collective investments jan 2015 - goals based investing

Goals-basedInvestIng

collective InsIghtinsiGht into sa inVestinG from leadinG professionals

ci January 2015

26 start saving with the end in mind

29 the end of the world as we know it

32 aligning assets with their owners

34 Why do we all fall down?

37 how smart is your investment strategy? 40 this time it’s personal

COLLECTIVE INSIGHT 29 JanUarY 2015 25

COLLECTIVE INSIGHT

The investment industry continues to be challenged on how it defines performance, how it delivers value and how it measures

success. Combine this with an increased regulatory oversight that focuses on what is actually being achieved on behalf of the clients and it’s clear that the industry needs to have a major rethink of its value proposition.

Certainly one way to enhance that value proposition is for the industry to evolve to a point where it begins to frame performance in terms of the investor’s objectives, so-called “personal performance”. There are several barriers to delivering more personal performance, not least of which is an institutionalised reliance on outdated constructs. The current system has been built around a concept of performance that is defined relative to market indices, consulting quadrants, performance surveys, rock-star stock pickers and revered research analysts. The investor doesn’t usually figure into the equation – and this needs to change.

Andrew Bradley of Old Mutual Wealth comments: “When money is managed in the traditional way the manager is either focused on beating a theoretical benchmark, beating their peers or managing the portfolio within some notional risk appetite. None of these particularly resonate with the investor’s individual lifestyle and investment goals. This is the key difference between the conventional

Editorial Introduction

NErINa VISSEretf strateGist and adViser

Contents

Please send any feedback and suggestions to [email protected]. Finweek publishes Collective Insight quarterly on behalf of the South African investment community. The views expressed herein do not necessarily reflect those of the publisher. All rights reserved. No part of this publication may be reproduced or transmitted in any form without prior permission of the publisher.

approach to managing money and a goals-based approach. A goals-based approach provides no guarantee of better performance, but it does significantly increase the probability of alignment between the investor’s objectives and their portfolio construction and ultimate performance.”

Robert C. Merton is one of the authorities on this new approach to investing – and also a Nobel laureate. We are priviliged in this edition to have him as a co-author on one of the articles, alongside Shaun Levitan, entitled Why do we all fall down?. They explain why it is so critical to apply this approach in the context of retirement, or otherwise risk getting your investment strategy entirely wrong. By understanding that not meeting your goal for retirement is the real problem, the whole focus of risk management changes.

Merton’s is the fourth article in this Collective Insight. Before that, for those who are new to the topic, we have introductions to the concept from Ronald N. King and Abigail Munsami. Then Deslin Naidoo and Ainsley To provide us with overviews of some key concepts in the industry which need to change to accommodate goals-based investing. Later in the edition, we have an article from Petri Greeff with a powerful analogy of how company strategy echoes goals-based investing, as well as a history of goals-based investing – which is older than you think – from Anne Cabot-Alletzhauser, which concludes with what it will take for the approach to become widely adopted in the industry.

In future, success – in terms of returns – will be defined differently. Truly sustainable returns – those that meet investors’ individual goals – must start with a deep understanding of the value components that are meaningful to the investor. But in order for the investor to fully appreciate – and be willing to pay for – those returns, the value components delivered and the fees charged must be transparent.

Over time, this new model for success will help to improve the alignment of interests across all industry participants, provide incentives for streamlining delivery models and reduce barriers to healthy decision-making. We trust that this edition will assist in that process. Enjoy! ■

ConvenoraNNE CabOT-aLLETzHauSErHead of Alexander Forbes Research Institute

edItorIal advIsory CommIttee

VaNESSa BELLDirector, Jonathan Mort Inc

DELpHINE GOVENDErChief Investment Officer, Perpetua Investment Managers

pETrI GrEEffHead of Strategy and Research, Riscura

paTrICE raSSOuHead of Equities, Sanlam Investment Management

HEIDI rauBENHEImErIndependent Research Consultant

SaNGEETH SEwNaTHDeputy Managing Director, Investec Asset Management

DI TurpINIndependent Consultant

NErINa VISSErETF Strategist and Adviser

muITHErI waHOmEHead of Investment Products, Investment Solutions

Start saving with the end in mind

COLLECTIVE INSIGHT

26 COLLECTIVE INSIGHT 29 JanUarY 2015

When I grew up my parents had a drawer full of brown envelopes w i t h w o r d s l i k e

‘clothing’, ‘food’ and ‘savings’ scratched across the front. Every payday they’d tuck cash into those brown envelopes to cover the family’s monthly expenses. They would start with the most critical and move down to the ‘nice-to-haves’. This was their system for managing money: not very sophisticated, but they always knew where they stood financially.

IRONICAlly, THE NEw PROgRAMMES uSE THE SAME kIND OF lOgIC: THEy MANAgE MONEy, IN PART, by DIvIDINg IT INTO A vARIETy OF SPENDINg AND SAvINg CATEgORIES.

The ‘envelope system’ was common in the era before computer-based money management programmes. Ironically, the new programmes use the same kind of logic: they manage money, in part, by dividing it into a variety of spending and saving categories.

These practices persist because they’re consistent with the way most people think about their money. People tend to regard their wealth not as a lump sum, but as distinct amounts needed to meet individual goals in life. This has led to the emergence of the ‘goals-based investing’ concept. This approach to wealth management emphasises investing with the objective of attaining specific life goals rather than focusing on generating the highest possible portfolio return or beating the market.

