STEP 3: Make the investment solution meaningful
So, your bags are packed and you’re ready to go. Now what? Life happens. And this is where most individuals without financial planning support fall apart. But first, let’s just challenge a bit of convention here.
Changing the mindset on the investing approach
What if we could completely change the way we think about investments? Instead of dedicating a considerable amount of time and resources to ensure that your retirement and discretionary savings are all invested with the top performing manager in the country (and then invariably failing), what if we became a bit more circumspect with why we invest and what we want to achieve?
Let’s take the problem of funding retirement income: the challenge for employees is to save enough over their 30 or 40 working years until retirement to buy a financial instrument (an annuity) that will give them the post-retirement income they need to live on for the rest of their lives.
From the start, the expectation for most individuals does not appear unrealistic. The assumption is that your retirement savings will gradually grow – ahead of inflation – for most of your life. As such, you should be able to make the transition into retirement without having to make too dramatic a change in your life circumstances.
In response to this expectation, life stage portfolios evolved as the preferred strategy for retirement funds. The life stage model appeared to be the best of both worlds. For the first 30 to 35 years of their employment, members would be invested in a portfolio whose primary goal was to accumulate the highest possible return for the risk appetite of the member (usually aggressive for this period in the cycle). Whether members selected active portfolios that combined multiple specialist asset managers or a blend of active balanced managers or even a blend of passive asset class indices, knowing which strategy to use was effectively irrelevant. There was simply no way to know after a specific 35-year period which one of these strategies would perform better.
But the real value-add in the life stage investment strategy was the fact that in the 5 to 10 years before retirement, this strategy would completely shift to one that tried to gain more certainty around the maximum income that an individual could buy in the annuities market (either by preserving capital or by targeting the cost of securing an income appropriate to the individual’s needs). Essentially, life stage investment strategies provided investors with the means to plan their retirement needs more effectively. But in many ways, life stage investment strategies at the fund level are like chainsaw art.
Chainsaw art reflects an attempt by an artist to replicate an image or statue out of a block of wood with a very bulky chainsaw. The necessary result is at best a very crude representation of the original concept.
While it’s better than doing nothing, it assumes that everyone entering into the derisking phases of a life stage strategy has the same fund credit and, more importantly, has the same expectations for their income requirements after retirement.
Beyond chainsaw art
In fact, technology and financial modelling have moved to the level where it is theoretically possible for every individual in a fund, irrespective of their income or fund credit level, to have their own tailor-made solution that would consider exactly where they were coming from (had they preserved in the past or contributed enough?) and helped them maximise where they could go in the future, given the specific objectives.
Sounds excessively costly? Not if you employ low-cost passive building blocks to construct the myriad solutions. Think of each of these building blocks as targeting different investment requirements: longterm growth, short-term growth, capital preservation, income targeting, and so on. Different blends of these building blocks would solve just about any investment problem an individual might face. As an individual moves through their financial life, the blend of these building blocks will shift to accommodate whatever strategy they need to maximise at that point in time.
The shift in mindset would not be trivial. A particularly pressing concern for fiduciaries would be how to fulfil their monitoring responsibilities if every member potentially has a different strategy. But that assumes that the way we currently monitor and assess performance is correct.
Consider the significant value destruction that occurs when trustees, members and their advisers chop and change managers or strategies that don’t outperform their benchmarks on time frames that may be completely meaningless given the context of the strategy.
In our brave new world of optimised solutions for members, trustees would still be able to assess whether each of the building blocks was fulfilling its respective performance expectations. And with technology now allowing us to track the progress of every member in a fund in meeting their long-term funding requirements, we would be able to immediately identify any journey that has gone off track.
What the change in thinking would do though, is to significantly transform the effectiveness of a life stage investment strategy into something that far more neatly recognises the considerable variability that exists for members of a given retirement fund in their current fund credits and their aspirations for those savings.
The important point to note, though, is that we have now, ever-so-subtly, introduced the first steps of financial planning to all members of a fund, irrespective of their income levels or level of financial sophistication and, with the right building blocks, we can do so cost-effectively.
STEP 4: How should you pack your bags?
Taking this new framework to the next logical step
Tailoring solutions to individual circumstances in the retirement space is hardly new. For example, although in its infancy, some funds have been introducing dynamic solutions in the risk benefit space that recognises that members have variable needs for different risk benefits as they move through life. By using an individual’s basic demographic information, we can create a far more efficient allocation of resources by ensuring that they only buy cover when circumstances demand it. Collect the necessary information such as age, gender, marital status and family circumstances and this becomes a solution that’s reasonably straightforward to automate.
But outside the pension fund, the real world and the real challenges await. Remember our suitcase problem: we each have our own size suitcase that requires us to consider trade-offs. If we want individuals to understand the critical interplay between their pension fund benefits and their families’ or dependants’ other day-to-day financial needs, we need an optimisation framework that allows us to get the optimal balance, given the constraints of that suitcase, between:
- What the individual needs to consume now, with
- What they need to save for in the future, with
- What they need to cover home loans or debt, to
- What they need for their children’s education, to
- Maximising the opportunities they have to reduce tax, to
- Funding medical expenses both now and in the future (when they will likely increase).