KiwiSaver Balance Fund’s Strategic Asset Allocation (SAA) Analysis

March 29, 2021March 31, 2021 / Kiwi Investor / Leave a comment

A review of KiwiSaver Balanced Funds, which are soon to become the Default Option, highlights:

A heavy reliance on equities to drive return outcomes – there are few return engines outside of equities.
Limited portfolio diversification – likely resulting in higher levels of portfolio volatility across a full market cycle (which could be dampened down for the benefit of investors).
A high allocation to Fixed Income – which is a concern in the current market environment.

By comparison, Australian Super Funds with similar return objectives to a KiwiSaver Balance Fund have lower allocations to equities despite having higher “growth” asset allocations. They achieve this by having higher weightings to alternative investment strategies such as Private Equity, Direct Property, Unlisted Infrastructure, Commodities, and Diversified Multi-asset Funds.

Consequently, the Australian Super Funds have lower weights to fixed income relative to their Kiwi peers. There are some nuances amongst asset class allocations of the KiwiSaver Balance Funds, these are similar to those identified from the KiwiSaver Conservative Fund analysis.

I think it is fair to say that New Zealand KiwiSaver Funds need greater levels of diversification.

Often liquidity is sighted as a reason for not investing into alternative investment strategies, to this point:

Portfolios often overestimate the level of liquidity they require (see here); and
There are ways of increasing portfolio diversification with more liquid investment options.

Fees may also be playing a part. Let us hope not, particularly in considering the best outcomes for customers.

The high allocation to fixed income is also a concern, particularly at this juncture in the economic and market cycles.

Fixed Income was recently described as a “slow moving train wreck” at a recent industry event in New Zealand, Heathcote Investment Partners’ Meet the Manager series, see Toot, toot: what to do when bonds go off the rails | Investment News NZ

The traditional roles of Fixed Income are likely to be challenged in the years ahead:

Returns are highly likely to be lower than those delivered from fixed income over the last 10-20 years; and
The risk mitigation characteristics of fixed income are also likely to be lower in the years ahead.

Purely from a risk management perspective, Kiwi investors should be looking to increase the genuine level of diversification within their portfolios – by lessening the role of equities and exploring investment options to substitute/complement fixed income allocations.

Personally, I am not convinced of moving the KiwiSaver Default Fund to a Balanced Fund option is the right solution. My views can be found here. It is clearly ridiculous to have a 20- and 55-year-old Default KiwiSaver investor in the same investment strategy.

My preference would be for Target Date / Life Cycle / Life Stage type funds as the Default Options – these align more with the financial planning theory. The criticism of these type of Funds is often incorrectly positioned, I provide a defense of Target Date Funds here.

Analysis of KiwiSaver Balanced Funds

The Table below provides average, min, and max allocations of the Strategic Asset Allocations (SSA) for 12 KiwiSaver providers, sourced from their latest Statements of Investment Policy and Objectives (SIPO).

Most of these managers are currently Default KiwiSaver Providers.

Income Allocations
	Cash	NZ Fixed Income	International Bonds	Income Allocations
Averages	5.2%	12.8%	23.7%	41.6%
Min	1.0%	6.0%	18.0%	39.0%
Max	10.0%	16.5%	28.0%	50.0%
Median	4.5%	14.0%	25.3%	40.0%

Growth Allocations
	NZ Equities	International Equities	Other Equities	Alternatives	Growth Allocations
Averages	19.1%	32.8%	5.0%	3.2%	58.4%
Min	11.5%	26.0%	0.0%	0.0%	50.0%
Max	29.0%	40.0%	8.0%	6.0%	61.0%
Median	20.0%	32.0%	5.5%	4.0%	60.0%

Income Assets

From a top level, the managers are tightly grouped around 40% allocation to Income assets (Cash, NZ Fixed Income and International Bonds).

A KiwiSaver Balanced Fund is very much the traditional 60/40 portfolio (60% Equities / 40% Fixed Income).

There is one Manager that is an outliner, a truly “Balanced” Fund of 50% Equities and 50% Fixed Income. There is significant peer risk here and with no published return objective it is not possible to assess the appropriateness of its SAA. Albeit they will likely be the best performing manager when global sharemarkets fall sharply. However, over the longer term they are likely to struggle in keeping up with peers.

Within Income Assets

The variation within the Income Assets is consistent with analysis undertaken on the KiwiSaver Conservative Funds, see analysis here, which also includes a review of the risk drivers within Fixed Income, particularly likely variation in duration exposure.

Growth assets

As would be expected, the Growth Allocation is reasonably tight around 40%, the flip side of the Income Allocation.

Listed equities, including New Zealand equities, international equities, and listed property and infrastructure dominate the growth allocations i.e. there are very little investments into Alternatives. See Tables below.

Of interest, on average Domestic Equities (New Zealand and Australia) make up around 36% of the core equities allocations within the KiwiSaver Funds e.g. domestic and international listed equities ex listed property and infrastructure combined.

Overall, core equities make up 52% of a Fund on average. This is by far the dominant risk within these portfolios. On a risk basis, the equities allocations contribute to over 90% of the risks within a “Balanced” portfolio.

	Ratio of Domestic Equities	Core Listed Equities
Averages	36.4%	51.9%
Min	26.0%	42.0%
Max	52.7%	60.0%
Median	35.4%	51.8%

The remaining growth allocations are predominately made up of listed Property and listed Infrastructure, with smaller allocations to alternatives. Direct Property dominates the alternative allocations, with smaller allocations to private equity and more liquid hedge fund type strategies.

	Total Listed Equities Allocation	Alternatives Allocation	Alternatives share of Growth Assets
Averages	56.8%	3.2%	2.7%
Min	50.0%	0.0%	0.0%
Max	61.0%	6.0%	10.0%
Median	56.0%	4.0%	0.0%

Below is the same Data for a broad selection of Australian “Balanced” Funds.

	Ratio of Domestic Equities	Core Listed Equities
Averages	39.8%	48.5%
Min	0.0%	30.0%
Max	51.0%	62.0%
Median	42.6%	50.0%

	Total Listed Equities Allocation	Alternatives Allocation	Alternatives share of Growth Assets
Averages	52.3%	27.2%	33.4%
Min	30.0%	8.0%	9.5%
Max	76.0%	53.0%	63.9%
Median	50.0%	25.0%	33.3%

Australian “Balanced” Funds have an 80% allocation to Growth assets but a lower allocation to Core Equities (Australian and International Equities) than their New Zealand counterparts, 48.5% versus 51.9% on average for the Kiwi Funds.

