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:
- Portfolios are now constructed in the context of the specific risks associated with the defined objective(s).
- Time horizon becomes a critical factor.
- Strategies are selected based on how well they improve the probability of meeting a specific goal.
- Success is defined in terms of whether the solution is actually meeting its stated goal.
How does this evolved thinking potentially change our current life stage solution?
The accumulation phase
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:
- The investments are primarily in growth assets such as equities and property to take advantage of long-term risk premiums and, as such, is not suitable for short-term investors as over the short term, returns are likely to be volatile with potential losses. These should not be a cause for concern.
- There are many ‘growth’ investment strategies that can produce the long-term accumulation the members require for their asset wealth growth. These strategies can be implemented in balanced, specialist active and specialist passive approaches.
The de-risking phase
This is where the most notable changes will take place. There are two critical changes in this phase:
- Defining an appropriate investment objective
- Desired outcome
- Over what timeline
- For how much risk?
- Constructing effective goals-based portfolios that recognise the specific risks and time horizon that the goal is exposed to.
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.