The practice of goals-based investing is generally still in its infancy among advisers, but there are some advisers who are embracing this approach and leaving traditional approaches behind. The traditional school of thought generally focuses on outperforming the market while staying within the investor’s threshold for risk.

Goals-based investing applies a specific investment strategy, tailored to a client’s specific goals, to the individual’s asset pool. This encourages investors to talk about the goals they’ve identified to date and also challenges them to think bigger and dig deeper. Once all of their dreams are on the table, they can prioritise and set timelines – a process that drives the individual to think even more carefully about the relative importance and urgency of each goal.

The idea beh ind goa l s-based investing is that investors should set specific, personal goals that they want to achieve and should then structure their investment plans around those goals.

With goals-based investing, instead of worrying about hitting conceptual benchmarks, investors can set goals that resonate with and make sense to them.

The power of a goals-based approach lies in its ability to highlight how realistic a goal is relative to your risk preferences and the investment opportunities avai lable. It a lso underscores the importance of separating needs and wants.

Most investors are willing to assume a higher level of risk to gain additional potential return with money set aside for a vacation home (a ‘want’) than

rONaLd KING HEAD OF TECHNICAl SuPPORT, PSg wEAlTHking has a b.Com llb llM Adv PDFP and an MPhil in Future Studies. He is the author of a number of books.

abIGaIL MuNSaMI JuNIOR lEgAl ADvISER, PSg wEAlTHHer previous experience includes a significant number of years at the Constitutional Court.She holds an llb degree

COLLECTIVE INSIGHT


with money they’ve set aside for college tuition for a child (a ‘need’). After all, if the additional risk taken with the money set aside for the vacation house results in losses, the investor could always forgo the second home or downsize their plans. However, they might not be so quick to let go of plans to fund their child’s college tuition.

As advisers and investors shift focus to goal-oriented investment approaches, a new perspective on risk and portfolio construction is emerging. Advisers are questioning conventional thinking on asset allocation and beginning to pursue new portfolio strategies that can better help their clients pursue the returns needed to achieve critical financial goals, while also seeking to protect current assets from a loss. This asset/liability-matching process ensures that investments are chosen to be more in line with a specific goal and investment time frame than with a specific risk profile. It doesn’t require new investment products, just a new approach to how existing investments are structured to achieve this new goal.

With both investors and their advisers willing to make the move to goals-based investing, one could assume that the transition would be relatively easy. But the hard truth is that going from agreement in theory to acceptance in practice will take a concerted effort from both parties. Advisers worldwide are aware of the need to enhance their knowledge and skills to better meet the changing needs of clients. Topping the list of subjects that advisers are looking to deepen their knowledge of, are investment strategies that are more explicitly target-enhanced, income generation and capital protection.

Goals-based investing is gaining increased traction, as it makes the principles of investing more tangible and relatable. It also once again underscores the value of appropriate financial advice, as financial advisers will have to know their clients well and interact with them regularly for goals-based investing to work properly. ■

as exercise is to a fitness plan, healthy contributions are usually the most difficult part of getting retirement-fit; it means having less of your salary in your pocket because you are saving more. as with a

6am gym session, increasing or maintaining a high level of contributions is a lot easier when you have fewer commitments – no children to get to school, no 7am meeting with the CEO. Similarly, for many, saving at the start of their career may be easier, as they have fewer financial commitments like mortgages. There may be other financial commitments such as paying off student loans, but there is a significant benefit of compound interest that makes saving more when you’re younger far more easy on your pocket than saving at far higher rates later on to compensate.

PreservIng your savIngsThis requires discipline – like not tucking into that piece of chocolate-fudge cake at the back of the fridge. while Treasury is looking at ways to discourage us from dipping into our retirement savings excessively when changing jobs or being retrenched, current legislation still allows us to “stick a hand in the cookie jar”. The majority of trustees surveyed in the 2014 Sanlam Benchmark Survey consider lack of preservation to be the most critical mistake members of retirement funds are making with their savings, and the same survey showed that 71% of members admit to taking some or all of their benefits in cash when changing jobs.

healthy ContrIbutIon

ChoosIng aPProPrIate InvestmentsThe final component, investment choice, is akin to eating correctly. Earlier on in your savings journey you want to have high exposure to growth assets – just like you need that first cup of coffee in the morning. Later on you will need to temper your investments and preserve capital – akin to low GI foods to sustain you. There are a number of solutions that have been developed to assist members to invest appropriately, so that they are taking on appropriate risk at the appropriate time of their savings journey. as with a prescribed eating plan, you need to ensure that your selection is appropriate to your own circumstances.

FItness Plan COMPONENT retIrement savIngs COMPONENT• Exercise • Healthy contributions• Avoid temptation • Preserving your savings• Eat correctly • Choosing appropriate investments

Like any fitness pLan, there are

components to retirement savings:3

SOuRCE: Rhoderic Nel, FASSA Chief Executive Sanlam Employee benefits and

Mayuri Reddy, Actuarial Specialist Sanlam Employee benefits

How to get retirement-fit

COLLECTIVE INSIGHT


Modern portfolio theory (MP T) has been the cornerstone of investment practice for more than 50

years. Underlying this framework is the concept of the rational investor, whose sole objective is wealth maximisation. As such, investment strategies focused on maximising return have been popularised throughout the world, with investment performance being the ultimate factor in portfolio selection.

