According to the 2009 Sanlam Benchmark Survey, roughly half of the retirement funds surveyed offer member-level investment choice (MLIC). Of those, 65% to 75% have a life-stage option available. The bottom line is that at least one in four members currently invest in a life-stage strategy and that number is likely to grow.
One of the arguments in favour of life-staging is that many members are incapable of making any sort of investment choice, so life-staging at least gives them an appropriate balance between aggression and conservatism – which, if all goes well, should deliver them to retirement with “enough”.
But not all life-stage solutions really resolve all issues for members. Understanding the issues is critical.
One implication of the life-stage model is a potential mismatch between long-term needs and a short-term focus. Members entering their 40s often have two things in common. First, due to lack of preservation, they’ve generally spent most or all of their previous retirement savings. Second, they have around 25 years left to retirement and an additional 15 to 20 years or more to live beyond retirement. That means they have four decades’ worth of inflation to beat – a very long time horizon. Yet in the life-staging approach their life is broken up into smaller time horizons, which creates a pressured, short-term focus on investment planning for each life stage.
Another implication is the impact on the income replacement ratio. Pension fund lawyer Jonathan Mort reminded us in a recent Collective Insight article that this is the most important consideration for trustees. By being too conservative prior to retirement, trustees are simply shifting the “market dip” risk from one date to another earlier date and hence another set of members. In that way the industry needs to adjust its mindset, as retirement is increasingly just another personal event in a long life and it need not be the “wall” life-staging seems to imply.
In its favour, it must be said life-staging has a good chance of targeting the required replacement ratio if members remain with one employer or if life-stage models are common across most funds and if members preserve. However, the reality in South Africa is that preservation hasn’t occurred and so even if those below age 40 successfully adopt growth strategies that usually don’t translate into sufficient assets to take forward into the more conservative stages of the model. As a result, members often don’t achieve their required retirement goals.
So now we understand some of the implications of life-stage strategies, what about the consequences? What could happen to your money anyway? Research conducted by acsis shows a “buy and hold” domestic, passive balanced fund has outperformed similarly constructed moderate, conservative and cash funds in 75% of historic five-year periods going back to 1925.
In other words, in three out of four arbitrary five-year periods a balanced fund has delivered the highest return. Therefore, reducing exposure to growth assets (equities and property) too early or too rapidly may prejudice those members whose time horizons are, in reality, not that short. The probability of a balanced fund outperforming cash increases with longer time horizons. So the reality is that by reducing the time horizon, the strategy’s expected chance of success is also reduced.
That’s demonstrated by the graphs, which show the likely ranges of returns of various investment strategies over various periods. Please note the best and worst cases are the top and bottom 2,5% of outcomes respectively (shown by the 95% confidence intervals for any one year) and are therefore not the absolute best and worst cases. A disciple of “fat tails” or “black swans” would be certain to raise an objection to some of the illustrations below. However, the underlying principles still hold for the purposes of the argument. (See Graph 1.)
From the graph it’s clear a balanced fund’s range of returns could be anywhere between -20% and +40%. The “nightmare” case for a member about to retire is the -20% return over one year and, of course, it’s impossible to predict when such a year is going to occur. There’s clearly good reason to try to avoid the worst-case scenario if a member has a one-year time horizon – and that’s one of the primary reasons why life-stage portfolios have gained prominence.
However, consider the ranges of returns over rolling five-year periods, as shown in graph 2.
Over five years, cash returns were between 3% and 11%/year, while a balanced fund could return between -1% and +26%/year. In the worst-case scenario the two investment strategies differ by 4%/year (-1% versus +3%). That translates into a superior capital value of around 20% to 25% for cash relative to the balanced option over the full five-year period, depending on the frequency and amount of contributions.
However, in the best-case scenario the difference is closer to 15%/year (26% versus 11%) in favour of the balanced fund. Over the five-year period that would have a significant impact on a member’s retirement capital: ie, approximately a doubling in wealth and hence pension.
