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Robert Merton, the Nobel Laureate in finance, is emphatic about one point when it comes to retirement investing: “Sustainable income flow, and not the stock of wealth, is the objective that counts for retirement planning.”
Robert Merton, the Nobel Laureate in finance, is emphatic about one point when it comes to retirement investing: “Sustainable income flow, and not the stock of wealth, is the objective that counts for retirement planning.” As a fiduciary on a retirement fund, which option is preferable to you?
1. An investment strategy that has a relatively high probability of providing the income replacement that your members require when they retire?
2. An investment strategy that either could equally provide high, inflation-beating, competitor-beating returns or could produce inadequate outcomes against either those benchmarks. More importantly, it could fail to provide the necessary income replacement.
Chances are that, while you intuitively understand that option 1 should be the preferred option, you also know that real or perceived performance pressures or lack of clarity around fund objectives will often lead a board of trustees to opt for option 2.
The interesting part is that, when the defined benefit model dominated, option 1 was the ubiquitous choice for trustees. Here the objective was clear and codified in the rules. The question is therefore whether the shift to defined contribution funds should have changed investment strategies – or whether it was an unintended consequence.
Asset management can be a powerful tool. Give an asset manager a target, a time frame, and the degree of certainty required of meeting that target, and a fund manager can generally deliver a reasonable outcome. Turn that requirement into a performance race, by demanding that the fund manager outperform their competitors in perpetuity, and outcomes (both in absolute returns and relative to a specific goal) become decidedly more random.
Bottom line: as an investment strategy, a goals-based framework has a much higher probability of fulfilling client needs by way of meeting an objective, than a performance-based framework. If the focus of retirement funds is to ensure that individuals have an adequate replacement for their income when they cease working, can we really afford to gamble?
Goals-based investing differs from traditional investing in three critical ways:
This sounds sensible, but why are we still locked in a performance race if goals-based investing is so powerful in reinforcing all the right behaviours in both our members and our fiduciaries?
Essentially, the shift towards a performance-driven investment model that has occurred over the last 30 years owes much to the technological limitations that made it infeasible to provide customised solutions to a massively expanded consumer base. The rise of the unit trust industry and the shift for employees from a defined benefit to a defined contribution model contributed to an explosion in the democratisation of investing to individual investors. Performance comparisons between managers became the easiest metric on which to base one’s choice of investment portfolio simply because it was easy to communicate, and the information was readily available.
Today, technology has evolved to the point where the industry can offer cost-effective solutions that both dynamically assess asset-liability shifts and then create the right investment mix to provide the best chance of meeting those funding goals over the required time frame. Ultimately, the more individualised the solution, the better the likely outcome.
Why are we still locked in a performance race if goals-based investing is so powerful in reinforcing all the right behaviours in both our members and our fiduciaries?
Perhaps, though, the real reason the goals-based concept has battled to gain momentum is that over the last 12 years markets have continued to set new performance records, in spite of the occasional blip (think Global Financial Crisis of 2008). As long as markets continue to power on, the pressure to change the model of ‘top performance as a meaningful measure of success’ is unlikely to change. But the more investors begin to appreciate that fund manager track record successes have very little to do with the investor’s personal financial success, the greater the pressure will be on the industry to change to a model that is more outcomes-based focused.
How would goals-based investing strategies work with retirement funds? Retirement funds provide a natural candidate for the goalsbased investment approach. Many trustees may be thinking this is exactly what they are doing now. But let’s put conventional retirement fund investing to the test to see if it properly adheres to a goals-based approach.
1. Have you got defined goals for your fund or its members?
What is the objective of a retirement fund? To provide the highest fund credit possible? To ensure capital protection at all times? Actually, the Pension Funds Act is fairly specific as it defines pension fund organisation to mean:
“(a) any association of persons established with the object of providing annuities or lump sum payments for members or former members of such association upon their reaching retirement dates, or for the dependants of such members or former members upon the death of such members; or...”
Regulation 28 to the Pension Funds Act deals with investment strategies, and says that:
“A fund has a fiduciary duty to act in the best interest of its members whose benefits depend on the responsible management of fund assets. This duty supports the adoption of a responsible investment approach to deploying capital into markets that will earn adequate risk adjusted returns suitable for the fund’s specific member profile, liquidity needs and liabilities…” “Principles (2) (c) A fund and its board must at all times apply the following principles: (iv) ensure that the fund’s assets are appropriate for its liabilities;…”
Most trustees probably feel they have met these requirements. Generally, in defined contribution funds, the goal has been defined as the member’s ability to replace a percentage (often 75%) of their final income on retirement. It’s not a bad start, but we need to take it further by directly translating this goal into action by the strategies we adopt.
This approach also has a few problems:
Importantly, a truly goals-based strategy is about maximising the probability of achieving the targeted replacement ratio whilst retaining a balance with other protection. And not what ratio is actually achieved as this will only be known afterwards.
2. Have you structured your solutions right to meet those goals?
Trustees may consider whether they have selected the correct asset management strategy. However, we have highlighted at previous Hot Topics sessions that getting the structure right involves the full value chain:
Only once we can tick all those boxes does selecting the right investment strategy become truly meaningful.