In 1979, Daniel Kahneman and Amos Tversky published their seminal paper titled Prospect Theory: An analysis of Decision under Risk. This work led to a key criticism of the rational investor premise of MPT: that investors make different risk choices dependent on the f inancial objective and its impact on their wealth. The work of Kahneman, together with mixed results from traditional f inance, was a catalyst to the development of a more holistic framework commonly known as goals-based investing.

this frameWork alloWs an indiVidUal to:1. Define and prioritise (multiple)

unique savings objectives over different horizons.

2. Differentiate their capacity to take risk for each objective.

3. Establish specific success criteria for each objective.

4. Adapt and restructure their strategy as time and circumstances change.

This provides a very intuitive financial planning framework for individuals and financial advisers to design more appropriate financial solutions. Since 2008, investments have been under scrutiny – from governance frameworks

to fees to remuneration. The UK Retail Distribution Review implemented in 2013 resulted in a substantial change in how financial advisers operate in the UK. Similar legislation has been tabled for South Africa. As a result the value (and remuneration) of an adviser has been put under the spotlight.

Goals-based investing shifts the typical investment conversation from best performing products towards establ ishing the correct f inancia l outcomes. Determining the correct goals, managing to meet those goals, maximising the probability of success, and helping the client understand the impact, would naturally lead to better financial behaviour and outcomes.

Charles Ellis, doyen of investment consulting, in his article The Rise and Fall of Per formance Investing, describes investment management as “two hands clapping” – one based on price discovery and the other on values discovery. Price discovery is the process of identifying pricing errors not yet discovered by other investors and generating additional performance – the realm of an asset manager. Values discovery is the process of determining each client’s realistic objectives with respect to various factors and designing the appropriate strategy – the realm of the adviser/liabilities manager/asset allocator.

What Ellis is reminding us of is that for investing to be truly effective, it has to include both an asset management focus and a liability focus. Over the years, a performance focus has tended to drown out the liability or goal target of the investment.

However, goals-based investing should not be an elaborate advisory framework that leads to the same old products. The investment strategies that

are needed to effectively execute a goals-based approach require newer thinking and skill sets for the financial services industry. Where MPT created efficient portfolios using return and volatility, alternate forms of ‘efficient’ portfolios need to be developed.

Global peers have taken different approaches to solving this problem.

THE fOur MOST POPuLar INVESTMENT STraTEGIES (SOMETIMES uSEd IN COMbINaTION) arE SuMMarISEd bELOW.

1. Construct portfolios that achieve predefined investment outcomes. Map clients based on their interactions with their adviser to these portfolios. This approach is more cost-effective and can be used in conjunction with technology-driven distribution. It approximates cl ient expectations and is a more commoditised offering.

2. Define underlying building block strategies that can be combined to create unique risk-controlled outcomes. This creates a more individualised solution with better controlled outcomes while remaining cost-effective.

3. Use dynamic asset allocation to change the asset strategy mix of an individual portfolio, based on market movements, risk levels and maximising the probability of achieving target objectives. As the goal has greater certainty of being met, these portfolios will reduce the risk they take. This is similar to the liability-driven investment strategies that are used by institutional pension fund assets.This is also the approach discussed by Nobel laureate Robert Merton in our centrepiece article.

The end of the world as we know it

COLLECTIVE INSIGHT


4. Start with the existing assets of the individual and then build a dynamically managed optimal portfolio that could include an infinite range of assets and securities.

despite differences to the desiGn of these Goals-based inVestment strateGies, three thinGs remain constant across the approaches:1. The emphasis and focus must be on

managing risk.2. The underlying investment strategy

must be relevant and structured to the objective.

3. Success must be measured against the goal and not traditional market-related performance benchmarks.

Goals-based investing will also bring changes to traditional financial adviser toolboxes. Risk profile questionnaires will soon become obsolete. Establishing a risk tolerance is no longer sufficient in a world of multiple financial objectives. A good adviser would need to establish a more comprehensive risk assessment for his client.

A common fa l lacy perpetuated by f inancial advisers is that most investment goals are translated into an inflation + real return target. Intuitively it makes sense: if your liabilities are l inked to inf lation, then a return greater than inf lation must put you in a better position. However, f inancial mathematics and investment pricing are not always linear.

For example: assume it is one year before your retirement. You have saved enough to purchase an inf lation-linked annuity that will cover your required expenses for the rest of your life. Assume inf lation remains stable over the year at 6% but real rates declined by 1%. You are invested in an ‘ inf lation + 3%’ strategy which returns 9% in line with its performance expectations. Does this mean you can

buy the inf lation-linked annuity? A 1% decline in real rates will increase the price of an annuity by over 12%. If real interest rates decline as they have over the past 10 years, you, like many people across the globe experienced, will most likely not meet your goal. This further emphasises the need for the investment strategies of GBI to match with the advice framework.

Goals-based investing brings with it the ability for an individual to take care

of their f inancial health. Its intuitive nature allows for a greater participation in charting your financial emancipation, whi le hav ing a more meaningfu l relationship with your wealth and a more constructive engagement with your financial services provider.