Research suggests that a balanced fund has an 85% chance of outperforming the cash fund over a five-year period. So graph 2 shows being too cautious too early can be detrimental to most members, especially since the worst one-year scenario is almost certainly contained in the worst five-year scenario.
Table 1 shows the impact on members’ replacement ratios. We compare a life-stage model – where members are switched into a cash fund likely to keep pace with inflation (net of all fees) when they’re five years from retirement – to the strategy of remaining invested in the growth strategy, targeting CPI+5% throughout. We assume all members buy a with-profit annuity at retirement.
Two things are apparent. First, fewer members are expected to retire with “enough” (more than 70% of their final salary) using the life-staging solution. One out of four retire without enough in the simplistic life-stage model compared to one out of six in the balanced fund, that is an additional 260 people who retire without enough.
Second, for those who retire with more than enough the opportunity cost of conservatism is a reduction of 20% in their expected pension. The 113% average expected replacement ratio for the whole fund drops to 89% under life-staging. Considering only those likely to meet or exceed the 70% benchmark, the replacement ratio increases from 105% to 129% – a 23% increase in pension.
Of course, that assumes the target returns are achieved or exceeded, which isn’t always the case. However, remember a balanced fund targeting CPI+5% has outperformed cash 85% of the time over five-year periods. Sticking to that strategy is a better strategy five out of six times. That’s important, because the life-stage solution aims to avoid the worst case scenario for members but ends up jeopardising a greater proportion of the members.
I return to the issue of the type of annuity bought by members. In order to adequately transition members into the correct strategy aligned to their post-retirement plans a life-stage solution must take cognisance of the type of annuity to be bought by the member. Those members who choose living annuities have to adopt a growth orientated strategy in their living annuity, so their needs aren’t served by spending an arbitrary period in an ultra conservative strategy just before retirement.
Over 10 years the difference in outcomes is even more marked (graph 3). Note: The worst-case scenarios start to look quite similar while the potential upside is more attractive for portfolios that include more growth assets. Remember: 12%/year for 10 years is an approximate trebling of wealth.
Of course, a truly long-term investor would consider the likely outcomes over 25 years, as shown in graph 4.
The worst case for cash now appears worse than the worst case for more risky portfolios, with outcomes limited to between 5% and 9%/year. A balanced fund is likely to return between 6% and 18%/year.
Note especially across all strategies – from cash to aggressive – that the worst-case scenarios are almost indistinguishable. Therefore, for time horizons measured in decades the apparent comfort gained from conservatism doesn’t improve the worst-case scenario. Instead, it reduces the best-case scenario dramatically. A few percent higher return compounded over 25 years is significant and that should be considered for life-stage solutions that become more conservative 10 or more years before a member’s retirement.
In conclusion, life-staging neither reduces investment complexity significantly nor reduces the need to communicate. Rather, it simply alters the nature of the required communication, the set of members exposed to market risk and the time horizons.
The aim of this research article is to show the principles underpinning life-staging coupled with SA’s savings reality could have detrimental implications and consequences, which aren’t widely understood and thoroughly analysed. The benefits of aggression must be reaped for the member to retire with enough. Once members appreciate those benefits through years of adherence – whether forced via life-staging or voluntarily through member education – they may be unwilling to give up the additional potential growth if they understand the best- and worst-case scenarios over periods longer than five years.
To address that, funds need to ensure their life-stage solution targets the appropriate level of return above inflation over the working lifetime of the average member in the fund and that the member receives adequate communication regarding the difference between a bought and living annuity and the investment implications thereof.
Only if correctly designed and used (with the likely impact on replacement ratios considered) – and with the option for members to adopt a strategy aligned to their goals – does the life-stage approach have the ability to generate excellent returns for members over a long period. However, the reality is that all factors are seldom in place for its optimal use. Therefore, this approach has the potential to disappoint members who thought they were on track for a blissful retirement.
MARTIN POOLE
acsis
POOLE is a consultant with acsis Institutional Asset Consultants. He holds a master’s degree in physics from Rhodes University and is a Certified Financial Planner. He’s also a CFA charter holder.