3. Have you identified risk in a meaningful way?
Some trustees think about risk as volatility of performance only. This manifests in several ways. Risk numbers for investment reporting are typically little more than measures of the volatility (returns relative to some benchmark) of an investment strategy. This is the typical risk versus return efficient frontier that trustees may be familiar with, so-called Modern Portfolio Theory. The problem is that this efficient frontier has little to do directly with the underlying target of a particular retirement income.
Risk questionnaires, often used in financial planning or advice, relating to member choice also typically try to determine the level of aggressiveness a member can tolerate in performance volatility.
Neither helps trustees with the discussion around how much risk is required to meet members’ goals. Nor do they help trustees structure an investment solution that has the highest probability of meeting a given target.
Consider two parameters:
4. Have you identified the investment or employee benefit strategy that has the highest probability of meeting your member’s needs?
The key here is rigorously testing for probability of success on both these parameters.
Strategies such as traditional life stage investment, whilst certainly at some levels leaning towards a goalsbased philosophy, are capable of doing a limited amount on behalf of members. The strategy is only effective if members have a reasonable level of fund credit at the beginning of the pre-retirement glide path that secures their future retirement income. In addition, many life stage strategies require a degree of homogeneity around members’ post-retirement investment requirements. These are rarely the case and often trustees may fail to appreciate whether the life stage strategy they have selected is really the most appropriate for their membership demographic.
As such, our evolutionary journey into the future must take these limitations into account. To increase our probability of success, we need to consider how we can improve our life stage approaches and ultimately better individualise the strategies for members. The strategy that has the highest probability of meeting our differentiated member goals is one that will recognise both the different start and end points of members as well as constantly realign movements in the markets and the member’s liabilities.
5. Have you identified the appropriate building blocks to tackle a goals-based approach?
A retirement funding goals-based approach may require a range of building blocks:
This is a discussion around the mandate intent of each strategy and whether it is adequately structured to deliver on what is required.
6. Are we monitoring success correctly?
Becausse monitoring is perhaps the most important part of a goals-based process, it should be given due attention. We have stated that there are two retirement related goals that are meaningful to the member:
Simplistically, we could easily measure the first goal by identifying the replacement ratio that members actually end up retiring on. The problem here of course is that, by then, it’s too late to rectify anything. The Alexander Forbes latest Member Watch database suggests that actual retirees have achieved a replacement ratio of 32.8% on pensionable salary from their funds – a figure which is consistent with other findings in the industry. It would be quite a shock to members to find out how little of their earnings they were replacing at retirement age.
Members should be provided with annual statements that inform them of where they are in their journey to that replacement ratio objective, whether they are still on target for success, and if not what could they do that could improve the long-term outcome before it’s too late.
But an even more successful monitoring strategy is one that acknowledges that both the trustees and the members play a role in influencing the final outcomes. In addition to providing members with insights into what they could do to influence outcomes, trustees need a clear understanding of how their decisions impact on outcomes.
LifeGauge provides a superb stress testing and monitoring framework which demonstrates how any trustee, member or employer decisions – from costs and preservation decisions, to investment strategies, to contribution, pensionable pay parameters, and more – impact on each member. Because each member is at a different point in their journey and has a different fund credit base, the impact of each decision (and even market impacts) can vary dramatically between members.
Monitoring this aspect of the process means we have to move away from the traditional way that manager performance is measured – in other words, did the manager beat some asset class benchmark? This may be of interest, and does have some relevance to trustees in ensuring the managers do their jobs but it has little to do with the actual objective of the fund.
In goals-based investing, what we need to be measuring is whether each strategy element is actually delivering as required:
These are clearly very different metrics to monitor, but they are not difficult to measure. What is required is mindset change on how fiduciaries think about their investments, select their investments and measure their investment solutions.
The Alexander Forbes latest Member Watch database suggests that actual retirees have achieved a replacement ratio of 32.8% on pensionable salary from their funds.
In summary To get goals-based investing right, which is in members’ interests, there needs to be a change of the norms in the industry, both in asset management and benefit consulting. What needs to happen?
To get goals-based investing right, which is in members’ interests, there needs to be a change of the norms in the industry
Overall, the industry needs to rethink how they are helping their clients set the right expectations and then manage continuously those expectations.
When all is said and done, hope is not an optimal strategy – whether we are dealing with investment performance or protection for our members. Goalsbased strategies say: “Let’s take the randomness out of the outcomes. Let’s focus on whether our members are getting where they need to go.”
And in case you feel that that this is the first time you have heard about goals-based investing, we take you back to Hot Topics March 2014. In that workbook, we were looking at life stage strategies and made the following points, still hugely relevant in this discussion:
“What we can say is that in a risk cognisant world, developing our investment strategy in such a way that it is at inception optimised to deliver our key objective (such as a replacement ratio) with as high a probability as we can, and then refining this over time to improved techniques, is more than intuitively correct – it is, based on the modelling and the inputs at the time, the most appropriate strategy for that objective because it is optimal. This does not guarantee that in hindsight, a slightly different structure could not have delivered a marginally better result. It is all about maximising the probability of success.”
An important takeaway here is that we are not determining success by comparing the various funds’ returns against each other, nor against market related benchmarks or other unrelated strategies. Instead we are determining the success of the strategy by comparing the experience to the stated objectives.
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