As the REM song goes: “It’s the end of the world as we know it... and I’ll be fine”; with the changes to the world of financial advice we are probably going to be better off. ■

dESLIN NaIdOO head: inVestment researchNaidoo is responsible for the investment research function at Alexander Forbes. He designs, manages and oversees all AF-branded investment products.

wHAT Investment return DO I NEED TO ACHIEvE My goal?

• Buy new car• Pay for children’s education• Go on holiday, etc

assume goal is to pay deposit on first home

GoalCost

achieve goal in 5 years

• By when do I want to achieve my goal?

• What is the cost now?• What will it be in 5 years’ time?

Timeframe

assume a goal of r200 000

lumP sum reCurrIng CombInatIonI only want to make a large upfront investment.

I don’t have any savings now, but I can afford to make monthly payments.

I have some savings, but I wish to also make monthly payments.

i.e. I have R115 000. i.e. I can afford R2 300 p.m.i.e. I have R80 000 and can afford R2 300 p.m.

R200 000

R100 000

Now 5yrs4yrs1yr 2yrs 3yrsR0

R200 000 R200 000

R100 000 R100 000

Now Now5yrs 5yrs4yrs 4yrs1yr 1yr2yrs 2yrs3yrs 3yrsR0 R0

REquIRED INvESTMENT RETuRN

11.4% p.a. REquIRED INvESTMENT RETuRN

14.8% p.a. REquIRED INvESTMENT RETuRN

7.3% p.a. To achieve 11.4% p.a. one can

invest in a moderate portfolio (40%-60% equities).

To achieve 14.8% p.a. one can invest in an aggressive portfolio

(90%+ equities).

To achieve 7.3% p.a. one can invest in a conservative portfolio

(10%-30% equities).


COLLECTIVE INSIGHT

The investment industry exists to serve asset owners, for whom retirement is an income challenge, not a return challenge. You can’t retire on a good Sharpe Ratio and you can’t eat alpha. And unlike the maximisation of returns, a defined goal in

the form of an income target is both achievable and controllable, which makes it much more suitable as an anchor for an investment process.

Using goals as a reference point for success would make for some interesting changes compared to a traditional investment process focused on maximising return. What follows is an analysis of four key ideas that will require attention if goals-based investing is to succeed.

INVESTMENT rISK VS SaVINGS rISKTRADITIONAl RISk-PROFIlINg techniques are still defining risk based on return metrics and not with reference to annuitisation. In a 2014 study on how savers think about risk, the Pensions Institute at CASS business school in the uk found that while traditional risk-profiling questionnaires accurately captured attitudes towards investment risk, they were thoroughly inconsistent in terms of defining clients’ attitudes towards savings risk; clients across the spectrum of Cautious to Adventurous all gave equivalent responses to questions on savings risk.

Is it prudent to suggest that a client has a high capacity for investment risk-taking if they are not willing or able to accept a large shortfall of their retirement goals? The study also found a significant amount of “reckless conservatism”: only 12% of savers disagreed that missing their savings goals was more acceptable than taking investment risk. If we define risk as the likelihood of falling short of that income replacement target, then it follows that risk attitudes should be determined by a client’s flexibility on the magnitude of shortfall.

Control and aCCountabIlItyASSET OwNERS DElEgATE to advisers who delegate to fund managers who ultimately leave the capital with company management. with this level of intermediation it is impossible for the ultimate asset owner to attribute accountability on a returns basis . Emphasising outcome-based selection criteria such as “the number of previous clients an adviser has helped achieved their goals” is a more relevant measure of investment success. Compensation on this basis will also better align interests in terms of reducing costs and incentivise asset retention over asset gathering for fiduciaries.

For the large majority of savers, the most significant factors determining investment success are their savings rate, how long they work until retirement and their future retirement spending − all of which are normally within a client’s control. This will shift the emphasis of accountability for reaching their goals onto their own actions, avoiding over-reliance on investment returns and reducing unnecessary emotional pain from having unrealistic expectations of financial markets. Saving more has the direct consequence of increasing your investment pot, whereas taking more investment risk by no means guarantees higher returns.

SHOrT-TErMISMwEAlTH ACCuMulATION IS a multi-year and often multi-decade process. basing decision-making on a long-term goal can remove the unwanted side effects of investor short-termism. while it is not a secret that the majority of active mutual funds underperform their benchmarks, the annual DAlbAR study* has estimated that end investors compounded underperformance through attempting to time entry and exit into the mutual funds:

from 1984-2013, the aVeraGe inVestor in Us eqUitY fUnds annUalised 3.69% Vs 11.11% for the s&p, a “bEHaVIOur GaP” of almost

8% per annUm.

This is particularly significant as the knock-on effects of investor behaviour on the whole economy can be profound. A longer-term focus from asset owners filters through to the behaviour of asset management companies, with less manager turnover and less style drift due to immediate concerns over outflows. In turn, a less transient shareholder base in companies relieves the pressure for corporate short termism at the management level − an NbER survey in 2004 found the majority of corporate management would not proceed with a profitable long-term project if it meant missing consensus earnings forecasts for the quarter! More earnings accretive investments would ultimately lead to better long-term returns for shareholders.

aligning assets with their owners

Gallo Images/Thinkstock

COLLECTIVE INSIGHT


SubjECTIVE ObjECTIVESMODERN PORTFOlIO THEORy and efficient frontiers are extremely impersonal (I have yet to come across any wealth manager who finds it practical to quantify each client’s utility into indifference curves). This is where many off-the-shelf solutions such as target date funds or ‘glidepath’ strategies are also not fit for purpose. If you start with high-equity allocations and simply shift to bonds as you age, you will miss out the bulk of potential returns for long-term clients by having investment risk too low when they have the largest amount invested (closer to retirement), thus over a client’s lifetime the majority of their assets are invested at too low a risk.

