investors get happy when the value of their portfolio goes up, but they are not actually better off if interest rates have fallen (meaning the price of a bond goes up).

Under this scenario buying new bonds will mean a lower level of income in the future.

This highlights that we focus on volatility of a capital as risk, the changing value in the pot of money, rather than volatility of future income.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

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

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

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

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

The rationale for the focus on income is provided below.

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Happy investing.

 

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

 

Please see my Disclosure Statement

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

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