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Investing for retirement demands a very specific form of investment option. It is as much about securing a meaningful income post-retirement as it is about maximising the ability to build up members’ savings pre-retirement: two objectives that require two very different investment strategies. Knowing how and when members should be exposed to which investment strategy in the course of their long journey to retirement is the critical test of an effective retirement funding plan.
Investing for retirement demands a very specifi c form of investment option. It is as much about securing a meaningful income post-retirement as it is about maximising the ability to build up members’ savings pre-retirement: two objectives that require two very different investment strategies.
Knowing how and when members should be exposed to which investment strategy in the course of their long journey to retirement is the critical test of an effective retirement funding plan.
For most of a member’s savings life, investing in an aggressive growth portfolio is a perfectly viable strategy. But, securing a monthly post-retirement income stream requires the purchase of an annuity. When interest rates fl uctuate, the cost of these annuities also fl uctuates. This means that the amount of income that can be purchased for every rand of capital at the point of retirement may be very different from the amount anticipated in the fi ve to seven years before retirement. How then can investors stabilise the certainty of that income enough in advance so that they can adequately plan for their retirement requirements?
To change one’s investment strategy from one that is growth oriented towards one that is more liability focused to secure the expected target income requires disciplined action to make the relevant portfolio changes through to retirement. For the average person this is a diffi cult process to manage independently.
Life stage investing is a convenient single-step investment strategy that takes this into consideration. This form of investing is not a new concept and has been applied in South Africa for some time. In fact, in Hot Topics March 2014 we considered whether life stage models had delivered the expected benefi ts and we took a brief glimpse into their future – which we now look to expand.
Life stage investing, in its earliest form, recognised that the ability of an individual to assume risk in their retirement portfolios decreases as they approach their retirement.
A life stage investment strategy is based on a two-stage framework, where the first phase focuses on saving and accumulating assets for retirement. During this early phase the individual has a long time horizon left to retirement and as such they can assume more investment risk which can potentially increase the long-term returns for the individual. An investment portfolio that contains mainly equity and other growth assets would be appropriate during this phase. Disciplined savings behaviour by the individual, such as regular contributions and preserving retirement savings when leaving a pension fund, will contribute hugely to a successful outcome for the life stage investment strategy.
The second phase of the investment strategy focuses on preparing the individual for retirement. During this phase, behavioural research has shown that the average person will tend to become more risk averse and would seek to avoid losses on their investments. The early life stage strategies recognised this change in risk tolerance and reduced the volatility of the portfolio as the individual approached retirement.
Traditionally the strategy would systematically reduce the asset exposure from the ‘more risky’ equity assets to ‘less risky’ fixed income and cash assets as the retirement date approaches, as depicted in the graph below.
The problem with this traditional approach though is that, while cash may provide high capital protection characteristics, it does not adequately protect against inflationary erosion. As such, it is largely uncorrelated to changes in the price of liabilities and annuities.
Clearly, the focus on reducing total risk (as volatility of returns or capital loss) has had several flaws. It assumes that by maintaining the portfolio’s ability to achieve an above inflation return the portfolio should be able to achieve the goal of replacing income on retirement. That said, the recent past has demonstrated that this assumption can fail, as many individuals in South Africa and especially in the UK found that their retirement savings were woefully inadequate to maintain their standard of living despite seemingly successful investment outcomes.
The reason for this is that the cost of replacing members’ income in the future depends on the expected future real interest rates and yields, exactly the same factors that drive annuity prices. Once members are close to retirement, changes in yields can have a significant impact on their standard of living unless their investment strategy explicitly manages this risk as well. The risk to the future obligations is often ignored as it is generally difficult to measure and communicate.
Evolved thinking Life stage products are evolving with the recognition that we need to create investment solutions that go beyond the simple requirement of reducing capital market risk. If income replacement more correctly specifies the problem, then the investment strategy to achieve this specific goal is substantially different. The problem is, standard investment portfolios built by using Modern Portfolio Theory will generally be inadequate as this approach only models volatility as a risk. Additionally, in all likelihood, the time horizon of the strategy may not be aligned to the remaining investment horizon. In summary, by replacing our traditional portfolio design approach with a goals-based approach, we should be able to see these qualitative and quantitative differences:
How does this evolved thinking potentially change our current life stage solution?
The life stage solution in the accumulation phase is not materially impacted by a goals-based approach, except for the recognition that investors can have more freedom in the design of their growth portfolios in terms of growth and risk objectives – a return maximisation objective. This strategy can be aligned to the investor’s preferred investment philosophy. Selecting which growth strategy will produce the best outcomes in the future is impossible to determine in advance regardless of what past performance data may reveal.
Research has shown that members remain invested in strategies that they understand best and the selection of portfolio is driven largely by philosophy and risk tolerance. The relevant points that investors need to appreciate about a growth portfolio are:
This is where the most notable changes will take place. There are two critical changes in this phase:
Time is a critical resource that the retiree does not have in this phase. Unlike the accumulation phase where market downturns could be waited out, time in this phase is limited.
Time helps to smooth out risks, as depicted in the graph below.
The graph above was part of an analysis of capital loss characteristics of different risk return profiles. One of the portfolios used assumes a CPI+3% return per annum with low volatility (similar to bonds). Over a one-year period there is a 20% probability of loss, which erodes to just over 2.5% over a four-year period. Another way of interpreting this graph is that in an independent world the risk-of-loss to retirement from 4 years out increases 8 times as you approach 1 year! It is therefore important to know that your solution was created to manage the right risks explicitly for the defined period of time. A risk budgeting framework would complement a goals-based approach to build and design the investment strategy.