Traditional glidepaths also fail to take into account the personal nature of cash flows. The biggest asset on a young investor’s balance sheet is the deferred income of their human capital. For the majority of young professionals, their salary shares similar characteristics to an equity: inflation-linked,

vulnerable to a recession, uncertain over the long term.

If the majority of the individual’s investment portfolio is also in equities, then tail events such as financial crises and the ensuing unemployment would create the need to cash in savings to substitute for lost salary, a forced liquidity event that ends up with the investor selling out of equities at a cyclical low point. The traditional reasoning that young investors have more ‘time to recover’ does not take into account these idiosyncrasies in client circumstances and targeting higher volatility in a bid to maximise return would not help this young client meet their objective.

Minimising shortfall risk for this type of young investor would instead suggest allocating to assets less correlated to equities initially and increasing equity exposure to replace the deferred asset of their human capital as it converts to cash over time – another example of how a goals-based approach better aligns a portfolio to its owner’s needs.

aINSLEy TOanalYst, credo capitalTo is an analyst for the multi-asset team at Credo Capital, under tak ing cross-asset research in asset allocation as well as fund selection. Prior to Credo, he also worked at Stamford Associates, Fidelity and bloomberg. To has been a CFA charterholder since 2014.

Each investor has their own savings desires and future consumption needs – thus assets under management (AuM) should not be thought of as a total dollar amount but as a collection of the individual goals of every saver underlying those assets. Today the over specialisation at every level of financial intermediation has created a wedge of multiple, divergent incentives between asset owners and their savings. Removing these layers of agency problems requires a structure which aligns managers of capital with the asset owner’s ultimate goal – incentives need to be personalised. Compensation based

on achievement of client-specif ic goals (net of fees), including claw-back clauses would provide a much closer alignment of interests than flat management fees. Demand from end-clients for accountability based specifically on reaching their own goals will remove the current ‘heads, I win; tails, you lose’ dynamic of incentives within investment management, and the rest will follow.

“Never, ever, think about something else when you should be thinking about the power of incentives.” – Charlie Munger ■*DALBAR’s 20th Annual Quantitative Analysis of Investor Behaviour 2014.

ConClusIon

“ “EMPHASISINg OuTCOME-bASED SElECTION CRITERIA SuCH AS ‘THE NuMbER OF PREvIOuS ClIENTS AN AdvIsEr HAs HElPEd ACHIEvE THEIr GoAls’ Is A

MORE RElEvANT MEASuRE OF INvESTMENT SuCCESS.

Why do we all f a l l dow n? ” Recently, one of us was asked

this question by a four-year-old child after the umpteenth performance of ‘Ring a ring a rosies’. Children have an ability to ask excellent questions that we often brush off or simply dismiss. Sometimes we become so accustomed to something that we fail to question why, or have forgotten why, we actually do it.

DEFINED CONTRIbuTION INvESTMENT STRATEgIESTo a large extent, this is the case with the typical investment strategies utilised in defined contribution (DC) schemes. We are constantly presented with ‘evolutions’ to strategies that have been around for many years, but do we ever take a step back

to question their overall appropriateness? The cornerstone of most DC strategies is a focus on how we can maximise accumulated savings (or reduce their variability).

Sometimes we need to be reminded that the primary concern of the DC fund members is (and always has been) whether they will have sufficient income in retirement to live comfortably.

A good retirement is measured by the standard of living you want in retirement; a standard of living is not defined by a pot of money, but a stream of income. The savings needed when you retire is the amount needed to sustain the standard of living which you have become used to enjoying in the latter part of your working life. That is an income goal; it’s not a wealth goal.

While National Treasury discussion


COLLECTIVE INSIGHT

“why do we all fall down?

papers, and consulting approaches, may make references to concepts like a replacement-ratio objective (a measure that expresses income in retirement as a proportion of a member’s salary), the actual investment strategies conceived do not in fact focus on them (other than the initial mention).

Investment statements that members receive focus on return and volatility. These in turn drive investor behaviour. They are not measured in terms of the members’ investment goals or the likelihood of meeting them. Members should not be focusing on how many rands they have in their account, but how many ‘income units’ they have.

lIFE-STAgE INvESTINgThe most popular investment strategy is a life-stage approach to investing. Simply put, younger members are invested in more aggressive portfolios targeting higher returns (i.e. portfolios with more equity) and are phased down to more conservative portfolios (i.e. portfolios with more cash and f ixed income) as they approach retirement. At no point is the member’s personal circumstances catered for. The only member-specific information used is their expected time until they retire.

The entire framework is essentially predicated on an assumption that investors become more conservative as they approach retirement and wish to reduce the volatility of their fund credit.

When you consider behavioural motivations, it is not hard to understand why such an investment approach has found favour.

gOAlS-bASED INvESTINgOur thinking should evolve to consider the obligations or goals of the individual member and design an appropriate investment approach that targets these.