This reflects that the Australian Funds have a higher allocation to Alternatives, which includes investment into Private Equity, Direct Property, Infrastructure, Commodities, and Diversified Multi-asset Funds.

Diversified Multi-Asset Funds

It should be noted that Diversified Multi-Asset Funds can have high allocations to listed equities, therefore some funds have a higher allocation to equities than appears based on sector allocations alone.

Diversified Multi-Asset funds offer “genuine diversification” relative to a traditional balanced fund and are more actively managed. In addition to investing in the traditional asset classes of equities and fixed income, they also invest into an array of alternative assets, often in more specialised areas and situations. These Funds seek breadth and depth across asset classes seeking to allocate to different return engines e.g. specialist areas of the health care industry, housing within property, renewable energy, and specialised credit opportunities.

Diversified Multi-Asset Funds offer an authentic option to increase diversification within a traditional portfolio, particularly for those investors who have constraints in relation to fees and liquidity.

There are several well-resourced managers in Australia with long histories of adding value with these types of funds.

Is it Apples vs Apples?

There is a wide variation in the Growth/Income split between New Zealand and Australian “Balanced” Funds.

Across both risk categories of Conservative and Balanced Funds, although the Australian Funds have higher Growth allocations than the Kiwi Funds, they have a slightly lower allocation to equities.

The difference is a lower allocation to fixed income and a higher alternative allocation in Australia. The portfolios are more diversified in Australia, this allows them to have a “higher” growth allocation. They are also most likely better positioned for the years ahead given the current stage in the economic and fixed income market cycles.

Although there is a degree of uniformity amongst the Kiwi Funds, you cannot choose a Fund by its name alone.

A review of the return objectives for both the New Zealand and Australian reveals:

The Australian Funds have return objective of CPI + 3% on average, they range from 2.5% to 4%.
The New Zealand Funds by and large fail to publish return objectives, those that do range from 2.5% – 3%.

This indicates that the universe of Funds is not too dissimilar from a return objective perspective, and the analysis above provides some real insights for consideration and to ask why the difference?

Personally, I think all managers should publish their return objectives in a CPI+ format. This is a valuable piece of information for the informed investor along with a Fund’s proposed risk category.

Please read my Disclosure Statement

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

Private Equity receives a boost from the US Department of Labor – significant industry potential

June 7, 2020June 9, 2020 / Kiwi Investor / 1 Comment

Based on the US Department of Labor (DOL) guidance US retirement plans, Defined Contribution (DC), can include certain private equity strategies into diversified investment options, such as target date or balanced funds, while complying with ERISA (laws that govern US retirement plans).

This is anticipated to result in better outcomes for US investors.

It is also anticipated to provide a further tailwind for the Private Equity sector which is expected to experience significant growth over the decade ahead, as outlined

Private equity investments have long been incorporated in defined benefit (DB) plans, DC plans, 401(k) retirement plans similar to KiwiSaver Funds offered in New Zealand and superannuation funds around the world, have mainly steered away from incorporating Private Equity in their plans due to litigation concerns.

By way of summary, the DOL provides the following guidance. In adding a private equity allocation, the risks and benefits associated with the investment should be considered.

In making this determination, the fiduciary should consider:

whether adding the asset allocation fund with a private equity component would offer plan participants the opportunity to invest their accounts among more diversified investment options within an appropriate range of expected returns net of fees and the diversification of risks over a multi-year period;
whether using third-party investment experts as necessary or managed by investment professionals have the capabilities, experience, and stability to manage an asset allocation fund that includes private equity effectively;
limit the allocation to private equity in a way that is designed to address the unique characteristics associated with such an investment, including cost, complexity, disclosures, and liquidity, and has adopted features related to liquidity and valuation.

It is worth noting that the SEC (U.S. Securities and Exchange Commission) has adopted a 15% limit on investments into illiquid assets by US open-ended Funds such as Mutual Funds (similar to Unit Trusts) and ETFs.

In addition, the DOL suggests consideration should be given to the plan’s features and participant profile e.g. ages, retirement age, anticipated employee turnover, and contribution and withdrawal patterns.

The DOL letter outlines a number of other appropriate considerations, such as Private Equity to be independently valued in accordance with agreed valuation procedures.

It is important to note the guidance is in relation to Private Equity being offered as part of a multi-asset class vehicle structure as a custom target date, target risk, or balanced fund. Private Equity cannot be offered as a standalone investment option.

The DOL letter can be accessed here.

Size of the Market and innovation

As noted DC plans have been reluctant to invest in Private Equity, by contrast DB plans allocate 8.7% of their assets to Private Equity, based on a 2019 survey of the US’ 200 largest retirement plans.

It is estimated that as much as $400 billion of new assets could be assessed by Private Equity businesses as a result of the DOL guidance, as outlined in this FT article.

Increased innovation is expected, more Private Equity vehicles that offer lower fees and higher levels of liquidity will be developed.

A number of Private Equity firms are expected to benefit.

For example, Partners Group and Pantheon stand to benefit, see below for comments, they launched Private Equity Funds with daily pricing and liquidity in 2013. These Funds were designed for 401(k) plans.

As you would expect, they reference research by the Georgetown Center for Retirement Initiatives which concludes that including a moderate allocation to private equity in a target-date fund could increase the participant’s annual retirement income by at least 6%.

They also comment, private markets provide valuable diversification in an investment portfolio in light of a shrinking public markets sector that has seen the number of US publicly-traded companies decline by around 50% since 1996.

This observation is consistent with one of the key findings from the recently published CAIA Association report, The Next Decade of Alternative Investments: From Adolescence to Responsible Citizenship.

The DOL guidance will provide another tailwind for Private Equity.

For those interested, this paper by the TIAA provides valuable insights into the optimal way of building an allocation to Private Equity within a portfolio.

Potentially significant Industry Impact

The DOL Letter has been well received by industry participants as outlined in this P&I article.

The article stresses that the guidance will help quell some sponsor’s litigation fears and with a good prudent process Private Equity can be added to a portfolio.

The DOL believes the guidance letter “helps level the playing field for ordinary investors and is another step by the department to ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement.”

The DOL Letter is in response to a Groom Law Group request on behalf of its clients Pantheon Ventures and Partners Group, who have developed private equity strategies that can accommodate DC plans. The DOL specifically referenced Partners Groups Funds and commented their Private Equity Funds are “designed to be used as a component of a managed asset allocation fund in an individual account plan.”

