The Role of Capital Guaranteed Products in Financial Plans

Transcription

1 The Role of Capital Guaranteed Products in Financial Plans May 28 Chris Condon and Richard Cornwell MLC Investments Limited ABN AFSL 2375 National Corporate Investment Services Limited ABN AFS Miller Street North Sydney NSW 26 Australia PO Box 2 North Sydney NSW 259 Australia

2 Important Information The views expressed in this publication are those of the author(s) and not necessarily those of MLC Investment Manment (a division of National Corporate Investment Services Limited), MLC Investments Limited or any other member of the National Australia Group (i.e. National Australia Bank Limited, its related bodies corporate and associated companies and businesses). They are based on the author s judgement at the time of this publication and are subject to change. This publication is intended to provide general information only. However where it contains general advice, it has been prepared without taking into account any particular persons objectives, financial situation or needs. Accordingly, investors should, before acting on any information in this publication, consider the appropriateness of this information having regard to their own circumstances. While due care has been taken in preparation of this publication no warranty is given to the accuracy or completeness of the information. Except where under statute, liability cannot be excluded, no liability (whether arising in negligence or otherwise) is accepted by the author(s), National Corporate Investment Services Limited, MLC Investments Limited, or any other member of the National Australia Group for any error or omission or for any loss caused to any person acting on the information contained in this publication. This publication does not constitute an offer or invitation to purchase any investment product. Any offer of an investment product will be made in a disclosure document and applicants will need to complete the application form attached to that document. Copyright: National Corporate Investment Services Limited and MLC Investments Limited. All rights reserved. This publication has been prepared by MLC Investment Manment, a division of National Corporate Investment Services Limited (ABN ) (AFSL 23687) for wholesale clients and MLC Investments Limited (ABN ) (AFSL 2375) for retail clients. Both these entities are located at Miller Street, North Sydney NSW 26 and are members of the National Australia Group. Last saved: 2 September 28 12:46 PM P 2 of 4

3 Abstract The financial planning challenge for most individuals is the ongoing need to make decisions regarding savings and consumption, investment strategy, borrowing strategy, career, housing, insurance and social security utilisation to satisfy future cash outflows for retirement income and bequeathment. For people with at least modest levels of wealth (or potential wealth through future savings) these cash outflows are generally many years, even decades, into the future. The sensible advice by many financial advisers is to encour their clients to adopt a disciplined, long term, investment strategy involving growth assets that have a good chance of delivering the returns required over these years, and a low chance that long term returns will be poor or that the individual will live too long for her money. But this approach has a flaw: although the planning horizon is often long term it is only one long term period. A low chance of poor returns or living too long will mean that a small proportion of individuals adopting this strategy will, ex post, experience unsatisfactory outcomes and will not benefit from the sharing of risk with most individuals who have met or exceeded their retirement and bequeathment objectives. This paper addresses this issue and examines the types of products that could be offered by insurance companies and other institutions to insure against the low probability that you will be one of those individuals that chance does not favour. These products, by reshaping the return profile and in some cases providing longevity insurance provide an improved match for a retiree s needs and reduces the risk of a financial plan failing over time. Keywords: capital guarantees; variable annuities; CPI linked annuities; financial plans; longevity risk. Acknowledgements We thank Wade Matterson of Milliman for providing the economic costs associated with the guaranteed strategies discussed in this paper. Contents 1 Introduction Where do White Papers fit in?... Error! Bookmark not defined. 3 Content Format... Error! Bookmark not defined. Last saved: 2 September 28 12:46 PM P 3 of 4

