Kiwi Investor Blog achieves 100 not out

Kiwi Investor Blog achieves 100 Posts.

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

 

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

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

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

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

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

The investment knowledge is available now to achieve this.

 

To summaries, the key topics of Kiwi investor blog:

 

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

 

 

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

I covered the EDHEC article in more depth recently.

 

 

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

 

 

 

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

 

 

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

 

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

 

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

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Designing a new Retirement System and Goal-Based Wealth Management

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:

  1. increase their monthly contributions;
  2. raise their retirement age; and/or
  3. 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

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

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:

  1. The portfolio size effect (what you do when the largest amount of your money is at risk matters); and
  2. 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:

  1. Griffith University = The Retirement Risk Zone: A Baseline Study poorly-timed negative return event
  2. 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:

  1. 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

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.

  1. 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”
  2. 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.

 

Fintech’s Colossal Solution – Uber Moment? Microsoft and BlackRock team up

BlackRock and Microsoft are building a platform that will help people develop better saving and investment habits through more regular engagement with their retirement assets.

This initiative was announced in December 2018 and the Wall Street Journal (WSJ) noted at the time:

“The firms plan to develop a technology platform that will provide digital financial-planning tools and new BlackRock funds offering guaranteed retirement income to employees through their workplace saving plans.”

 

This is close to the Uber moment for the Wealth Management industry: technology platform providing retirement planning tools and direct access to new generation Investment Solutions.

 

BlackRock, the world’s largest money manager, according to WSJ “wants to shape the technology plumbing that connects it to different parts of the financial ecosystem handling workers’ retirement money.”  And for Microsoft, who needs no introduction, “an investment platform built with its technology could bring in new revenue as it looks to become a bigger cloud-computing player.”

 

BlackRock and Microsoft have made progress since December and FinancialPlanning.com provided further details in July 2019:

“The technology giant and the asset manager overseeing 15 million Americans’ 401(k) portfolios are developing an app and desktop tool aimed at narrowing the widening gap between what workers will need in retirement and how much they’re saving.”  (401 (k) is like KiwiSaver)

BlackRock and Microsoft are looking to reimage America’s path toward achieving greater financial security in retirement by bringing together BlackRock’s investment capabilities and Microsoft’s technology strength.

Together, they are exploring the next generation of investment solutions to help more people make better decisions as they work toward their financial goals in retirement.

Taking advantage of Microsoft’s technologies and BlackRock’s investment products, the companies are aiming to make it easier for people to both save for retirement and achieve the lifetime income they need through their employers’ workplace savings plan.

The firms will begin rolling out their tool later this year.

By all accounts, this is going to be a powerful platform.  I’d imagine some of the tools will be like the BlackRock CoRI Index, which estimates the level of lifetime retirement from current savings.

 

Lifetime Income Focus – Next Generation of Investment Products

From an investment perspective the retirement tool will include guaranteed retirement income planning.

As part of the rollout Microsoft and BlackRock are designing methods of showing workers how much extra contributions today could end up netting them in retirement.  The intended result is that employees “have a clearer picture of how their contributions today will translate to long-term retirement income”.

BlackRock intends to offer the platform in connection with next generation investment products that it will design and manage. The new products from BlackRock will seek to provide a lifetime of income in retirement.

 

Therefore, BlackRock will be offering more sophisticated products than widely available now.  These Funds will seek to provide guaranteed income streams to participants as they get older, an element not common in 401(k) (like KiwiSaver) and other retirement plans.

The funds will be like Target Date Funds, a blend of investments that get more conservative as investors head into retirement. However, the funds BlackRock wants to roll out will also increase their concentration in financial instruments that provide regular payouts as participants reach retirement.  This is a massive enhancement.

As an aside, Target Date Funds would be a good option as the Default Fund for KiwiSaver.

 

Importantly, the focus is on providing an income stream in retirement.  There is a strong argument this should be the primary investment goal and not the targeting of a lump sum at time of retirement. What matters in retirement is income.

The OECD encourages the retirement objective 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 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, volatility of income in retirement is a good risk measure.

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.

 

More specifically, the focus on retirement income and use of more advanced portfolio construction techniques as liability-driven investing overcomes one of the main criticisms of Target Date Funds.  Particularly, Target Date Funds should have a greater focus on generating income in retirement.  This means the fixed income allocation should act more like an annuity so that is pays a steady stream of income to the investor once they reach retirement.

The investment knowledge is available to achieve this.

 

Accordingly, BlackRock’s solutions appear to be more aligned with Goals-Based Investing and will be a more robust Retirement Income Solution than those available now.

There is a real need for these new generation investment solutions as many of the current financial products have shortcomings in meeting future customer needs, particularly the delivery of a stable and secure level of retirement income.