Partners Group said in a statement that the DOL has taken “a major step toward modernizing defined contribution plans and providing participants with a more secure retirement. At a time when working families are struggling to save, this guidance gives fiduciaries the certainty they need to finally provide main street Americans access to the same types of high-performing, diversifying investments as wealthy and large institutional investors, all within the safety of their 401(k) plans.”

Further comments by Partner Group can be found here.

Happy investing.

Please see my Disclosure Statement

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

Are Investment products meeting people’s needs over their working life?

May 25, 2020May 26, 2020 / Kiwi Investor / Leave a comment

A key finding by the Australian Productivity Commission is that “Well-designed life-cycle products can produce benefits greater than or equivalent to single-strategy balanced products, while better addressing sequencing risk for members.

There are also good prospects for further personalisation of life-cycle products that will better match them to diverse member needs, which would require funds to collect and use more information on their members.

Some current MySuper life-cycle products shift members into lower-risk assets too early in their working lives, which will not be in the interests of most members.”

This is one of many findings from of the 2018 Australian Productivity Commission Inquiry Report, Superannuation: Assessing Efficiency and Competitiveness.

Mysuper is a default option in Australia, similar to the Default Options by Kiwisaver providers in New Zealand and around the world.

The above findings are from the Section 4, Are Members needs being met, of the report (pg 238). This section, 4.3, Are products meeting people’s needs over their working life?, focuses on Life Cycle Funds. (Lifecycle Funds are often referred to as target-date funds in the United States, the United Kingdom, and other countries. They are popular in the US, accounting for 25% of their saving for retirement assets, and growing.)

Life cycle Funds, also referred to as Glide Path Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

Section 4.3 concludes “the Commission now recognises the value of well-designed MySuper life-cycle products, and the potentially significant gains that could arise from further personalisation.”

As covered in the report, they highlight that the poorer products currently on offer “requires some cleaning.”

Two areas of Section 4.3 are of interest to me.

The relative attractiveness of Lifecycle Funds

The report covers the varying views on Lifecycle Funds.

On this the Commission notes that the underperformance of some Lifecycle Funds does not “repudiate the principle of varying the management of risk as a person ages.”

Importantly, the “costs and benefits of life-cycle products depend on their design and on the characteristics of fund members (for example, the size of their balance).”

They note “the determinant of the variation between life-cycle products is the glide path from growth to defensive assets as the member ages”

“The lowest average retirement balances occur for life-cycle products with accelerated transitions to defensive assets as the member ages.”

As noted by several submissions, Lifecycle Funds can provide better outcomes if they maintain a higher growth allocation in the earlier years of saving for retirement. They also offer additional benefits in market downturns, particularly closer to retirement, they produce less poor outcomes than a standard single-strategy product, such as a Balanced Fund i.e. they manage sequencing risk better.

The criticism of Lifecycle Funds is often associated with poor design, as covered in this Post.

Increased Customisation of the Investment Solution

It is important to appreciate that not one investment product can meet all investor’s needs. It does not make sense for a 29 year old and a 50 year to be in the same Default Fund.

This is an attractive feature of Lifecycle Fund offerings, they can be more tailored to the investor.

Specifically, they can be tailored for more than just age, such as Balance size, and this can in the majority of cases result in better outcomes for those saving for retirement. As outlined in this research article by Rice Warner. Tailored investment solutions boost retirement savings outcomes.

On this point the Commission’s Report notes “There is significant scope for more personalised MySuper products”…

Specifically there is the scope to customise the investment strategy of Lifecycle Funds beyond age.

The report outlined a submission that observed that “… data and technology provide the opportunity for giant advancements in the design of personalised lifecycle strategies. Such strategies could account for: age, balance, contribution rate (which entails non-contribution due to career breaks etc), gender, expected returns, [and] risk.”

“Ultimately, individualised product design could also take into account other member characteristics, such as household assets, income from any partner and the potential capacity to extend a working life if there are adverse asset price shocks.”

The following two submissions in relation to Lifecycle Funds by David Bell and Aaron Minney are well worth reading for those wanting a greater understanding and appreciation of broader topics associated with Lifecycle Funds.

These submissions are also well worth reading by those interested in designing effective investment solutions for those saving for retirement.

Happy investing.

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

May 11, 2020May 12, 2020 / 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:

Generate higher expected lifetime income relative to a Balanced Fund (70% equities and 30% Fixed Income and Cash); and
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:

Balanced Strategy which adopts a fixed 70% allocation to Growth assets.
High Growth strategy which adopts a fixed 85% allocation to Growth assets.
First-generation Lifecycle (Lifecycle 1 (Age)) with a focus on defensive assets and de-risking at young ages.
Second-generation Lifecycle (Lifecycle 2 (Age)) with a focus on growth assets and de-risking at older ages.
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.

Target Date Funds – 25 Years of US Learnings

December 18, 2019 / Kiwi Investor / Leave a comment

Launched in 1994, target-date funds now boast assets of more than $2 trillion in the US, according to a recent Wealth Management.com article, Target-Date Funds Aging Gracefully

The article concludes: “Naturally it is difficult to foresee how target date funds will evolve over coming decades, as the list of potential innovations is endless, but one thing is certain: the benefits target-date funds present both to plan participants and sponsors ensure they will play a dominant role in building comfortable retirements for years to come.”

The growth Target-Date Funds (TDF) has significantly changed the Defined Contribution (DC), superannuation, industry in the US.

TDF are also referred to as Life Stages or Life Cycle strategies.

Since their launch in 1994 TDF have become to dominate DC plans. According to the Wealth Management.com article total assets in TDF mutual funds alone have grown from about $278 million at the end of 1994 to more than $1.2 trillion in the second quarter of 2019.

Considering other investments, it is estimated that $2 trillion or about 25% of total DC assets today are invested TDF.

Why the Growth?

The growth in TDF can be attributed to their appeal to those saving for retirement (Participants) and those offering investment solutions e.g. Sponsors such KiwiSaver Providers.

For the Participant, TDF remove the “burden of creating an asset allocation strategy and choosing the investments through which they would execute it.” Participants do not need to make complicated investment decisions.

For Sponsors, they can “streamline their investment offering (reducing complexity and administrative costs), while meeting their fiduciary responsibility to participants.”

Also, and of particular interest given New Zealand is currently reviewing the Default option for KiwiSaver, TDF have also experienced a significant boost from the enactment of the Pension Protection Act (PPA) in 2006.

