The arrival of efficient frontiers for retirees

Transcription

1 The arrival of efficient frontiers for retirees Luis Sarmiento, Associate Director, Macquarie Group David Barrett, Division Director, Macquarie Group

2 Agenda 1. Why discuss asset allocation in retirement? 2. Extending efficient frontier analysis to incorporate sequence of return risk 3. Aligning risk and return measures to retirees

3 Why discuss asset allocation in retirement? Context of today s discussion 94% of retirement savings in account based pensions (ABPs) (source: Mercer, Post retirement market trends in Australia July 2014, see also Financial System Inquiry Final Report page 120) Strategic asset allocation is arguably the most important portfolio construction decision accounts for most of portfolio s return variability over time (source: Wallick, Shanahan, Tasopoulos & Yoon, The global case for strategic asset allocation July 2012) But GFC highlighted ABP vulnerability traditional asset allocation doesn t consider retirees needs: sequence of return risk, confidence & sustainability of income stream Despite industry debate, consensus approach is yet to emerge

4 Why discuss asset allocation in retirement? Financial System Inquiry (FSI) Final Report December 2014 FSI s target versus your client base FSI: Key retirement income decision drivers are: level of income, risk management and flexibility 85% of pre-retirees are not confident in having an informed conversation around retirement income (source: AustralianSuper 2014, Data provided to Financial System Inquiry, 10 September 2014) without advice, simplicity may lead to a decision for a lump sum hence FSI s trustee-pre-selected CIPR solution (page 117: CIPR comprehensive income product for retirement)

5 Why discuss asset allocation in retirement? So what s wrong with ABPs? FSI suggests ABPs may not deliver high levels of income (pg 120) Why? Risk of outliving capital => more frugal lifestyle adopted by retirees FSI concludes: evidence: most draw down ABP at minimum more certainty in retirement income products will encourage higher consumption and a higher standard of living for retirees Greater use of products that pool longevity risk could significantly increase retirement incomes. For many retirees, incomes from CIPRs could be per cent higher than those from the current typical strategy of drawing the minimum amount from an account-based pension. (FSI Final Report page 123)

6 Why discuss asset allocation in retirement? Context of today s discussion Compare income levels of: ABP drawn at minimum payment level lifetime annuity / other protected products market-linked ABP where asset allocation/ sustainable draw down level is managed... Can marketlinked returns lead to high income?

7 Agenda 1. Why discuss asset allocation in retirement? 2. Extending efficient frontier analysis to incorporate sequence of return risk 3. Aligning risk and return measures to retirees

8 Recap 1: What is sequence of return risk? The sequence of returns does not impact the final balance

9 Recap 1: What is sequence of return risk? unless cash flow drawn

10 Recap 1: What is sequence of return risk? The impact can be significant

11 Recap 2: Traditional efficient frontier analysis Objective is efficient diversification Efficient portfolios (asset allocation): Maximise expected return for a given risk level; and Minimise risk for a given expected return level Ret Balanced DME Efficient False True 5.5 AFI Cash Risk (% pa)

12 Recap 2: Traditional efficient frontier analysis Each dot represents one of 10,626 different 8.5possible portfolios using: 5 asset classes: Cash Australian fixed interest (AFI) Australian Equities () Developed market equities (DME) Emerging markets equities () Ret Balanced DME Efficient False True 5% asset allocation buckets 5.5 AFI Cash Risk (% pa)

13 Multi-period asset model Mercer Capital Market simulator: Stochastic forward-looking model 2000 scenarios of yearly serially correlated and mean-reverting asset class returns and inflation Not normal return distributions Based on Mercer s long term equilibrium assumptions Balanced fund example 2000 scenarios

14 Incorporating an income stream Income stream scenarios: Starting income levels as percentage of initial balance: 0%, 1%, 2%..., 15%. Income level indexed to inflation 40 year cash flow projection inclusive of terminal value (if any) Portfolio return = Internal rate of return i.e. money-weighted return Returns assumed to be net of fees Balanced fund example 2000 scenarios 4% starting income

15 Traditional efficient frontiers: Single period model No cash flows Expand to take sequence of return risk into account: Multi year projections Income stream cash flows Results will vary by size of income stream... Re DME 7.6 Balanced AFI 5.2 Cash Risk pa

16 Efficient frontiers by income level Starting income level: 0% pa Efficient portfolios Not efficient Re DME 7.6 Balanced AFI 5.2 Cash Risk pa

17 Efficient frontiers by income level Starting income level: 1% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

18 Efficient frontiers by income level Starting income level: 2% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI 5.2 Cash DME Risk pa

19 Efficient frontiers by income level Starting income level: 3% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI 5.2 Cash DME Risk pa

20 Efficient frontiers by income level Starting income level: 4% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

21 Efficient frontiers by income level Starting income level: 5% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

22 Efficient frontiers by income level Starting income level: 6% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

23 Efficient frontiers by income level Starting income level: 7% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

24 Efficient frontiers by income level Starting income level: 7% pa Indexed to inflation: Yes allocation %: Re Balanced AFI Cash DME Irrational area Risk pa