Gallo Images/Thinkstock


COLLECTIVE INSIGHT

Rather than regarding the member’s fund credit as the liability, we should be measuring the liability as the cost of securing an appropriate inf lation-linked income stream for the member at retirement. This is analogous to the traditional defined benefit plans where the member was guaranteed an income at retirement based on their salary and tenure with the retirement plan.

This change in formulation results in a significantly different investment strategy.

Consider the investment strategy that focuses on preserving a fund credit in the year before retirement. While history is not an indication of future performance, we consider how two different investment strategies would have fared for a member if the past five years of investment returns are used as a proxy.

The benefits of a more conservative cash-based strategy are apparent if your objective is to preserve the accumulated savings.

But if we consider the reality that the retirement savings are intended to be used to provide an ongoing inf lation-linked income stream, the results are very different.

The graph reflects that inflation-linked bonds are now the optimal investment for an individual wishing to secure a given level of income in retirement. This is because annuity prices are driven by changes in interest rates. The cash investment is a very poor choice of investment.

Of course, investments are never simple and we need to consider whether the individual might need to actually

increase their equity exposure to provide the maximum likelihood of affording a reasonable income benefit, or reflect the reality that a member may make use of the tax-free withdrawal of some of the savings at retirement. This can easily be incorporated into a framework reflecting meaningful goals.

SO wHAT SHOulD MEMbERS OF A DEFINED CONTRIbuTION PlAN bE INvESTED IN? The investment strategy should optimally allocate the member’s assets to a mixture of risky assets (such as equities) and risk-free assets (which is not cash!). The allocation

SHauN LEVITaNCOO, COlOuRFIElD lIAbIlITy SOluTIONSShaun levitan is the Chief Operating Officer of Colourfield liability Solutions, a business that is exclusively dedicated to delivering liability-driven investment solutions.

rObErT C MErTON DISTINguISHED PROFESSOR OF FINANCE, MIT SlOAN SCHOOl OF MANAgEMENT Robert C. Merton is also Professor Emeritus at Harvard university and was awarded a Nobel Prize in Economic Sciences in 1997 for his work on derivatives.

ConClusIonIt’s convenient and tempting to dismiss a four year old’s question about ’ring a rosie’ by saying it’s just a silly nursery rhyme and we shouldn’t pay too much attention to the words. The reality, though, is that it describes the black Plague in England centuries ago, with the final verse of “we all fall down” referring to the inevitable death due to the disease. Conversely, it is also tempting for a retirement fund member to assume that his/her default DC fund investment strategy is well thought out (when closer analysis in many instances suggests otherwise). by identifying meaningful goals and asking the right questions, we can help prevent our members from all falling down. ■

SOuRCE: Colourfield liability Solutions

to each should change over time so as to maximise the likelihood of achieving the investment goal. The devil remains in the details, but the key differences to current frameworks are that risk is defined as the possibility of not achieving the required retirement income, and the risk-free asset is defined with reference to a deferred inflation-linked annuity.

Cash Inflation-linked bonds

chanGe in ValUe of fuNd CrEdIT5%

0%

-5%

Jan

10

May

11

Mar

10

Jul 1

1

May

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Se

p 1

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Jul 1

0

No

v 11

Se

p 1

0

Jan

12

May

13

Se

p 1

2

Jan

14

No

v 10

Mar

12

Jul 1

3

No

v 12

Mar

14

Jan

11

May

12

Se

p 1

3

Jan

13

May

14

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p 1

4

Mar

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Jul 1

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No

v 13

Mar

13

Jul 1

4

No

v 14

chanGe in ValUe relatiVe to aNNuITy PrICE MOVEMENTS

5%

0%

-5%

Jan

10

May

11

Mar

10

Jul 1

1

May

10

Se

p 1

1

Jul 1

0

No

v 11

Se

p 1

0

Jan

12

May

13

Se

p 1

2

Jan

14

No

v 10

Mar

12

Jul 1

3

No

v 12

Mar

14

Jan

11

May

12

Se

p 1

3

Jan

13

May

14

Se

p 1

4

Mar

11

Jul 1

2

No

v 13

Mar

13

Jul 1

4

No

v 14

COLLECTIVE INSIGHT


I have been involved with building and implementing investment strategies for various clients for over a decade now. Some of these

clients are investors with a long-term focus like pension schemes and life insurers, while others are investors with a short-term focus like general insurers and trusts. All of them have investment goals that they would like to achieve. For example, the pension scheme would like to see its members retire with the lifestyle they expected, while the insurer would like to be commercial while putting shareholder capital to work. Therefore, when it comes to building investment strategies, these goals form the foundation on which the strategy is built and its success measured.

This brings me to goals-based investing. The phrase might be new, but the concept is not. It has been around for a number of years in the pension world in the form of liability-driven investment or LDI. I recall attending the first conference on LDI hosted in Amsterdam in 2004, where Dutch and Nordic pension funds spoke about how they apply LDI principles within the goals set by their regulatory framework which is essentially a solvency framework for pension funds.

In LDI the investment goal is defined by the financial liability created by the fund rules of a defined benefit (DB) pension scheme and the ability of the assets to cover that liability or expectations through the funding level.

Unlike South Africa, most pension schemes in the rest of the world are still DB schemes and LDI has remained the exclusive tool used to set investment strategy, especially after the global

financial crisis that sent funding levels tumbling. Many schemes in Europe are now attempting to achieve funded status over a set time horizon on trajectories referred to as their ‘f light path’ where the scheme, for example, wants to be 90% funded in two years’ time with 90% probability, 95% funded in three years’ time with 80% probability, etc.