As noted by the Wealth Management.com article “The PPA relieved plan sponsors from fiduciary responsibility for investment outcomes if they provided a suitable Qualified Default Investment Alternative (QDIA), such as TDFs, to anyone auto-enrolled in their plans. The combination of auto enrollment and safe harbor relief for plan sponsors paved the way for the wide adoption of TDFs.”

Future Growth and Innovation

The growth of funds invested into TDF is expected to grow, primarily from the ongoing innovation of the vehicle.

It is likely that the TDF will evolve into the key investment vehicle over the complete lifecycle of an investor, not only by accumulating capital for retirement (Defined Contribution Fund) but also helping generate a stable and secure income once in retirement (Defined Benefit Fund).

A recent enhancement to TDF is the addition of Guaranteed-income options. These Funds convert into a personalised investment plan for those seeking the security of a guaranteed income for life.

TDF offering guaranteed income are available now in the US, but they have not been widely embraced by either participants or plan sponsors. They do face a higher fee hurdle to be adopted. Albeit, the Wealth Management.com article notes “TDFs offering guaranteed income are likely to gain traction in the DC space. Participants contemplating decades in retirement naturally have concerns about outliving their savings, and guaranteed-income TDFs address that anxiety.”

The innovation and focus of these Funds is consistent with the framework proposed by EDHEC Risk Institute, as I outlined in the Post: A more Robust Investment Solution

They are also consistent with the Next Generation of Retirement solutions promoted by Nobel Laureate Professor Robert Merton: Funding Retirement: Next Generation Design, which was written in 2012. I summarise Professor Merton’s Paper in this Post: Designing a new Retirement System, which is the most read Kiwi Investor Blog Post.

Such considerations will greatly increase the efficiency of TDF.

These solutions are about making Finance great Again (Flexicurity in Retirement Income Solutions – making finance great again)

New Zealand Perspective

TDF would make more sense as a Default KiwiSaver solution, and stack up better relative to a Balanced Fund option (Balanced Funds not the Solution for Default Kiwi Saver Investors).

Lastly, the criticism of TDF is often due to poor design (In Defence of Target Date Funds).

An example is a large Kiwi Saver provider promoting a 65+ Life Stages Fund which is 100% investment in Cash. This is scandalous as outlined in this research by Dimensional, this research is summarised in the Post High Cash holdings a scandalous investment for someone in retirement.

Happy investing.

Please read my Disclosure Statement

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

Kiwi Investor Blog achieves 100 not out

October 7, 2019October 8, 2019 / 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:

I have posted frequently on Goals-Based investing, as I believe this provides a more robust and tailored investment solution for the individual.

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.

A greater allocation to alternative investments has been promoted on the Blog to gain truer levels of portfolio diversification. KiwiSaver investors are missing out. Allocations globally to alternative investments is only set to grow according to Prequin. This is most pertinent as we face a low return environment. More asset classes do not equal more diversification.

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.

I have covered KiwiSaver issues in many blogs, this one in relation to the OECD Pension Scheme Recommendations was well received.

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.

The Post on the Disaggregation of Investment Returns has been popular. This Post provides a lens on how to consider different levels of diversification within a portfolio. This includes the appeal of Factor Investing.

The largest article download has been the research article on Challenging the Conventional Wisdom of Active Management.

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.

In relation to Behavioural Finance, access to a Tool Kit has been provided, the behavioural finance underpinning modern wealth management has been discussed. This led to a discussion around the Regret Portfolio.

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.

Designing a new Retirement System and Goal-Based Wealth Management

September 23, 2019September 25, 2019 / Kiwi Investor / 4 Comments

This Post covers an article by Nobel Laureate Professor Robert Merton: Funding Retirement: Next Generation Design, which was written in 2012.

It is a relatively long but easy article to read, very entertaining, he is a wonderful conversationalist with some great analogies.

It should be read by all, particularly those interested in developing a robust Retirement System.

The concepts underlie a move globally to the development of more innovative investment solutions to meet a growing need from those in retirement.

I have tried to summarise his concepts below, probably without full justice.

Before we begin, it is important to emphasis, what Professor Merton has in mind is a retirement system that supports a mass produced and truly customised investment solution.

This is not a hypothetical investment strategy/approach he is advancing, cooked up in a laboratory, investment strategies are already in place in Europe and the United States based on the concepts outlined in his article.

These concepts are consistent with the work by the EDHEC Risk Institute in building more robust retirement income solutions. The performance of these solutions and those provided by the likes of BlackRock can be tracked by the indices they produce.

The behavioural finance aspects of these approaches are outlined in a previous Post.

Merton begins

Due to excessive complexity in investment choices and a focus on the wrong goals, hundreds of millions of low- to middle-income earners face a precipitous decline in their living standards upon their departure from the workforce.

But it doesn’t have to be that way. Technology, innovation and our understanding of what are meaningful choices about retirement funding mean we are now in a position to design a better system that serves all people, not just the wealthiest ones.

And he concludes:

In designing a new retirement system, Merton argues first we need to define the goal. He defines the goal as helping participants achieve income throughout retirement, adjusted to keep pace with inflation.

Merton notes, the current system is no longer sustainable and requires individuals to make overly complex investment decisions and the industry bombards them with jargon that is meaningless to them.

Therefore, he argues strongly we should move away from the goal of amassing a lump sum at the time of retirement to one of achieving a retirement income for life.

This requires customisation of the investment strategy. Asset allocation strategies should be personalised. And, each individual is given regular updates on how “they” are travelling in ways that make sense to them.

However, unlike simple target-date funds that mechanically set the asset allocation using a crude calculation based on a single variable — the participant’s age — Merton proposes a customised, dynamically managed solution based on each participant’s tailored goals for desired outcomes, life situation, expected future contributions and other retirement-dedicated assets, including current savings accumulated, and any other retirement Benefit entitlements.

To improve effectiveness of engagement of the Participant, all of the complexity of the investment strategy is kept under the bonnet, out of sight. The user is asked a series of simple questions around their essential and their desired income targets. Once they achieve a very strong likelihood (more than 96 per cent) of reaching that desired income, they lock in an asset allocation to match that desired lifetime income at retirement.

Merton concludes, this is not a hypothetical investment strategy/approach. Such strategies are currently being implemented in Europe and the United States.

And, it begins and ends with turning the focus back onto what superannuation should be about — ensuring people have adequate incomes in retirement.

Therefore, the investment strategy is focused entirely on achieving the retirement income goal, no consideration is given to achieving more than that goal. Such a strategy limits the downside and upside relative to the investment objects – narrowing the variation of likely outcomes relative to a desired level of income in retirement.