4 1 Introduction There is now an extensive literature on variable annuities and modern capital guaranteed products. Most of these have primarily focussed on the manufacturer s point of view. Much of the discussion is around basic product design, pricing and risk manment practices, primarily the hedging of the guarantees and the practical implications of this. This paper considers these products more from the customer s point of view. Do these products have a legitimate part in the development of a financial plan? Do they provide a useful tool in financial plans allowing investors to man the financial risks that they are exposed to over their lives? The paper looks at the financial risks faced by individuals and considers them in terms of matching assets to future retirement income needs (the present value of which can be considered as liabilities ), thus drawing out the implications for financial plans. We then develop a simulation model for a sample investor and compare the outcomes of traditional financial plans which primarily man the long term risks through exposure to risky assets and those using guaranteed products. These examples highlight the benefits and costs of using these products to man the tail risk that individuals are exposed to. 2 Literature Survey In this paper we have chosen to focus on the role that capital guaranteed products can play in the financial plans of individuals. In acknowledging the narrowness of this focus we note that others have considered broader aspects of the financial planning problem. We mention a few of our favourites here without any pretence that these references are a comprehensive survey of the wealth of writing on personal financial planning. Ibbotson et al (27) highlight the importance of individuals considering their whole financial circumstances, including human capital, i.e. the present value of future earned income. Human capital dominates the wealth of younger people early in their careers and is a strong reason why people at this st in their lives can tolerate greater risk in their financial assets (including lever). But human capital is not riskless, and the ability for people to recover from setbacks in their financial assets diminishes rapidly as people near the end of their working lives. They discuss the role of annuities and the need to man the risks of longevity. This work covers many aspects of the financial planning problem which are outside the scope of this paper. Another extensive compilation of excellent observations from eminent commentators including Zvi Bodie, Paul Samuelson, Robert Merton, Philip Dybvig, James Poterba, François Gadenne and many others has been published by Research Foundation of CFA Institute (28) under the title The Future of Life-Cycle Saving and Investing. This compilation covers most of the challenges that face individuals in planning for their retirement. But even here, there are few references to the need to eliminate unacceptable long run outcomes. One exception is Gadenne (on p 86) who suggests that the crucial periods for protecting capital are in the decade or so on either side of retirement: Path dependency matters greatly. As a conditional probability statement, the experience of zero returns (let alone negative returns) in the first decade in retirement may be 7 8 percent correlated with portfolio ruin (that is, running out of money before the retiree dies). The likelihood of ruin declines from decade to decade in retirement. Thus, there is a transition phase before and immediately after retirement when return maximization and risk taking may be considerably less desirable than downside protection for many investors. Last saved: 2 September 28 12:46 PM P 4 of 4

5 Another important aspect of the financial planning problem is to truly understand, and even adjust, an individual s expectations. Statman (22) explores some of the behavioural aspects of financial planning, recognising the powerful human driver of status, and noting that well-being and wealth are not the same thing. How affluent individuals may feel about a significant loss of wealth may be just as important as a driver to their desire to protect it than the practical impact on their standard of living. For example, later in this paper we identify the social security pension safety net as an asset. The value of this asset will vary to different people depending on their self perception of status etc. Given the extensive writing on options pricing and hedging strategies in the finance literature, we were surprised to find a relative paucity of papers dealing with how assets with asymmetric payoffs could be used in an individual s long term financial plan. We suspect that we have missed some important papers; those we found most pertinent are discussed below. Bodie (1999) conducted some very straightforward modelling that suggests long term investors combining inflation linked securities over one and five year periods with one or five year equity call options can capture much of the upside available from pure equity strategies and remain confident of having wealth accumulation not fall behind inflation. His analysis suggested that using five year options provided better access to potential equity upside with little downside risk. I believe that Bodie limited his analysis to five year options as longer term options were not available for practical use. The Bodie results are contrary to expectations and have been disputed by Dert et al (23), who claim that the strategy of using a five year call option has about the same likelihood of below target outcomes as buying and holding 1% in equities, but considerably lower mean outcome. However, Dert et al do not dismiss the use of well chosen option strategies to outperform in a number of risk-return frameworks, for example as discussed in Carr & Madan (21). Carr & Madan (21) note that arbitr-free option pricing models are based on replicating option payoffs by dynamically hedging a portfolio that includes the underlying risky asset. This implies that options are not necessary to develop optimal investment strategies as their return distributions can be created by a dynamic strategy involving the underlying assets. This observation is inconsistent with the real world, in which options are used extensively and are heavily traded. They relax the assumptions of arbitr-free models by considering nts with different beliefs about return and volatility, and also considering nts with different utility functions, and show that an option will be attractive to different nts in different ways. The consequence of this is that options will form part of different investment strategies and that trading in options should be frequent. This consequence is consistent with the real world. Carr & Madan also make the observation that not all investors are able to run dynamic hedging strategies (involving continuous trading) and so are denied option payoffs if their choice of investments is limited to the underlying risky assets. We note that in fact, no nt can trade continuously, but that some nts are better at approximating this than others and will either (a) sell their trading skills to clients either in the form of a guaranteed payoff, or (b) offer their services as an nt acting with delegated authority on behalf of the other less able nts. An example of the type of dynamic trading strategy this is commonly sold to investors is Constant Proportions Portfolio Insurance (CPPI). Black and Perold (1992) designed this strategy, which attempts to replicate option payoffs using trading rules on a physical asset. The technique involves a simple rule to invest a constant multiple of the cushion in risky assets up to the borrowing limit, where the cushion is the difference between wealth and a specified floor 1. There are numerous issues with this type of protection. Wilcox (23) argues that the size of the multiple needs to be quite large to benefit from the option type payoffs promised by CPPI. But this means that many participants who experience an early period of sharply negative returns on the risky asset will be sold out of the risky asset early and will not participate in later higher returns. Last saved: 2 September 28 12:46 PM P 5 of 4

