Forum. Russell adaptive investing methodology: Investment strategies for superannuation before and after retirement.

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1 Forum A meeting place for views and ideas Russell adaptive investing methodology: Investment strategies for superannuation before and after retirement. Published August 2012 Tim Furlan Director, Superannuation Russell Investments

2 Russell Adaptive Investing methodology: Investment strategies for superannuation before and after retirement Lifecycle funds have increasingly become the primary default for retirement savings in the US and UK, however they have not been widely adopted in Australia to date. That may be due to some of the limitations of lifecycle funds, but we believe that there are enhancements that can be made that overcome some of those limitations and deliver better outcomes for members. Russell s Adaptive Investing (RAI) methodology is designed to give a superannuation fund and account based pension members, a path of optimal asset allocations among major asset classes that changes with the member s age, savings rate, salary, account balance and planned retirement withdrawals. Russell has developed the RAI methodology that can be applied to both accumulation (or superannuation) and decumulation (pension or post-retirement) phases of retirement saving. This paper provides a summary of the Adaptive Retirement Income Strategies (ARIS) designed for the management of asset allocation through the post-retirement, pension payment period. Figure 1: RAI has four Distinctive Features: The investment strategy is optimised to meet specific retirement spending goals. A more appropriate measurement of risk is used. This is defined in terms of retirement spending falling below a specified threshold level (referred to as shortfall). The investment strategy is dynamic. In retirement, the investment strategy depends on age, planned retirement withdrawals and account balance. RAI takes into account the main features of Australia s Government age pension. In doing so it gives full consideration to the impact of the age pension means tests which can lead to increases in the age pension after a fall in a retiree s account. 1

3 Moving the mindset to outcome oriented At Russell, we believe that a comprehensive retirement plan needs to balance a member s spending goals with their available assets also known as taking an asset and liability perspective. While this has historical foundations in managing institutional defined benefit strategies, this approach can also be a powerful tool to help retirees to understand the trade-off between the level of income they wish to draw and how likely they are to be able to sustain that over their retirement. When using this approach, the retirement assets of an individual need to be managed considering the liabilities they will fund. While this may seem simple, some complexities include:»» Retirement spending needs span a long and uncertain time horizon»» Spending needs may change and be inconsistent over time due to external circumstances (eg. increase in inflation) or individual needs (eg. Medical expenses, family needs)»» The portfolio that must support these variable liabilities is also likely to fluctuate through time as markets respond to economic and political events. Therefore, an asset and liability approach needs to consider both the growth and uncertainty of the assets and liabilities over time. RAI utilises a member s individual Funded Ratio and their age, to determine an appropriate investment strategy. Funded Ratio = Assets/Liabilities This Funded Ratio will change over time as both the i) Member s portfolio changes due to withdrawals and market impacts (Assets) and ii) Member s expected income needs are revised (liabilities). this approach can also be a powerful tool to help retirees to understand the trade-off between the level of income they wish to draw and how likely they are to be able to sustain that over their retirement In the RAI strategy, this unique Funded Ratio is a key determinant of the member s asset allocation and the way in which the asset allocation evolves over time. Measuring and managing retirement risk Managing investment risk in retirement is a different challenge to traditional portfolio management. Modern portfolio theory is based on a single time period and no cashflows. The reality is that retirement is all about a particular set of cashflows, the pension payments that a member needs to draw. Therefore, an alternative measure of risk is required. Traditional measures of risk such as standard deviation of the portfolio return are included as inputs to the model, but are not alone an appropriate risk measure. We believe that a retirement strategy must align with the goals and objectives of the member, and therefore an appropriate measure of risk must be based on those goals and objectives. RAI focuses on the concept of shortfall. Shortfall is a measure of both the probability and also the magnitude of any shortfall in the provision of retirement cashflow. This means that not only is the probability of failing to meet a spending target calculated, but also whether these scenarios expect spending targets to be missed by $1 or $100,000. 2