In a risk budgeting framework one would explicitly define the types, levels and horizon of different risks relevant to the investor and strategy. By introducing risk budgeting into the exercise we can assess not only how to allocate risk, but we can exercise control over the risk of the different components in the context of maintaining an overall risk level for the total portfolio.
Risk-of-loss to retirement from 4 years out increases 8 times as you approach 1 year!
What makes the de-risking framework complex here is that we effectively have to solve for multiple risks. These are: income replacement, capital preservation and capital growth.
The challenge is to design a strategy that acknowledges that these goals have differential priorities in our lives, but recognises that we still need to address all three to meet our members’ requirements.
Taken by themselves, these distinctly different goals could potentially demand very different solutions as we show below.
By combining investment stategies or building blocks, bespoke individual solutions can be created
Capital protection Capital protection
strategies seek to protect investors from losses, particularly when markets become stressed. Funds that take advantage of general asset class behaviour under normal market conditions may deliver favourable outcomes over such times but may fail when it’s really needed. In Figure 2 the risk of loss increases as you reach retirement. If the objective of your retirement portfolio was to protect your capital, the real test of the portfolio has to be viewed over rolling 1-year periods.
Historical performance would fail to capture the risk the fund was exposed to as in most instances the risks did not materialise. However, it is important to know that there is a risk management strategy to control the expected level of loss should a critical market event take place. Banks in particular were brought under the spotlight post the 2008 crisis in terms of managing their capital adequacy for these events. This would not be dissimilar for a member who chooses this objective. This is measured through the Conditional Value at Risk metric – a measurement of how much one expects to lose in adverse market conditions.
These types of techniques can be used to explicitly control the downside risk outcomes according to the risk budget. In the figure above, we see that all assets (except cash) are exposed to losses in different adverse markets. Diversification of assets is a means to limit but not eliminate losses except through the use of explicit hedging and insurance mechanisms which come at a cost.
Income replacement as an objective measures the ability of the portfolio to protect the expected income stream that the member could create from the accumulated value of the retirement savings. For purposes of building the investment strategy, the strictest and prudent form of this is implied by the expected monthly income that an inflation-linked annuity would pay given the accumulated fund value of a member.
Portfolio solutions can be constructed using different liability structures:
Therefore the goals-based portfolio needs to be built to reduce the variation around this income replacement objective. It also needs to reduce the risk of not meeting the expected outcome.
The ability to eliminate the risk completely would require an LDI strategy but the efficacy of alternative strategies can be tested against different horizons and risk tolerances.
Goals-based solutions are focused on delivering the outcomes that are sought with a higher probability of success with lesser variation. This makes pure performance-based comparisons archaic. Goals-based life stage products do not need to explicitly target singular objectives. A board of trustees may set multiple objectives for both the accumulation and de-risking portfolios; each objective would be prioritised and set with appropriate risk levels. For example, we might ask our next generation de-risking portfolio to achieve the following:
Immediately one would notice that the portfolio strategy also reduces equity exposure as with a traditional strategy but does not move into cash assets but instead to assets that are more related to liability risk, such as inflation-linked bonds, more property and other fixed income instruments.
The portfolio would also need to choose its underlying asset class strategies in line with the objectives. For example, given that the horizon to retirement is very short, long-term alpha strategies such as equity value investing is not ideal due to the certainty of disinvestment by the member.
A monitoring framework that only reflects historical performance and volatility numbers is not effective in determining the efficacy of a fund’s objective. Alternative measures need to be established. Probability of success is one of these measures. The reciprocal element of this is measuring the probability of failure. In the exercise below trustees asked us how such a de-risking portfolio would compare against a popular absolute return portfolio in meeting the trustees declared objectives.
Let’s examine how the two portfolios stand up against multiple measures of goal success:
In this example we compare a retirement life stage goals-based de-risking portfolio against a more traditional absolute return portfolio from 2003 to 2014. There is a material shift between examining the risk-return attributes of the funds towards measuring success (or in this case failure) of the stated objectives.
Although the failure percentages seem small, let’s consider them in the real world of the member experience. In the absolute return portfolio, 1 in 15 members experienced a loss of capital. On top of that, 1 in 11 experienced a loss of expected income. In the next-generation goals-based solution, 1 in 100 members experienced a loss of capital and 1 in 40 experienced a loss of expected income.
That said, against the traditional measure of performance, the absolute return fund certainly looked like it would be the better portfolio. The absolute return fund would in all likelihood generate more instances of growth greater than 3%.
The question any solutions provider needs to ask, though, is whether the additional return is worth the loss of certainty to your objective if you are 1 to 2 years from retirement.
What this exercise should demonstrate, though, is that historical performance comparisons simply do not provide a strong basis to make meaningful comparisons between products. Strong interrogation of the investment process as described elsewhere in this workbook, as well as how the portfolios are positioned with respect to appropriate risk measures of the objective, is clearly the key point of assessment.
Life stage solutions are particularly effective in automatically adjusting members exposure to risk as they approach retirement. The critical question being addressed here is what risks are really important to the member and how can we go beyond conventional de-risking strategies to better address those risks.
While we can identify new approaches that can address these goals more effectively, the critical issue is that we can only begin to appreciate this added value if we learn how to assess that value. Conventional performance measures simply don’t provide that answer. There’s a weaning process that will be required here no doubt. But if we can shift our view to whether the member is winning rather than focusing on whether the fund is beating its peers, we believe we can add significantly more value to members’ lives.
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