6 Ledlie et al (28) give an excellent summary of the product features of Variable Annuities and the actuarial issues arising from them. They give summaries of the main types of guarantees given over variable annuities and give an overview of their development in a number of countries such as the US, Japan and Europe. A number of papers were presented to the IAA Conference in Christchurch last year discussing these products and their potential application in Australia. Hayman and Hickey (27) consider the needs of retirees and discuss a range of potential products and financial planning tools, but without detailed modelling. Brennan, Nicholls and Roberts (27) discussed how modern financial hedging techniques would facilitate the provision of new generation capital guaranteed products in Australia and the attractiveness of these products. Matterson (27) similarly discussed the variable annuity products, the hedging of investment risks and the capital requirements for manufacturers. 3 The Moving Parts of the Financial Planning Challenge While financial plans can have many different objectives, we have assumed that their primary purpose is to ensure an adequate standard of living for a person s entire life. This means that we need to consider the risk of running out of money by living too long, poor investment performance, or a combination of the two. We believe that the concept of a personal balance sheet is useful for examining the structure of the financial planning challenge and analysing the risks that individual investors are exposed to. This then allows us to identify financial and insurance tools that mitigate and eliminate these risks using the classical concepts of asset and liability matching. The analysis allows us to see that traditional financial plans leave many investors exposed to significant tail risks, or conversely over-insure against some risks at an excessive cost. This personal balance sheet includes a number of items that don t appear in traditional analyses. These are, nevertheless, real factors in peoples financial decision making. 3.1 Liabilities Home Mortg Most people acquire a house by borrowing the money. This is usually their main financial liability for their lives. For the purposes of this paper we will assume that the mortg has been paid off Investment Loans Borrowing to invest effectively levers the return and volatility of an investment and can be considered as part of the asset strategy rather than a liability in the accounting sense. This is particularly useful for individuals at younger s who tend to have modest exposure to financial assets compared to their non financial assets such as human capital (discussed later). For the purpose of this paper we assume that any investment borrowing is considered with investment assets and can be used to lever the return and volatility of the investment portfolio. Last saved: 2 September 28 12:46 PM P 6 of 4

7 3.1.3 Credit Cards etc. Credit cards are another, expensive, form of debt. Hopefully retirees will have little need for these except as a cash manment tool Future Living Expenses (Self and Dependants) The fundamental liability that we all have is the necessity to pay for living expenses. The level of these expenses is, of course, discretionary to some extent but we assume for the purposes of financial planning that there is a desired standard of living that is to be funded and that failing to achieve that objective is a failure for the financial plan. Living expenses covers any dependents who rely on the financial resources of the family. Living expenses are obviously dependent on how long you live and are influenced by future inflation. The desired level of living expenses is a variable that needs to be squared with the available assets. Too high a desired living standard may require too much risk to be taken to justify it or just ensure that the money will run out Future Holidays/Travel etc. These are more obvious discretionary expenses but they make up a significant part of many people s retirement objectives. These expenses are also dependent on how long you live and remain in good health and are influenced by future inflation Future Health Expenses Health expenses include hospital and prescription expenses as well as nursing home and other expenses associated with extreme old. Some of these expenses are covered by government benefits, such as Medicare and the Pharmaceutical Benefits Scheme, some are covered by health insurance, but others, such as nursing homes are not well covered Bequeathment Most people wish to leave some money to their children or other family members. The level of this desire will affect the amount of risk that investors are prepared to take. There will, of course, be some interaction between desired standard of living (or the amount that people are prepared to spend on living and discretionary expenses) and the targeted legacy. Ibbotson et al (27) show how the relative preference between income and bequeathment can affect investment strategy. 3.2 Assets Assets can be divided into two classes: Physical assets such as homes, superannuation, other financial assets (including investment properties) and, Contingent assets are items such as future earnings, social security, inheritances and insurance. Last saved: 2 September 28 12:46 PM P 7 of 4