Therefore, it increases the probability of reaching a desired level of income in retirement.

Now to the Body of the Article:

Background

Merton identifies the shortcomings of the current retirement system, particularly the shift from Defined Benefit (DB) to Define Contribution (DC) has burdened the users with having to make complex decisions about issues in which they have no knowledge or expertise.

The current system is far from ideal.

Therefore, in considering how to reshape the system, Merton argues we should start by establishing the goal.

What are members seeking to achieve?

To his mind, people “want an inflation adjusted level of funding that allows them to sustain the standard of living in retirement that they have grown accustomed to in the final years of their working lives.”

Merton then asks: How do we define a standard of living in financial terms?

Traditionally this has been a sufficiently large lump sum. “Indeed, that is the premise of most DC plans, including most in the Australian superannuation system. The focus is on amassing a sufficiently large lump sum in the accumulation phase“.

However, “in reality, when talking about a standard of living, people think of income”.

For example a Government sponsored pension is described in terms of an annual/weekly payment. Likewise DB plans were expressed as income per year for life and not by its lump-sum value.

This is why DB plans were so attractive to the investor. The income was to be received and there were no complex decisions to be made.

Contrast this to the DC system, there is a mirror of products and investment decisions that need to be made and it is no wonder people sit in default funds and are not engaged.

Furthermore, over and above the complexity Merton notes: “most DC plan allocations take no account of individual circumstances, including human capital, housing and retirement dedicated assets held outside the DC plan. Those are all important inputs for an allocation decision customised to the needs of each person.”

Therefore, he argues the next generation of retirement solutions need to meet the following criteria:

To be robust, scalable, low-cost investment strategies that make efficient use of all dedicated retirement assets to maximise the chance of achieving the retirement income goal and manage the risk of not achieving it.
A risk-managed customised solution with individually tailored goals for each member — taking into account his or her age, salary, gender, accumulation plan and other assets dedicated to retirement.
A solution that is effective even for individuals who never provide information or who never become involved in the decision making process at all. And, for those who do become engaged, we need a solution that gives them meaningful information about how they are travelling and what they can do if they are not on track to achieve their retirement income goals.
Allows plan sponsors (or pension fund trustees) to control their costs and eliminate balance sheet risk.

Next-generation retirement planning

Merton argues: “The simplest retirement solution is one in which the members do absolutely nothing. They provide no information and make no decisions. In fact, they are not engaged in the process at all until they reach retirement.”

He acknowledges that such extreme behaviour is rare, nevertheless, a well-designed retirement solution would display such characteristics.

It has to be to a standard that when members do engage “(it) enhances the chances of success in achieving the desired income goal.”

But how is that achieved?

Investment solutions need to be designed based on questions that are meaningful for people, such as:

What standard of living do you desire in retirement?
What standard of living are you willing to accept?
What contribution or savings rate are you willing or able to make?

The key point of these questions:

“Such questions embed the trade-off between consumption during work life and consumption in retirement and they make sense to people, unlike questions about asset allocation.”

Importantly the focus is not on what investments you should have or your “risk preference”, it is on what are your retirement goals.

The objective is to create a simple design with only a handful of relevant choices.

Merton also argues that “we need a design that does not change, at least in the way that users interact with it. An unchanging design leads to tools that people will be more likely to learn and use. In fact, a design that is unchanging is almost as important as a design that is simple.“

Something simple and consistent is easier for people to learn and remember than something complicated and changing.

A point made in the article, is that the design can be simple, but what is underneath can be complex. The underlying investment solution needs to flexible and innovative to improve performance over time. Not fixed, rigid, and independent of the changing market environments.

“We must, therefore, design a system that is user friendly, one that people can become familiar with and thus are willing to use — a system in which the designers do the heavy lifting, so users need only make lifestyle decisions that they understand and the system then translates into the investment actions needed to achieve those goals.”

Wealth versus sustainable income as the goal

The second dimension is the use of wealth as a measure of economic welfare.

Merton makes a strong case Income is what matters in retirement and not how big your pot of money is i.e. Lump sum, or accumulated wealth.

It is often said that if you have enough money you will get the income and everything will be fine. This may be true for the super wealthy but is not reality for many people facing the prospect of retirement.

By way of example: 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 $30k if they had remained invested in term deposits. That’s a big drop in income (-63%) and also does not take into account the erosion of buying power from inflation. You would be a bit concerned if you lost 63% of your lump sum!

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

Focusing on accumulated wealth does not distinguish between the standard of living and wealth as the objective.

As Merton says “Sustainable income flow, not the stock of wealth, is the objective that counts for retirement planning.”

Investment Reporting

Merton makes another, and important point, the reporting of Investment results to members is not trivial. Crucially what is reported to members by providers heavily influences behaviour e.g. volatility of capital as a measure of risk influences behaviour, often bad behaviour.

Therefore, the measure of risk is important.

From this perspective, in Merton’s mind reporting should focus on the level of income that will be generated in retirement. This is the most important measure. The volatility of likely income in retirement is a better measure risk.

And from this standpoint 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.

Essential and desired income goals – Goals-Based Investing

The system Merton is describing “seeks to increase the likelihood of reaching nominated income goals by sacrificing the possibility of doing significantly better than desired”.

In effect he is seeking to narrow the likely outcomes, technically speaking the “distribution” of income outcomes in retirement.

We do this by focusing on desired and essential target income goals.

These goals are what the member would see as a good retirement income given their set of circumstances and on how much risk would be acceptable in achieving those goals.

The desired income goal would be defined as a level of income that while not guaranteed, has a very high probability of being achieved and which serves to indicate the degree of risk of the member’s strategy.

Therefore, the investment objective is to maximise the estimated probability of achieving a desired level of income in retirement.

Accordingly, as the probability of reaching the desired level of income in retirement rises risk is reduced so as to “lock in” the chances of achieving the goal at retirement.

As Merton notes “by taking as much risk as possible off the table when it is no longer needed, we are trading off the possibility of achieving ‘even more’ against increasing materially the probability of achieving the goal.”

In this way, the investment strategy is focused entirely on achieving the retirement income goal, no consideration is given to achieving more than that goal.

Such a strategy limits the downside and upside relative to the investment objects – narrows the variation of likely outcomes relative to the desired level of income in retirement.

Therefore, it increases the probability of reaching desired level of income in retirement, particularly relative to a less focussed investment strategy.