4 ...the member s asset allocation responds to external changes such as market impacts to their individual account balance, and changes to their own circumstances such as revised spending needs Adaptive asset allocation RAI creates a dynamic asset allocation strategy designed to provide pre-specified retirement cashflows that have a high likelihood of being sustainable until death. To that RAI considers the member s financial capacity to deliver those cashflows (the Funded Ratio) and the implications of failing to meet minimum cashflow requirements. This is where the use of the shortfall risk is important. While traditional approaches such as mean variance optimisation play a role in the management of portfolio volatility, adaptive asset allocation is a multi-period optimisation approach that seeks to solve the retirement problem of the member not running out of money in their lifetime. Therefore a unique asset allocation is determined by optimising the tradeoff between growing the member s balance over time and the risk of falling short of their spending needs. Based on changes to the individual member s characteristics (including age, account balance, target spending, Government Age Pension), an updated Asset Allocation can be identified on a periodic basis. As this process continues, the member s asset allocation responds to external changes such as market impacts to their individual account balance, and changes to their own circumstances such as revised spending needs. This process can result in a significantly more efficient investment outcome for retirees. The diagram below shows the improvement in investment efficiency that this type of dynamic strategy can achieve. Exhibit 1: Improvement in Efficient Frontier Expected Ending Balance (Thousands) $ RA 10.0 RA 0.5 RA 1.0 RA 0.25 RA 0.1 RA % Eq RA 0.05 RA % Eq % Eq 40% Eq % Eq 100 Constant Mix Strategy ARIS Risk of failing to meet retirement goals The improvement in efficiency means that for a similar average outcome there is significant protection from negative outcomes, highlighted orange in the chart above. For example, looking at two portfolios with similar average outcomes at the worst 1% the RAI portfolio still has some value at age 90, although it s less than that target level. On the other hand the equivalent fixed asset allocation portfolio ran out of money five years earlier at 85. In the Australian context we include the impact of the Australian Government Age Pension in our calculation of the optimal asset allocation for an individual. The implication of the means testing in the Australian Government Age Pension is that the Government Age Pension can partly absorb market falls. This means that Australian retirees can take on more risk than would be the case if we did not have access to a means tested age pension. 3

5 Incorporating longevity risk - Annuity deferral It is not anticipated that a pure investment strategy can eliminate longevity risk for individuals. Annuities can be a solution for longevity risk, but you lose the opportunity to remain invested and maintain the flexibility to access wealth. Therefore, RAI aims to manage the optimal investment portfolio of assets for the individual s goals, while continually evaluating the option to annuitise those assets. This allows members to retain the flexibility and the upside of being invested as long as possible. RAI identifies an annuity hurdle that allows members to evaluate whether their wealth has fallen to an extent that they need to purchase an annuity to protect against their longevity risk or whether they can continue to invest and defer annuity purchase. Using this approach, members can defer their annuity purchase, potentially indefinitely, but retain the option of purchasing an annuity and obtaining longevity protection if necessary. Practical implementation While RAI may look complicated on the surface the implementation can be done relatively simply. A small number of inputs are required for the RAI model from data normally held on an administration system or readily available from contact with the member. The level of interaction and support for members is a key decision in the implementation of this type of strategy. From this data, RAI model produces a series of individual asset allocations. The individual asset allocations can be thought of as analogous to member investment choice elections. The asset allocations can use existing building blocks that superannuation funds already have in their member investment choice structure or options they could readily add. Hence, we believe that administration systems or processes should not be a limiting factor that prevents the adoption of this type of strategy. We believe that Russell s Adaptive Investing methodology can produce practical asset allocation strategies that are superior to those currently used. Conclusion We believe that Russell s Adaptive Investing methodology can produce practical asset allocation strategies that are superior to those currently used. Russell s Adaptive Retirement Income Strategies provide a means of managing withdrawal risk in retirement. It offers a liquid, low-cost way of getting members through retirement. While superior performance is the intended primary advantage of RAI, another important feature is its transparency as compared to alternative means of providing dynamic strategies to members. Unlike typical structured products, RAI strategies do not use derivative securities. Our strategies are designed to use existing investment structures like balanced, growth and conservative funds. 4

6 For more information contact Russell: Phone Sydney Melbourne Website Address Level King Street Sydney NSW 2000 Tim Furlan Director, Superannuation tfurlan@russell.com Michael Clarke Managing Director, Institutional mclarke@russell.com This document is issued by Russell Investment Management Pty Ltd ABN , AFS License (RIM). It provides general information for wholesale investors only and has not prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Past performance is not a reliable indicator of future performance. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Copyright 2012 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from RIM. Copyright 2012 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. MKT/4848/0812. R_NEWS_Forum_Adapt_V1F_1108