8 3.2.1 Physical Assets Home The home is a physical asset that also provides for a large component of future living expenses, being a place to live. To the extent that people may be prepared to live in cheaper accommodation then the value of the home could effectively be subdivided into the value of a place to live and an investment asset to pay for future expenses. But this investment value does not generate a return until the home owner takes action such as downsizing, taking in lodgers etc. Until then, a home owner may continue to live in apparently unnecessarily large house. He or she is essentially paying a high, but opaque, price for accommodation, being imputed rent. Often these people are fooled by mental accounting cognitive errors, being unable to assess the opportunity cost of not downsizing. But in many cases the emotional utility from remaining independent by living in the family house is very high and such individuals may explicitly or implicitly be prepared to pay a considerable price for this. The value of a house is market dependent, somewhat sensitive to interest rates and also provides some inflation protection as house values tend to go up with inflation. If maintained it will provide accommodation for as long as the owner lives. Many people want to be able to leave their house as a bequest to their children, which make them reluctant to access their equity in the house. The house is often thought of as an additional safety net. In the event of a person running out of financial assets or superannuation then they can access some of the house s value by selling it and downsizing. In essence, this is no more than belt tightening by reducing imputed rent. Its attractiveness as a strategy can probably be attributed to mental accounting. Various equity release products such as reverse mortgs or home pensionisation can be used to access home equity while still living in the home. But to the extent that effective downsizing has not occurred, then the home owner continues to pay higher imputed rent than may be necessary. House sale can also be used to meet nursing home costs and similar health expenses of advanced old Superannuation Superannuation is more of a tax structure than an asset class. However, due to its tax advants and liquidity disadvants it is worth considering separately. The risk and return profile of superannuation assets can be tailored to meet the needs of the investor. This is, effectively, one of the key variables in determining the financial plan for an individual. In the past defined benefit superannuation plans and traditional life insurance products provided mechanisms where some or all of the market risks were borne by companies rather than the individual. With the demise of these products it is currently difficult for consumers to access assets that are insulated to a greater or lesser extent from market risk. This means that market risks are now being primarily borne by individual investors Financial Assets Some assets will be held outside superannuation. This may be because the money may be needed prior to retirement or it cannot be put into superannuation yet because of the contribution limits. Last saved: 2 September 28 12:46 PM P 8 of 4

9 3.2.2 Contingent Assets A number of assets do not appear on a typical balance sheet, but are, nevertheless, real and should be allowed for in formulating financial strategies Future Earning Capacity or Human Capital One of the largest assets that a person has is their ability to earn future income. Sometimes this is referred to as human capital. This asset diminishes over time as people approach retirement. Income from work is usually correlated with inflation and provides a natural hedge against inflation. Retirement dates are often somewhat elastic as retirement can often be deferred if some extra income is needed. Once someone has fully left the workforce, however it is difficult to re-enter it. Future income also gives the possibility of investing money at lower prices if market prices do fall, allowing assets to be rebuilt over time. This gives a resilience that allows some higher financial risks to be taken in order to achieve investment goals. The level and volatility of earned income will depend on the skills of a person and the industry that they work in. Someone working in, say, an investment bank with volatile earnings dependent on investment markets is in a different position to someone whose income is largely fixed and is not dependent on markets, for example, a public servant. Ibbotson et al (27) explore this issue Social Security The Australian Social Security system is a very good system which provides a minimal level of income, which increases with inflation and is for life. It is subject to assets and income tests and therefore acts as a cushion for reductions in other asset values, as the pension increases as assets decline over the range between full eligibility to no eligibility. Many people believe that they won t need much income at an advanced and that they will be happy to live on the pension alone at old. Many people don t factor in the costs of long term health care at older s, which can mean that the combination of Medicare and the pension is inadequate at these older s. Our position is that for most retirees living on the social security pension on its own is a failure of the financial plan. It does, however, offer a real safety net for retirees and can form an important component of a person s financial plan. The jury is out regarding the reliability of this asset into the future. Certainly many countries with deteriorating dependency ratios and cradle to grave social security systems are, or will need to, significantly reduce old pensions or increase retirement s. Arguably Australia is in a better position than most, primarily due to immigration and compulsory superannuation. And the electoral power of the aging baby boomers may be a force to retain the value of social security well into the future. Nevertheless, the quantum of this contingent asset is not certain Inheritances Many people can expect to receive some sort of inheritance from their parents. It is interesting to note that many people mentally segregate inheritances and are keen to preserve them for their own children. This means that they can have a different risk and return preference for this part of their assets. The timing of such bequests is unpredictable and there is a risk that it may not materialise for one reason or another. Last saved: 2 September 28 12:46 PM P 9 of 4