Pension Alerts

Merton recommends that should a Member’s progress suggest they have a less that say 50% probability of reaching their retirement income goal they are contacted.

At which point in time they have three options:

increase their monthly contributions;
raise their retirement age; and/or
take more risk.

The Member gets these alerts during the accumulation phase. This can be formal systematic process under which the plan sponsor and trustees, as part of their fiduciary responsibilities, seek to guide that member to a good retirement outcome.

Happy investing.

Please see my Disclosure Statement

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

In defence of Target Date Funds

September 10, 2019 / Kiwi Investor / 4 Comments

This is a great article from i3 providing some interesting perspectives into Target Date Funds, referred to as Life-Cycle strategies in Australia.

Target Date Funds have been around since the 1990s and have had an increasing presence in Australia following the MySuper legislation of 2012, which set the legal requirements for the default pension (KiwiSaver) options in Australia.

As a result, many Australian providers introduced Life-Cycle Funds as default options. Target Date Funds are also increasingly the default option in the USA.

It is fair to say there has been wide spread criticism of Target Date Funds.

Some of this criticism is warranted, nevertheless, consistent with the point made in the i3 article, the criticism of Target Date Funds is often the result of the poor design of the Fund itself, rather than the concept of a Target Date Fund.

For example, as noted in the article, the Australian Productivity Commission “criticised a number of existing life-cycle strategies for derisking too early and not being as good as many balanced fund options.”

This is fair criticism, but it is a design issue. I have previously noted that at least one KiwiSaver provider places their clients into 100% Cash at age 65, that is scandalous.

On the positive side, the Commission “acknowledged life-cycle strategies could help in addressing sequencing risk”.

These themes are touched on in the interview with Michael Block, Chief Investment Officer with Australian Catholic Superannuation.

“To always place a member who is 20 years old with a 60-year old member in the same strategy is clearly ridiculous,” Block says in an interview with [i3] Insights.

“Why would any fund use a one-size strategy that clearly does not fit all?”

“I absolutely concede, especially with people living longer, that moving members into a low-risk strategy at 60 is not a great idea. Even at 60 years old, a member is likely to have a 30-year investment horizon and should still have a decent amount of growth assets,” he says. (Growth asset include equities, alternatives and non-traditional assets.)

As the article notes: “The result of the shift is that half of the fund’s members now have a higher allocation to growth assets, while one-quarter, generally older members, have a lower allocation. The rest have retained a similar exposure to growth assets.”

Comments on De-risking

De-risking is reducing the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

Australian Catholic Super looks to reduce the allocation to equities in small annual increments, 31 steps to be precise, not the normal 3-4 lumpy transactions of many Target Date Funds.

“As long as you still contribute to your super, you’ll get a better outcome compared to a single-strategy investment option,” Block says. (An example of a single strategy is a Conservative or Balance Fund.)

“This gradual process of derisking also reduces a member’s sequencing risk as there is never more than a 2 per cent reduction in growth assets in any given year.”

This makes some sense and is a nice design feature of their Target Date Funds.

Customisation

The Australian Catholic Super’s life-cycle fund is based on age only. They hope to add other variables over time, such as account balance and salary.

“In a perfect world, you would ask everyone what they wanted out of a superannuation fund and tailor an individual portfolio for them, but if you don’t have complete information, then a life-cycle strategy based on age is a good attempt at mass customisation,” he says.

Quite true, it is a start, and a good start at that. With further sophistication of the investment approach and the helping hand of technology the mass customised investment solutions is not far away.

Increased customisation of the superannuation solution is the future. Customisation will consider the generation of a required level of income in retirement, take into consideration income earned outside of super, risk preferences, account balance, and any likely endowments. Such customisation is available now.

More on Target Date Funds

For those wanting more on Target Date Funds, I have previously Posted on their Short Comings and suggested improvements. They are also worth considering as the KiwiSaver Default Option.

Lastly, Target Date Fund can be improved upon by 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.

Interestingly, Kiwis can learn from the Aussies, maybe not when it comes to rugby, or certain cricket practices, but most certainly we can learn from them when it comes to Superannuation and the management of Pension Funds.

Happy investing.

Please see my Disclosure Statement

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

The Retirement Planning Death Zone

September 2, 2019 / Kiwi Investor / 11 Comments

The retirement risk zone (also known as the ‘conversion’ phase) is commonly defined as the final 10 years of working life (the ‘accumulation’ phase) and the first 10 years of retirement (the pay-out phase or decumulation).

This period is right before and right after you retire.

Importantly, it is this 20 year period when the greatest amount of retirement savings is in play and, subsequently, risk is at its highest.

This can be thought of along the lines of the death zone when climbing Mt Everest. The risky time is the final ascent, clambering over the Hillary Step, on the way to the summit of Mt Everest. However, once at the summit risks remain on the decent and until below the death zone when the ability to breathe becomes easier.

The summit in terms of retirement savings is generally reached at age 65, this is when the amount saved will be the “peak” in savings accumulated. It is here when accumulated wealth is at its largest. Albeit, from an investment perspective, risks remain heightened over the first 10 years of the pay-out/decumulation phase.

The Retirement Risk Zone, the 10 years either side of retirement, is the worst possible time to experience a large negative return given this is when the greatness amount of money is at stake. Risks to portfolios are heightened at this stage.

It is a very important period for retirement planning.

During the Retirement Risk Zone two factors can potentially combine to have a detrimental impact on the standard of living in retirement:

The portfolio size effect (what you do when the largest amount of your money is at risk matters); and
the problem of sequencing risk (how much you lose during a bear market (20% or more fall in value of sharemarkets) may not be anywhere near as important as the timing of the loss, again, especially during the Retirement Risk Zone).

To explain, sequencing risk, is the risk that the order of investment returns are unfavourable, resulting in less money for retirement.

Sequencing risk impacts pre-and post-retirement i.e. the retirement risk zone.

Cashflows, investments in and withdrawals out of the retirement savings plan, add another dimension to sequencing risk.

Sequencing Risk can be viewed as the interaction of market volatility and cashflows. The timing of returns and cashflows matters during both the accumulation of retirement savings and in retirement. This impacts on longevity risk.

This is where Warren Buffet could be wrong in recommending people maintain high equity allocations for the longer term. As noted in my previous Post, Could Buffet be Wrong? “once an investor needs to take capital or income from a portfolio volatility of the equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives”. This is sequencing risk at play for those planning for retirement. This is also why many US Endowments do not hold large equity allocations.