It is also important to note that there is a paradigm shift underway within the wealth management industry in relation to the development of new and improved investment solutions.

The industry is evolving, new and improved products are being introduced to the markets in other jurisdictions to meet a growing savings crisis.

 

Defining Social Challenge – Addressing the Savings Crisis with Technology

As BlackRock outlined when making the initial announcement in December 2018:

Retirement systems worldwide are under stress and providing financial security to retirees has become one of the most defining societal challenges of our time,” said Laurence Fink, chairman and chief executive of BlackRock.

BlackRock has a tremendous responsibility to help solve this challenge, and we recognise the need to act now. Working with Microsoft will enable us to build a powerful solution for millions of hardworking Americans.”

There has been a major shift globally away from Defined Benefit (DB) schemes to Defined Contribution (DC).

As a result, the individual has become increasingly responsible for investment decisions, for which they are generally not well equipped to make.   This has been likened “financial climate change” by the World Economic Forum

In America, millions are struggling to achieve their financial goals in retirement.  BlackRock and Microsoft are aiming to narrow the “gap” between what workers will need in retirement and how much they are saving.  This gap is estimated to be expanding by $3 trillion each year!

Therefore, there is a very real need to help people who are struggling with the difficult task of saving, investing, and turning this into a retirement income.

In BlackRock and Microsoft’s view the “shift in responsibility, from corporations to individuals, combined with ever increasing life-spans, has created a need to reimagine a new approach to securing a sound financial future in retirement – one that is powered by innovative investment solutions and the most advanced, trusted and cutting-edge technologies.”

“Technology is already revolutionizing entire industries and the way people interact with everything from health care to education and transportation. And yet, retirement solutions of today have been slow to keep pace. Taking advantage of Microsoft’s cutting-edge technologies and innovative investment products from BlackRock, the companies aim to make it easier for people to both save for retirement and achieve the lifetime income they need through their employers’ workplace savings plan.”

 

Thus, the need for new innovative investment solutions and technology platforms.

This is close to the Uber moment for the Wealth Management industry.

 

Happy investing.

Please see my Disclosure Statement

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

 

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

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

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

 

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

 

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

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

A good estimate to this question can be determined.

 

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

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

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

 

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

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

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

 

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

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

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

 

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

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

How these Indices work is outlined below.

 

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

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

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

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

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

 

Happy investing.

Please see my Disclosure Statement

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

 

BlackRock CoRI

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

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

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

Estimations based on a range of ages can be undertaken.

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

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

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

Greater detail on the CoRi methodology is available here.

 

EDHEC-Princeton Goal-Based Investing Index Series

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

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

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

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

 

There are two Indices.

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

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

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

There are Retirement Wealth Indices as well.

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

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

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

 

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

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

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

 

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

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

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

 

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

 

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

 

KiwiSaver and OECD Pension Scheme Recommendations

The OECD has identified for some time the growing importance of Defined Contribution (DC) pension schemes.

There has been a major shift globally away from Defined Benefit (DB) schemes to DC, such as KiwiSaver here in New Zealand.

As a result, the individual has become increasingly responsible for investment decisions, for which they are generally not well equipped to make.   This has been likened to a “financial climate change” by the World Economic Forum

The OECD has undertaken a review of DC potential drawbacks and how to incorporate them into regulatory frameworks to protect members. This led to the formation of a Core Principles of Private Pension Regulation.

In addition, the OECD Roadmap for the Good Design of DC Pension Plan made several recommendations.

 

Off interest to me, from the perspective of designing investment solutions, were the following:

  • Ensure the design of DC pension plans is internally coherent between the accumulation and pay-out phases and with the overall pension system. 

 

  • Consider establishing default life-cycle investment strategies as a default option to protect people close to retirement against extreme negative outcomes. 

 

  • For the pay-out phase, encourage annuitisation as a protection against longevity risk.

 

The OECD made a number of other recommendations which also have merit and they are provided below.

 

The OECD Core Principles of Private Pension Regulation emphasised that the objective is to generate retirement income.

Importantly, investment strategies should be aligned with this objective and implement sound risk management practices such as diversification and asset-liability matching.

“These should be appropriately employed in order to achieve the best outcome for the plan members and beneficiaries” (Guidelines 4.1).

Interestingly, these principles should apply not only to KiwiSaver, but to any forms of voluntary savings plans and mandatory arrangements.

 

The emphasis on generating retirement income and coherency between accumulation and pay-out phase (de-cumulation) are important concepts.

 

In my mind, a greater focus should be placed on 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. The investment knowledge is available now to achieve this.