Even though LDI was originally developed around DB scheme liabilities, over the years the concept of LDI in SA has been generalised for other types of clients like DC schemes, insurers and trusts, building investment strategies around these types of client goals. For example, a defined contribution (DC) scheme may not strictly have a liability determined by the its fund rules, but there is an expectation by the member about the type of retirement product they want to buy. It means that every member in a DC scheme is, in essence, running their own DB scheme, as expressed in their targeted replacement ratio.

Another example is where an insurance client wanted their return on capital to exceed the cost of capital by some margin 75% of the time over a one-year period. These are all examples of generalised LDI or goals-based investing approaches. But have LDI and the broader goals-based investment strategies worked for investors and what message is there for investors interested in goals-based investing? To answer these questions, we need to draw an analogy with another kind of strategy: corporate strategy setting.

The para l lels bet ween set t ing noticeable corporate strategy and setting investment strategy are very noticeable.

How smart is your investment strategy?

buT HAvE lDI AND THE bROADER gOAlS-bASED INvESTMENT STRATEgIES wORkED FOR INvESTORS AND wHAT MESSAgE IS THERE FOR INvESTORS INTERESTED IN gOAlS-bASED INvESTINg?

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COLLECTIVE INSIGHT


A goals-based investment approach continuing on the corporate strategy analogy, I would summarise my message to investors who already implemented or who are thinking of implementing a goals-based investment approach in the following three points:

1. Think l ike a CEO about your investments. What is your vision for your investments? What do you want your investments to achieve? A DB scheme wants to pay liabilities as and when they fall due. A DC scheme wants to provide the retirement to members that they expect. An insurer wants to maximise return on shareholder capital in order to be commercially competitive. Once you have established what this vision for your investments is, make sure that your service providers also understand and buy into your vision. This will ensure alignment of interest between all parties.

2. Make sure your investment goals are SMART, meaning specific, measurable, attainable, relevant and time-bound. Too

many times an investor is too fuzzy about their goals and this leads to confusion and expectation gaps when investment strategies get built, implemented and monitored. A client once defined their investment goals saying that they want their return on their capital to exceed the cost of their capital by at least 2% with a 75% probability over a one-year period. That statement was so powerful, yet so clear, that I had tears in my eyes.

3. You can’t manage what you can’t measure. To manage your progress in realising your vision you need to measure on an ongoing basis whether you are achieving the goals you set. Think of it as keeping an eye on your satnav: you don’t want to find out too late that you should have turned left instead of right, it wastes valuable time and opportunity and you could quickly end up in the dodgy part of town. Measuring your investment performance is obviously important, but don’t forget to also check on how you are measuring up to the goals you set. ■

PETrI GrEEffHEAD OF RESEARCH AND STRATEgy, RISCuRAgreeff is responsible for safeguarding academic rigour throughout risCura’s research processes, challenging existing investment industry wisdom and promoting critical thinking throughout the business. His approach is to dig deep into scientific and financial theory, examine problems from different angles and take an academic standpoint on investment challenges and asset/liability positions.

NOw LET’S appLy the company strategy analogy to say a DC pension scheme. As a board of trustees your vision is to keep pensioners from eating cold baked beans one day and therefore, one of your goals is to deliver at least a targeted replacement ratio of 75% for those members that have 40 years of membership in the fund. your measure of success would be how many members retire with an actual replacement ratio of 75% or more. At year-end, you pull the statistics and see that 90% of retiring members had a replacement ratio of 75% or more. were you successful in achieving your goal based on your vision? yes. were you successful in beating your peers’ performance numbers? Perhaps not. but does it matter? No two pension schemes are exactly the same. what is more important is that as a board you have a vision and that you have put down tangible goals to measure your progression against as you move towards realising your vision for the scheme. This same analogy could also be applied to any other type of investor, whether you are an insurer, a trust or even an individual.

aPPlyIng the PensIon Fund analogy

Your measure of success would be how manY members retire with an actual replacement ratio of

75% or more.

aPPlyIng the Ceo strategy you measure your success in applying a corporate strategy in terms of how well you achieved the goals that were set and met based on your vision statement over a period. For example, you are the CEO of a company that sells thingamajigs and your vision is to be the number one online retailer of these thingamajigs. Textbook company strategy would tell you to set goals in line with this vision. For example, one of your goals could be to double your online sales of thingamajigs by the end of the year. year-end comes and your online sales have trebled. were you successful in achieving your goal based on your vision? yes, definitely. were you successful in beating your competitor’s profit numbers? Perhaps not. but does it matter? No two companies are exactly the same and comparable on an apples-for-apples basis. what is more important is that as CEO you have set yourself a vision and you have put down tangible goals that you could measure your progression against as you move towards realising your vision. This is ultimately your guiding principle.

This time it’s personal

asset management can be particularly powerful. Give an asset manager a target, a t ime f rame and the

degree of certainty required of meeting that target, and the fund manager can general ly 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.

So, the question we need to address is: if goals-based investing is so powerful in re-enforcing all the right behaviours, and so effective in terms of rebuilding a critical level of trust and customer-centricity, why are we still locked in a never-ending performance race?