It is untrue to say that volatility does not matter for the long term when cashflows are involved.

A brief explanation of interplay between the timing of returns and cashflows is provided below.

Longevity Risk

The portfolio size effect and sequencing risk have a direct relationship to longevity risk.

For individuals, longevity risk is the risk of outliving ones’ assets, resulting in a lower standard of living, reduced care, or a return to employment.

Or put another way, longevity risk is the likelihood that superannuation savings will be depleted prior to satisfying the lifetime financial needs of the dependents of those savings.

One way longevity risk manifests itself is when an investor’s superannuation savings is subject to a major negative market event within the Retirement Risk Zone.

The point to take away: the size of your portfolio, order in which returns are experienced, and timing of cashflows into and out of the retirement savings account have an impact on accumulated wealth and ultimately standard of living in retirement.

The basic conclusions. First, it is better to suffer negative returns early in the accumulation phase.

Secondly, it is better to suffer negative returns later in retirement.

Materiality of Sequencing Risk

In short, the research finds that the sequence of returns materially impacts peak accumulated wealth (terminal wealth) and heightens the probability of running out of money in retirement (longevity risk). The research backs up the two conclusions above.

The Griffith University research paper mentioned below “finds that sequencing risk can deplete terminal wealth by almost a quarter, at the same time increasing the probability of portfolio ruin at age 85 from a probability of one-in three, to one-in-two.“

Terminal wealth is “peak” accumulated savings in our Mt Everest example above.

Based on their extensive modelling, investors have a 33.3% chance of not having enough money to last to aged 85, this raises to a 50% chance due to a large negative return during the Retirement Risk Zone.

They also note “It is our conjecture that, for someone in their 20s, the impact of sequencing risk is minimal: younger investors have small account balances, and plenty of time to recover …… However, for someone in their late 50s/early 60s, the interplay between portfolio size and sequencing risk can cause a potentially catastrophic financial loss that has serious consequences for individuals, families and broader society.”

This is consistent with other international studies.

For those wanting a more technical read please see the papers that have been drawn upon for this Post:

Griffith University = The Retirement Risk Zone: A Baseline Study poorly-timed negative return event
Retirement income and the sequence of-returns By: Moshe A. Milevsky, Ph.D., and Anna Abaimova, for MetLife

Managing Sequencing Risk

The combination of the portfolio size effect, sequencing risk, and longevity risk combine to form a trinity of investment issues that need to be managed inside the Retirement Risk Zone.

Mitigation of sequencing risk is critical across the retirement risk zone.

Sequencing risk is largely a retirement planning issue. Albeit a more robust portfolio and a suitably appropriate investment approach to investing will help mitigate the impact of sequencing risk:

A greater focus on generating retirement income earlier

In my mind, a greater focus should be placed on positioning retirement portfolios for generating income in retirement at the later stages of the retirement accumulation phase i.e. at least 10-15 years out from retirement.

This is achieved by using asset-liability matching techniques as recommended by the OECD. This is not just about increasing the cash and fixed income allocations within the portfolio but implementing more advanced funds management techniques to position the portfolio to deliver a more stable level of income in retirement.

The investment knowledge is available now to achieve this and these techniques can improve the outcomes of Target Date Funds.

This is also consistent with the OECD’s Core Principles of Private Pension Regulation that emphasised that the objective is to generate retirement income.

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

Therefore, it is important to have coherency between the accumulation and pay-out phase of retirement as recommended by the OECD.

I have highlighted the OECD recommendations in a previous Post.

2. A greater focus on reducing downside risk in a portfolio

This is beyond just reducing the equity allocation within the retirement portfolio on approaching retirement, albeit this is fundamentally important in most cases.

From this perspective Target Date Funds would be an appropriate default option for KiwiSaver, as I have previously outlined.

A more robust portfolio must also display true portfolio diversification, that helps manage downside risk i.e. reduce degree of losses within a portfolio.

This includes the inclusion of alternative investments. Portfolios should be built more like US endowments as I outlined in a previous Post.

An allocation to Alternatives have also been shown to improve the investment outcomes of Target Date Funds.

The inclusion of low volatility equities may also be option.

The article from Forbes is of interest in managing sequence of returns in retirement, and recommends amongst other things in having some flexibility around spending, maintaining reserve assets so you don’t have to sell assets after they fall in value, and the use of Annuities.

Many argue that sequencing risk can be managed by Product use alone.

My preference is for a robust portfolio, truly diversified that is based on the principles of Goals-Based Investing, and is therefore using asset-liability matching type strategies. I would complement the Goals-Based approach with longevity annuities so as to manage longevity risk. This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.

Sequencing risk is currently a growing and present danger given it has been a long time since both the US and New Zealand sharemarkets have incurred a major fall in value. Hopefully, sequencing risk is getting some consideration in investment decisions being made today.

Happy investing.

Please see my Disclosure Statement

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

Background – Understanding Impact of returns and Cashflows

It is hard to believe, but two investors might both experience “average” returns of 8 per cent over a 20-year period and yet have materially different balances due to sequencing risk.

The 20-year periods would occur at different times, yet the “average” return is the same.

Nevertheless, the sequence of returns to generate an “average” return over the 20 year periods can result in different accumulated wealth.

This reflects there is a difference between time weighted returns and dollar invested returns. The time weighted return assumes you held the same investment over the time period. A dollar weighted return takes into consideration that money goes in and comes out of a savings account and each dollar earns a different return given the period it is invested for. Dollar weighted returns impact on accumulated wealth.

Although the sequence of returns is crucial, so too are the timing of Cashflows into (deposits) and out (withdrawals) of a savings account.

To appreciate this, it is important to understand the impact of market volatility, it is hard to recover a dollar lost from a negative market movement. For example, if your portfolio falls in value by 40%, it’s takes a 67% return to recover your loses e.g. you have $100, this falls in value by 40%, wealth falls to $60, to get back to $100, the portfolio must recover 67%.

When there are cashflows not every dollar will experience the same return e.g. a dollar withdrawn after a 50% fall will miss out on any subsequent recovery in market prices, which can take up to six to ten years.

Therefore, the introduction of cashflows can also result in different outcomes for investors. This is why the pulling of funds out of markets following a large fall (draw-down) early in the accumulation phase can have a detrimental impact on accumulated wealth at the time of retirement.

The sequence of returns and cashflows matters during both the accumulation of retirement savings and in retirement.

During accumulation cashflows are going into the savings account and the account balance is growing. Therefore, each dollar invested has a different investment return.