25 Efficient frontiers by income level Starting income level: 8% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

26 Efficient frontiers by income level Starting income level: 9% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

27 Efficient frontiers by income level Starting income level: 10% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

28 Efficient frontiers by income level Starting income level: 11% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

29 Efficient frontiers by income level Starting income level: 12% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re AFI Cash Balanced DME Risk pa

30 Efficient frontiers by income level Starting income level: 13% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re AFI Cash Balanced DME Risk pa

31 Efficient frontiers by income level Starting income level: 14% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re AFI Cash Balanced DME Risk pa

32 Efficient frontiers by income level Starting income level: 15% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced DME AFI Cash Risk pa

33 Efficient frontiers by income level Portfolio name Cash Starting income Starting % income Starting % income Starting % income % Return pa Risk pa Return pa Risk pa Return pa Risk pa Return pa 5.2 Risk pa 8.2 AFI DME Balanced Return pa and Risk pa broken down by Starting income % vs. Portfolio name. The view is filtered on Portfolio name and Starting income %. The Portfolio name filter excludes Null. The Starting income % filter keeps 0, 5, 10 and 15.

34 Efficient frontiers by income level Starting income level: 5% pa Indexed to inflation: Yes Efficient at 0% income Efficient portfolios Not efficient Re Balanced AFI Cash DME Risk pa

35 Agenda 1. Why discuss asset allocation in retirement? 2. Extending efficient frontier analysis to incorporate sequence of return risk 3. Aligning risk and return measures to retirees

36 Retirees objectives Align risk and return measures to retiree objectives. However: We assume retirees primarily seek a sustainable income stream and use: multiple (conflicting) objectives likely different objectives for different retirees different objectives over time Return measure: Money weighted return (IRR - Internal rate of return) Risk: Probability of running out of funds in X years

37 Retirees objectives If seeking a sustainable income stream, risk and return vary by: the size of the income stream the time horizon the selected asset allocation Starting income % Avg Avg Avg Avg Avg Avg Balanced fund Year

38 Retirees objectives Efficient portfolios should minimise risk / maximise return for a given: income stream level and time horizon Probability of running out of funds before 35 years by income level & asset allocation Starting income % % 20% 40% 60% 80% 100% P 35yr fail allocation %

39 Aligning risk and return measures to retirees Retirement efficient frontiers Income level LOW Probability of running out of funds in X years should be generally low irrespective of asset allocation. Re DME Balanced AFI 5.2 Cash 2% starting income (indexed) 35 year term 10,626 portfolios allocation % 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% P 35yr fail

40 Retirees objectives Efficient portfolios will minimise risk / maximise return for a given: income stream level and time horizon Probability of running out of funds before 35 years by income level & asset allocation Starting income % % 20% 40% 60% 80% 100% P 35yr fail allocation %

41 Aligning risk and return measures to retirees Retirement efficient frontiers Income level MEDIUM % starting income (indexed) 35 year term 10,626 portfolios 7.4 Balanced More growth assets typically increase risk and return. The optimal portfolio depends on the client s risk appetite. Re DME allocation % AFI 5.2 Cash 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% P 35yr fail

42 Retirees objectives Efficient portfolios will minimise risk / maximise return for a given: income stream level and time horizon Probability of running out of funds before 35 years by income level & asset allocation Starting income % % 20% 40% 60% 80% 100% P 35yr fail allocation %

43 Aligning risk and return measures to retirees Retirement efficient frontiers Income level HIGH More growth assets typically decrease risk and return. May need to review objectives if optimal portfolio risk level too high. Re Balanced DME 6% starting income (indexed) 35 year term 10,626 portfolios 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% P 35yr fail AFI Cash allocation %

44 Retirees objectives Efficient portfolios will minimise risk / maximise return for a given: income stream level and time horizon Probability of running out of funds before 35 years by income level & asset allocation Starting income % % 20% 40% 60% 80% 100% P 35yr fail allocation %

45 Aligning risk and return measures to retirees Probability of running out of funds by income level, term & asset allocation Starting income % % 50% 100% 0% 50% 100% 0% 50% 100% 0% 50% 100% 0% 50% 100% 0% 50% 100% 0% 50% 100% P 35yr fail P 30yr fail P 25yr fail P 20yr fail P 15yr fail P 10yr fail P 5yr fail allocation % Source: Macquarie

46 Conclusions 1. Consider sequence of return risk when setting asset allocation increasingly important as increase draw down level 2. Sequence return risk significantly increases potential cost of getting diversification wrong 3. Client objectives and preferences vary so case-by-case approach required: in some cases lowering growth assets can increase risk of not meeting objectives in some cases increasing growth assets can increase risk of not meeting objectives 4. Objectives and preferences will vary over time a dynamic management approach needed to ensure the client s strategy remains aligned