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The new paradigm of goals-based investing is particularly appropriate for linking savings and investments to an individual’s overall well-being. Goals-based saving ties the money you accumulate to a specific purpose. Goals-based investing looks at what strategies you should use to best reach your households’ priorities. The measure of success is how close you come to meeting your objectives and not whether you achieve the highest possible return. This shift in focus has significant consequences for how we build investment products.
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”.
So, let’s ask a simple question: if you were a fiduciary on a retirement fund, which option is preferable to you?
Chances are that, while you intuitively understand that option 1 should be the preferred option, you also know that perceived performance pressures will invariably lead your Board to opt for option 2.
Asset management can be particularly 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 – i.e. demand that the fund manager outperform their competitors in perpetuity – and outcomes become decidedly more random. Bottom line: as an investment strategy, a goals-based framework has a much higher probability of fulfilling client needs than a performance-based framework.
Goals-Based Investing differs from traditional investing in three critical ways:
Sound imminently sensible? It should. But then the important question here is: if goals-based investing is so powerful in re-enforcing all the right behaviours in both our members and our fiduciaries, why are we still locked in a never-ending performance race?
Essentially, the shift towards a performance-driven investment model that has occurred over the last thirty years owes much to the technological limitations that made it infeasible to provide customised solutions to a massively expanded consumer base. Both 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 democratization 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. But two other factors, the technical limitations created by unitised portfolios and the limited capabilities of asset classes to adequately match liabilities, made it difficult to target specific outcomes such as income replacement.
Today, all of those impediments have been overcome. Technology and asset strategy breadth have evolved to the point where we can offer cost-effective solutions that both dynamically assess an individual’s asset/liability shifts and then create the right investment mix to meet those funding goals over the required timeframe. But while the way is now there, we still, as an industry, need to deal with the will.
Perhaps, the real reason the goals-based concept failed after the two post-crash attempts was the fact that both crashes were followed by massive rallies. Why bother changing out of a good thing (or at least a highly profitable one - for the industry), if the performance game is working. In this sense, the consumer was as guilty as the service provider for opting for the “hope the manager wins” option. Therein lays the challenge.
Retirement funds provide a natural candidate for the goals-based investment approach. In fact, many trustees would be almost right in 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.
Most of our clients feel they can readily tick this box. For the most part in the defined contribution fund space, our clients have been defining that goal as being the ability for a member to replace 75% of their final income on retirement.
It’s not a bad start as a basic rule of thumb, but we need to start evolving our thinking here. There are three fundamental problems here with this approach of which we need to be cognizant:
Again, most trustees think about this in terms of whether they have selected the correct asset management strategy. In fact, as we have described many times in our Hot Topics presentations, “getting the structure right” involves the full value chain:
Only once we can tick all those boxes does selecting the right investment strategy become meaningful.
Many trustees only get as far as thinking about risk in terms of volatility of performance. Risk numbers for reporting are typically little more than measures of the volatility of an investment strategy. Risk questionnaires relating to member choice typically try to determine the level of aggressiveness a member can tolerate in terms of the performance volatility.
Neither one of these criteria help trustees with the discussion around how much risk is required to meet members’ given goals, nor do they help trustees structure an investment solution that has the highest probability of meeting a given target.
What’s required? Two parameters:
This part of the process has several moving parts.
The key here is rigorously testing for probability of success on both these parameters.
In truth, strategies such as life stage investment funds are only capable of doing a limited amount on behalf of clients. It’s a bit like chainsaw art. The strategy is only effective if members are sitting with a reasonable level of fund credit at the beginning of the pre-retirement glidepath that secures their future retirement income. This is rarely the case. Similarly, many lifestage strategies require a degree of homogeneity around members’ post-retirement investment requirements. Again, this is rarely the case and often trustees may fail to appreciate exactly whether the lifestage strategy they have selected is really the most appropriate for their employment demographic.
As such, our evolutionary journey into the future must start taking these limitations into account. If we genuinely want to increase our probability of success, then we need to start considering how we can 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, and will adjust to the fact that movements in both the markets and the member’s liabilities will demand a constant realignment.
Adopting a goals-based approach means that many trustees, may have to get out of their comfort in terms of what investment strategies are most effective. (This challenge equally applies to asset managers). A retirement funding goals-based approach may require a range of strategy building blocks: one that maximises long term growth (this will be the most familiar), one that maximises income replacement, one that protects against downside loss and potentially one that provides growth over a short term time frame (to be used just before and after retirement).
These strategies have distinctive differences to conventional balances funds. Note that this is not a debate about active vs. passive, but rather a discussion around the mandate intent of each strategy and whether it is adequately structured to deliver on what is required. Bottom line: make sure your asset consultant / umbrella fund provider is equipped to understand these requirements.
This is perhaps the most important part of the goals-based process, and typically where most trustees get it wrong right now.
We have stated that there are two goals that are meaningful to the member:
Are members retiring with enough?
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.
A better option is to provide members 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. This we already do for members on Alexander Forbes’ administration platform.
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 as to what they could do to influence outcomes, trustees need a clear understanding as to how their decisions impact.
This is where the power of the Lifegauge tool comes in. This tool provides a superb stress testing and monitoring framework exactly how any of their decisions on the fund, from costs, to investment strategies, to contribution and pensionable pay parameters (etc.) impact each and every member. And because each member not only is at different points in their journey, but have a different fund credit base to work with, the impact of each decision can vary dramatically.
Are your investment performing as required to meet those funding requirements?
Here is where we need to be the most creative in our thinking. Monitoring this aspect of the process means we have to move away from the traditional way that manager performance is measured – i.e. did the manager beat some asset class benchmark? 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 metrics to measure. What is required is dramatic rethink on how fiduciaries think about their investments, select their investments and measure their investment solutions.
Are your members getting the greatest efficiency from their employee benefits?
This is probably the aspect of our goals-based framework that will demand the most creative attention in the future. As of now, we have some fairly crude ways of assessing whether the benefit structure of a fund is providing the greatest efficiency for members in terms of benefit cost vs. utilisation. As noted earlier, outcomes here will be dependent on both the industry and individual is working in and the nature of their job. Solving for both of those parameters at once provides an element of complexity. For now, this is top on our list of challenges to tackle.
What we have described here clearly suggests that if the concept of Goals-Based investing is ever going to become a reality, there needs to be a dramatic overhaul of the industry, both at the asset management level and at the benefit consulting level. And if the member is actually the one we care about here (and TCF suggest it is), then it must come right.
What needs to happen?
Overall, the industry needs to rethink how they are helping their clients set the right expectations and then manage continuously to those expectations.
When all is said and done, HOPE is not an optimal strategy – whether we are dealing with investment performance or protections for our members. Goals-based 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.
Let’s get this Goals Based framework up and running.
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