In retirement, cashflows coming out of the portfolio will gradually reduce the capital base, therefore, investors will be better off if returns are stronger at the start of retirement, as the account balance will be larger and growing, meaning cashflows out will not reduce the capital base as much when returns are poorer in the earlier years of retirement.

For those wanting a more technical explanation, along with some great charts and graphs, this article by Challanger will be of real value.

Approaches to generating Retirement Income

August 26, 2019August 27, 2019 / Kiwi Investor / Leave a comment

In New Zealand the Ministry of Business, Innovation and Employment (MBIE) is currently reviewing the Default Option for KiwiSaver and the Retirement Commission is undertaking its three-yearly review of Retirement Income Polices.

In this regard, a recent Paper by the Brookings Institute is of interest.

The Paper compares the different retirement policy settings of a number of countries and the growing array of new investment solutions that target the delivery of retirement income. The Papers title: From saving to spending: A proposal to convert retirement account balances into automatic and flexible income has some interesting insights. (The Brookings Institution is a nonprofit public policy organization based in Washington, DC. Their mission is to conduct in-depth research that leads to new ideas for solving problems facing society at the local, national and global level.)

Retirement Income Products

The shift from defined benefit pension plans to defined contribution plans makes it even more important for individuals to save for their own retirement. See my previous Post on the looming Savings Crisis.

The gravity of the problem is well presented in a recent nationwide poll in the USA highlighted by Brookings, 73 percent of Americans said they do not have the financial skills to manage their money in retirement.

Converting retirement savings balances into a stream of retirement income is one of the most difficult financial decisions that households need to make.

Encouragingly, new financial products offer people alternative ways to receive retirement income.

New and innovative financial products are disrupting traditional approaches. The new approaches combine existing products in new and different ways. While they do not always provide guaranteed lifetime income, the innovations nevertheless can give savers options and features that annuities do not provide. They are offering Flexicurity.

The Brookings paper explores non-annuity retirement savings options, but not after first providing a good discussion around annuities, highlighting the benefits, drawbacks, and behavioural attitudes towards annuities.

The paper looks at retirement investment solutions beyond annuities. To do this they provide a good comparison of the traditional approach versus a Goals-Based Investment approach (safety-first).

As they outline, there are two fundamentally different approaches to thinking about retirement income that might be viewed as defining the opposite ends of the spectrum of preferences.

There are “probability-based” approaches. This approach has goals similar to those of the accumulation phase in seeking to maximize risk-adjusted returns from the total portfolio in accordance with modern portfolio theory (MPT). “Probability-based retirees tend not to base their retirement planning on a distinction between essential needs and discretionary wants, but instead look at ways to meet their total budget. Their investment portfolio during retirement balances market risk against the probability that the money will run out prematurely. This usually requires a high concentration of equities”
By contrast, there is the “safety-first” approach. This approach engages in asset-liability matching, or financing different income uses with different assets. For example, consumption of necessities would be financed from an annuity or largely riskless portfolio, while less essential goals could be financed with higher-risk investments. “This school tends to believe that retirees must develop a strategy that will at least meet their essential needs (as opposed to desires or preferences), no matter how long they live or how their investments perform.”

I would sit in the safety-first approach. I would complement the Goals-Based approach with longevity annuities so as to manage longevity risk*. This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.

It is also consistent with the Paradigm shift occurring within the global wealth management industry, as outlined in a previous Post, and with the drive to increased Customisation (EDHEC-Whitepaper-JOIM) as promoted by EDHEC.

A very recent example of the innovation occurring is covered in my last Post that outlines the collaboration of BlackRock and Microsoft to develop a technology platform that will provide digital financial-planning tools and new BlackRock funds offering retirement income to employees through their workplace saving plans.

The Brookings paper also provides an example of the ongoing innovation within the industry. The paper provides a good discussion on Managed Pay-out Funds.

Managed Pay-out Funds, which are a major alternative to an annuity, are designed to produce a relatively consistent level of annual income but that does not guarantee that outcome.

They are similar in some respects to Target Date Funds (TDFs) but have a different objective. A well designed TDF would sit in the second category above and would make a good investment solution for a Default KiwiSaver Option.

Managed pay-out funds serve as decumulation (Pay-out) vehicles, paying monthly or quarterly cash distributions to retirees.

The goal is stable income pay-outs stemming from consistent investment returns, and possibly growth, over time rather than maximum gains. The annual income amounts are calculated using both investment performance and, in the case of many managed pay-out funds, a gradual distribution of the principal amount invested in the fund.

Unlike many annuities, these managed pay-out funds are also flexible enough to allow retirees to revise their decisions as circumstances change.

Some of these Funds are the extensions of TDF where the investment strategy shifts from accumulation to income (Pay-out).

Brookings also make the observation that Defined contribution (DC) plans, such as KiwiSaver, will not fulfil their potential to deliver retirement security until they include an automatic mechanism that efficiently helps participants to convert retirement savings into income. “Experience has demonstrated that most new retirees who are handed a lump sum are ill equipped to understand and successfully navigate the many complex risks, trade-offs, and necessary decisions.”

New Zealand can learn from other countries experiences. Particularly the learning that a greater focus should be placed on the generation of retirement income late in the accumulation phase.

Significant improvements can be made to retirement solutions by better positioning portfolios to generate a steady and stable stream of income in retirement.

This should be undertaken in the late stage of the accumulation stage and not left until one reaches retirement.

As outlined in a previous Post this is consistent with what 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.

The retirement investment solution needs to 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 (Pay-check).

This highlights the ongoing need for investment solution innovation in New Zealand.

As Brookings note: “What ever the solution, one thing is clear: Retirees need innovative solutions that help them make the best use of their savings as they transition to a new phase of life.”

Happy investing.

Please see my Disclosure Statement

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

* By way of explanation, a longevity annuity provides protection against outliving your money late in life. This type of annuity requires you to wait until you reach age 80 or so to begin receiving a pay-out.

Analysis of KiwiSaver Balanced Funds

Income Assets

Within Income Assets

Growth assets

Diversified Multi-Asset Funds

Is it Apples vs Apples?

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

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Size of the Market and innovation

Potentially significant Industry Impact

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

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The relative attractiveness of Lifecycle Funds

Increased Customisation of the Investment Solution

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

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Rice Warner – The benefits of Multifactor Lifecycle Funds

Rice Warner Analysis

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

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Why the Growth?

Future Growth and Innovation

New Zealand Perspective

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

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

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

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

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

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

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