Over the last 15 years, goals-based investing periodically appeared on our doorstep and then, ever so quietly, slinked off as the enthusiasm for it waned. The two most notable time periods occurred in the wake of the financial crises of that period: post the 2002/03 market collapse and the global f inancial crisis of 2008. Today, it is creeping back into our vocabulary again as a much more realistic investment model to address investor needs, but unless we understand what impediments the industry faces in adapting a goals-based framework, it will remain a concept only.

HOw DID wE gET HERE IN THE FIRST PlACE?‘Goals-based investing’ bears a striking resemblance to the type of trust fund management practices employed by

COLLECTIVE INSIGHT


wealthy families from the 1950s to the 1970s. Trust fund companies saw their fiduciary responsibility from a goals-based perspective. Typically, the two goals they would try to address would be how to provide the dependent with their basic day-to-day income requirements and then how to structure the residual funds to maximise the wealth transfer to the next generation.

The key point is that, to meet these very different goals, two very different portfolios were structured – the first portfolio used an optimal fixed-income blend to match the dependent’s cash flow requirements. The second portfolio used higher risk growth assets that reflected the specific investment interests or risk appetite of the family or individual.

But by the end of 1970s, the global stage would be set for a very different investor. Investing would no longer remain the prerogative of the wealthy.

fOur faCTOrS WErE INSTruMENTaL IN EffECTING THIS CHaNGE:

1. Stronger regulatory protections for mutual funds (unit trusts) meant that these investment vehicles could provide safe, cost-effective vehicles for smaller investors wishing to access the markets.

2. The stagf lation of the 1970s threw into question the v iabi l it y of the conservative, liability-driven investment strategies that were the hallmark of trust companies. The search for yield was on, and that meant venturing out of conventional investment comfort zones, with the emphasis shifting to equities and international investments.

3. Fuelling the growth of this emerging industry was a massive marketing campaign. Financial services companies

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aNNE CabOT-aLLETzHauSErHEAD OF THE AlExANDER FORbES RESEARCH INSTITuTECabot-Alletzhauser heads up the Alexander Forbes Research Institute – an initiative that looks at the full spectrum of issues that confront the savings and investment sector for South Africa in particular and Africa in general.

Prior to that, she was an asset manager and CIO for 32 years, managing pension fund assets in North America, Japan, the uk, Europe and South Africa. In 1994, Cabot-Alletzhauser pioneered the development of the multi-manager management approach of pension fund management that has become the hallmark of that industry today.

COLLECTIVE INSIGHT


began to organise their distribution models around selling clients products (unit trusts), and not just investment ideas.

4. Finally, with the emergence of 401k plans in the US in 1980, responsibility for developing an effective investment strategy to meet retirement funding now fell on the shoulders of the guy on the street.

The democratisation of the investment markets had become a reality – but how well equipped was the industry to meet the challenge?

To service an exponentially expanding market, the industry needed to be able to commoditise solutions and simplify answers. While unit trusts provided a way to commoditise the investment strategy, tailoring solutions to meet a specific client requirement couldn’t be commoditised. Technology simply hadn’t evolved to that level at that point.

How then should investors select their investment strategies?

Performance comparisons proved to be the simplest to sell and the easiest to comprehend. This also simplified both the performance reporting message and the advisory message.

Essentially, the shift away from a goals-based model owes much to the technological limitations that made it unfeasible to provide customised solutions to a massively expanded consumer base. A further complication was that the unitisation framework employed by a unit trust made it next to impossible to provide any form of cash flow matching or liability driven type of solution to this broad mass of investors. Finally, asset classes themselves were limited in scope. Inflation-linked bonds, for example, don’t really become viable, liquid investments until the early 2000s. This meant that the only means asset managers had to address such challenges as keeping pace with cost of living increases, or the cost of future annuitisation would be to increase the fund’s exposure to higher risk/

higher return assets such as equities or international assets and hope this would build up an adequate cushion.

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, as an industry, still need to deal with the will.In truth, perhaps the ultimate culprit to why 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 for opting for the hope-the-manager-wins option as the service provider was.

So, therein lays the chal lenge. Effectively, the asset management business model needs a complete overhaul if goals-based investing is ever to take hold. And if the consumer is actually the one we care about here, it must come right.

What needs to haPPen?■ The advisory and asset management framework must change in tandem. It’s not enough to ask clients what their investment goals are and then simply shoe-horn their assets into performance-based unit trusts, hoping these strategies just might deliver what’s required. The investment vehicles themselves must change so that targets have a higher probability of being met.■ The regulatory environment needs to support these types of solutions and not confound their delivery. while Treating Customers Fairly (TCF) rightly requires us to put clients’ requirements first (and ensure that investments are appropriate), regulations that restrict essential asset class exposures, or require risk questionnaires or performance reporting that do not reference a goals-based approach, can be hugely problematic.■ Performance measurement needs to change dramatically. Technological innovations mean that we can cost-effectively provide even the smallest investor with some notion as to whether they are meeting their investment goals and, if not, what types of interventions could take place to get them on track. The place and time for an effective ‘robo-adviser’ solution has most decidedly come.■ Overall, members of the industry need to rethink how they are helping their clients by setting the right expectations and then continuously managing to those expectations.

when all is said and done, hope is not an investment strategy. while top performance is simply not attainable on a sustainable basis, meeting a specific goal should be. let’s get our clients to where they need to go! ■

collective investments jan 2015 - goals based investing

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