This reflects that the goal of most modern investment Products is to accumulate wealth and risk is defined as volatility of capital. Although these are important concepts, and depending on the size of the Pool, the focus on accumulated wealth my not lead to the generation of a stable and sufficient level of income in retirement.

This is a key learning out of Australia as they near the end of the “accumulation” phase of their superannuation system.

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.

 

I have Posted previously on the concept of placing a greater focus on retirement income as the investment goal (as recommended by the OECD). The argument for such a goal is well presented by Noble Memorial Prize in Economic Sciences Professor Robert Merton.

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

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

 

It is appropriate to consider the OCED recommendations at a time that the New Zealand Government are reviewing the Kiwisaver Default Provider arrangements.

This Review is being undertaken by the Ministry of Business, Innovation & Employment (MBIE) and submissions are due 18 September 2019.

This GoodReturns article provides some context.

 

It is also important to note that there is a paradigm shift underway within the wealth management industry. The industry is evolving, new and improved products are being introduced to the markets in other jurisdictions.

New and innovative financial products are disrupting traditional markets by offering alternative ways to receive retirement income. 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.

For example, Managed Payout Funds in the USA are a major alternative to an annuity. These Funds 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.

 

More robust investment solutions are being developed to meet the retirement income challenge, they also display Flexicurity.   EDHEC Risk Institute provides a sound framework for the development of Robust Investment Solution and the need for more appropriate investment solutions.

Increasingly the robust solution is a Goal-Based investment solution coupled with longevity annuities that begin to make payments when the owner reaches an advanced age (e.g. 80) as a means to manage longevity risk.

 

The future also entails an increasing level of customisation. This reflects that saving for retirement is an individual experience requiring much more tailoring of the investment solution than is commonly available now. Different investors have different goals.

The investment techniques and approaches are available now to better customise investment solutions in relation to the conservative allocations within ones portfolio so as to generate a level of income to meet retirement goals.

Likewise, the allocation to risky assets (e.g. equities) should also be based on individual goals and circumstances.

The risky asset allocation should not be based on age alone, other factors such as assets outside of Super, other forms of income, and tolerance for risk in meeting aspiration retirement goals for example should also be considered.

 

In summary, the retirement investment solution needs be customised and focus on generating a sufficient and stable stream of replacement income. This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI). Focusing purely on an accumulated capital value and management of market risk alone may lead to insufficient replacement of income in retirement, greater variation of income in retirement, and/or other inefficient trade-offs are made during retirement.

Importantly the investment management focus is not on beating a market index, arguing about fees (albeit they are important), the focus is on how the Investment Solution is tracking relative to the “individuals” retirement goals.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

The OECD also recommends:

  1. Encourage people to enrol, to contribute and contribute for long periods.
  2. Improve the design of incentives to save for retirement, particularly where participation and contributions to DC pension plans are voluntary.
  3. Promote low-cost retirement savings instruments.
  4. Establish appropriate default investment strategies, while also providing choice between investment options with different risk profile and investment horizon.
  5. Promote the supply of annuities and cost-efficient competition in the annuity market.
  6. Develop appropriate information and risk-hedging instruments to facilitate dealing with longevity risk.
  7. Ensure effective communication and address financial illiteracy and lack of awareness.

 

 

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

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

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

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

 

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

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

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

 

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

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

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

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

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

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

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

 

Retirement Goal

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

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

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

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

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

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

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

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

 

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

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

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

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

 

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

 

The death of the Policy Portfolio

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

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

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

It is a single Portfolio solution.

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

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

 

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

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

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

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

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

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

 

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

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

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

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

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

 

Evolution of Wealth Management – the new Paradigm

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

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

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

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

 

Goal-Based Investing

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

As explained by EDHEC Risk Goal-Based Investing involves:

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

 

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

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

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

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

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

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

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

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

 

Industry Challenge

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

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

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

 

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

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

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

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

 

Conclusion

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

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

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

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

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

 

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

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

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Target Date Fund’s popularity set to Grow

Target Date Funds are popular, particularly amongst Millennials, and this growth is expected to continue.

This is a key insight from a WealthManagement.com survey of 530 retirement plan advisors in the US. The survey was conducted in February 2019. (TDF Survey Feb 2019)

 

Target Date Funds (TDF), also referred to as Glide Path Funds or Life Cycle Funds, automatically reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

In previous posts I have highlighted it is important to understand the shortcomings of TDF given their growing dominance international. According to the FT “Assets held in US target date mutual funds now stand at $1.1tn, compared with $70bn in 2005, according to first-quarter data compiled by the Investment Company Institute, a trade body.

Encouragingly, the shortcomings of TDF can largely be overcome.

 

The WealthManagement.com survey highlighted that almost half of those surveyed expect to increase their use of TDF in the next two years.