10 3.3 Summary The above can be summarised in the following table which looks at the key characteristics of each of the assets and liabilities that make up the Personal Balance Sheet. We believe that this gives a very useful framework for considering how a financial plan should be structured at various time of life. Market Sensitivity Interest Rate Sensitive? Time Inflation? Longevity Risk? Physical or Contingent? Discretionary? Liabilities Home Mortg Physical None Yes No No No No Investment Loans Physical None Yes No No No Yes Credit Cards etc. Physical None Yes No No No Yes Living Expenses (self and dependants) Physical None No Reduces Yes Yes No Holidays/Travel etc. Physical None No Reduces Yes Yes Yes Health Expenses Contingent None No Increase Yes Yes No Bequeathment Contingent None No No Yes Yes Yes Assets Home Physical Positive Indirect No Yes No n/a Superannuation Physical Positive? No? No n/a Financial Assets Physical Positive? No? No n/a Future Earning Capacity Contingent None No Reduces Yes No n/a Social Security Contingent Negative No Reduces Yes Yes n/a For the purposes of this paper, we will conduct case studies on individuals d 5, 65 and 75. These will include earnings over the period to retirement and then on superannuation assets and living costs in retirement. Other elements of the personal balance sheet will be ignored. We also assume a preference for income over maximising a potential bequest. The typical financial plan for a retiree will have their superannuation invested in a mix of financial assets such as a Balanced or Growth oriented diversified fund. This will be subject to market risk. They have no financial liabilities; the only liability we consider is the value of future retirement income. We show by way of these simple cases that the typical financial plan leaves investors with a significant asset-liability mismatch, with longevity and inflation risk that isn t matched by the typical portfolio of financial assets. It is interesting to note that some financial planning packs give probability distributions for the outcomes of financial plans. Advisers often only show quite narrow probability ranges, such as the 4th to 6th percentiles. This is probably because the wider probability bands highlight the fact that there is a Last saved: 2 September 28 12:46 PM P 1 of 4

11 considerable risk of their client running out of money and they have no satisfactory tool to meet that risk. They therefore avoid the conversation by not illustrating it. It is this risk that is the focus of our concern in this paper. 4 Attitudes to Risk Attitudes to risk are both varied and often inconsistent. Spectacular risks, such as being eaten by a shark or an aeroplane crash tend to be overestimated while more mundane risks such as being involved in a motor vehicle accident are ignored. In financial services many people do not understand the link between risk and returns. Additionally high personal discount rates mean that for many people long term issues and risks tend to pale into insignificance. Interestingly attitudes to risk can be affected by how the questions and issues are framed. McCrae (undated) shows how the framing of questions can influence the responses of clients to financial planners in setting investment objectives and structures. Brown et al (28) investigate using surveys how framing annuities as either consumption tools or investment vehicles change the attitude of people to annuities in the US market. Their conclusion states: We hypothesize that framing matters for annuitisation decisions: in a consumption frame, annuities are viewed as valuable insurance, whereas in an investment frame, the annuity is a risky asset because the payoff depends on an uncertain date of death. Survey evidence is consistent with our hypothesis that framing matters: the vast majority of individuals prefer an annuity over alternative products when presented in a consumption frame, whereas the majority of individuals prefer non-annuitised products when presented in an investment frame. To the extent that the investment frame is the dominant frame for consumers making financial planning decisions for retirement, this finding may help to explain why so few individuals annuitise. We would expect that this would also apply in the Australian market, except more so, as annuities have such a small market presence in the Australian financial planning landscape. 5 Four Strategies In this section we consider four strategies that may be considered when developing a financial plan. We label them: 1. Matching 2. Long term investment strategy 3. "Using insurance with embedded guarantees 4. Using deferred withdrawal guarantees for life, with uplift Other strategies that could have been considered, but were omitted from this paper include partial matching combined with geared surplus, constant proportions portfolio insurance, rolling short term put options, and lifecycle glide paths. These are briefly discussed in Section 7. Last saved: 2 September 28 12:46 PM P 11 of 4