From this perspective, the following insights are provided from the survey:

  • TDF are an important tool in many retirement plans: 61% of Advisors surveyed currently have clients invested in target date funds.
  • TDF also typically represent an important component of their retirement plan when used.
  • Many plan advisors expect the reliance on TDFs to increase in the coming years.

 

Risk Management and Glide Paths

Of the Advisors surveyed longevity and volatility where the top two risks.

“The popularity of TDF was partly attributed to their ability to help retirement plan advisors address two of the biggest risks to successful retirement: longevity and volatility risk.”

“These two risks line up well with the strengths of the glide path concept. In particular, the gradual reduction in equity exposure over time seeks to minimize volatility in retirement, while the exposure to the growth potential of equities beyond retirement hedges against longevity risk.”

 

It is also noted that Glide paths help manage other risks, such as behavioural risks – to guard against investors adjusting their investment allocations based on emotions.

 

Interestingly: Nearly two-thirds of plan advisors (63%) report favouring a “through” glide path for clients, over a “to” glide path (37%); the latter achieves and maintains a conservative allocation at the target date, while the former reduces its equity allocation gradually throughout retirement.

“Given that retirement can last for 30 years or more, and that more plan advisors prioritize longevity risk over volatility risk, a “through” glide path is logically the more attractive feature.”

 

Customisation

The report observes that one of the major appeals TDF is the ability to contribute money to an investment account that automatically shifts its asset allocation over time according to a pre-determined schedule.

Therefore, in evaluating TDF Advisors tend to focus on the mix of assets and allocation in the glide path and the glide path itself.

Although Fees are a consideration, it is worth emphasising the above two aspects are considered the most important by Advisors in determining which TDF to recommend to Clients.

 

Therefore, it is not too surprising that a greater degree of customisation would be attractive to Advisors so as to better meet Client’s investment objectives:

  • Most advisors surveyed (59%) believe that more customization versus off-the-shelf options would help make TDFs more useful and more attractive to clients.
  • In fact, the most commonly cited reason advisors say they don’t use TDFs in the plans they advise is the lack of customizability (33%).

 

Goals-based Investing

Further to the above customisation observations, the report notes that the popularity of TDF among retirement plan advisors may be linked to advisors’ tendency to take a goals-based investment approach:

  • Just over half of the plan advisors surveyed (51%) identified most strongly with a goals-based label, as compared to targeting outperformance against a benchmark (41%)

“It’s perhaps not surprising that a group that favors the use of TDFs would also favor an investment strategy built around a specific target or outcome. This trend suggests that if goals-based investing is in fact gaining broader popularity, TDFs may benefit from increased usage as well.”

 

Shortcomings of Target Date Funds

I have posted previously on the shortcomings of TDF.

Essentially, Target Date Funds have two main shortcomings:

  1. They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration future income requirements or likely endowments, current level of income to retirement, or risk profile.
    • They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
  2.  Additionally, the glide path does not take into account current market conditions.
    • Risky assets have historically shown mean reversion (i.e. asset returns eventually return back toward the mean or average return, prices display volatility to the upside and downside.

Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:

    • Delays in pace of transitioning from risky assets to safer assets
    • May require step off the glide path given extreme risk environments

 

I have advocated the customisation of the fixed income allocation within TDF would be a significant step toward addressing the shortcomings of many TDF. The inclusion of Alternative assets and the active management of the glide path would be further enhancements.

These shortcomings are consistent with the desire for a greater level of customisation from Advisors.  Although not explicitly addressing the shortcomings outlined above, the following commentary from the report is interesting:

“A comment from one retirement plan advisor with more than 25 years of experience in the industry hits on multiple suitability issues at once. “TDFs look only at age and not where we are in the interest rate cycle,” he says. “Retirement date is not a terminus date, and many clients still need growth well after their retirement date.”

While most TDFs do not explicitly factor the interest rate cycle into their glide paths, many do address the need to maintain exposure to growth beyond the target retirement date—particularly through the choice of a “through” glidepath, although perhaps not at the level advisors would like to see. “

 

This is a great insight and consistent with my previous posts where it has been highlighted that maintaining high levels of cash at time of retirement is scandalous. This is addressed by having an equity allocation at the time of retirement (through glide path) and a more customised fixed income allocation within the TDF.

 

Measuring success

Great to see:

“In keeping with the general tendency toward a goals-based approach identified earlier, however, it is noteworthy that advisors most commonly evaluate TDF performance relative to peer groups (40%) and not based on outperformance of a benchmark, whether an industry index (21%) or a custom benchmark (16%).”

 

Happy investing.

 

Please see my Disclosure Statement

 

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