12 We discuss each strategy in turn and present the outcomes from simple modelling of investment and longevity risk. In Section 6 we propose some metrics that attempt to describe this risk in a readily understandable form that could be used by planners with their clients. The values of these metrics for each of these four strategies are then summarised and discussed. 5.1 Strategy 1: Matching The most obvious way an individual can attempt to remove investment and longevity risk is to set the asset portfolio to have future cash flows that approximately match the desired cash flow stream in retirement. Significant and obvious life uncertainties such as the timing of death and future inflation could conceivably be hedged by inflation linked life annuities, but even here few truly suitable products are available. Other less obvious uncertainties such as credit risk, inflation basis risk and unforseen lifestyle changes make even these vehicles only approximate matches to retirement income requirements. Even if the ideal product was available, we observe that few individuals find these products attractive. Perhaps the two most cited reasons are (a) the irrational sense of unfairness of losing capital in the event of early death, and (b) the rational concern that many of these products are too expensive compared to other strategies in which the individual retains some risk. For example, we understand that $1, can buy CPI linked annuities at 65 of around $4,5 for males and $4, for females. We are able to approximately replicate these rates using best estimate annuitant mortality rates with mortality improvement, discounting at a real rate of around 1.3% pa (tax free) less a spread of 1% pa, and then adding 25% loading. The spread and loading are intended to make some allowance for the profit, expenses and risk associated with hedging CPI liabilities into the distant future. In this, and the other strategies, we examine the outcomes for three individuals: A single male 2 d 5 who planned to work to 65, save at a rate of $15, pa before then and draw a retirement income from this investment of $3, and has just sufficient assets at 5 which, together with savings until retirement, will pay for deferred CPI adjusted annuity to match this retirement income requirement. (All dollar amounts in this paper are expressed in today s dollars, with rates of return and discount rates expressed in real, after tax 3, terms.) The amount required at this is $344,19 4. We do not believe that such deferred CPI annuities are available and have based this purchase price on the above assumptions, which are consistent with observed market prices at 65. A single male 65 just retired with $666,719 5 in assets, once again just sufficient to purchase a CPI annuity providing a real income of $3,. A single male 75 with $425,685 in assets, just sufficient to purchase a CPI annuity providing a real income of $3,. In the following charts we show the value of such annuities to 95. The lines are very close to each other, but not identical, as the older purchasers do not benefit from the survivor benefit of buying these annuities at earlier s. Of course, this value is not a market value. The life office would offer a surrender value well below this amount, and the secondary market (if available) would not offer much more. But the line does give a sense of the level of assets that you would require in this range to buy such an annuity if it was available. Last saved: 2 September 28 12:46 PM P 12 of 4

13 Matched strategy; Commencing at 5 Value of CPI annuity 12 1 Wealth $ Matched strategy; Commencing at Value of CPI annuity 1 Wealth $ Last saved: 2 September 28 12:46 PM P 13 of 4

14 Matched strategy; Commencing at 75 8 Value of CPI annuity 7 6 Wealth $ One interesting aspect of these lines are that they are mildly convex in retirement, i.e. the value decreases at a decreasing rate. This is due to the fact that an annuity is only paid if you are alive to collect it, and thus survivors benefit from the release of reserves when others in the pool die. This is unlike the paths of median investment assets (see later charts) that tend to diminish at an accelerating rate as assets are drawn to pay retirement income. One reason why this type of approach to completely matching retirement income is rare may be due to the fact that it can only be relevant to a small subset of individuals with assets not significantly in excess or deficit of that required for the match. An individual with insufficient assets to match their expected retirement needs will simply lock in misery by adopting a matched strategy. The blandishment to spend less now and save more for tomorrow may help in some circumstances but can often be patronising and insensitive to the immediate financial challenges facing many people. In these circumstances the individual may be best to save what he can, invest sensibly according to his attitude to risk, develop realistic expectations about standards of living and simply rely on social security and fortune for his retirement. Some of the strategies discussed later may be suitable for this investor, but matching will be unlikely to play a role. On the other hand, an investor with assets significantly in excess of that needed to defease retirement living requirements faces an interesting optimisation issue which is typically expressed in terms of maximising long term wealth (or retirement income) subject to an acceptable probability of having enough to meet satisfactory retirement income needs. Pure matching is not appropriate in such cases, but may play a part, as discussed briefly in Section 7.1. Last saved: 2 September 28 12:46 PM P 14 of 4

15 5.2 Strategy 2: Long Term Investment Strategy A more typical approach to setting investment strategy for a long term investor is to estimate the individual s future cash flows (savings, retirement income and anticipated lumpy cash flows, such as replacing the car, downsizing the family home etc) and demonstrate the range of outcomes that would occur if a particular investments strategy was to be used. Under this approach the investment strategy is defined in advance. Indeed it will often involve an asset allocation maintained over the individual s life. Marginally more sophisticated approaches will adjust the asset allocation over time, but in a predefined way, often referred to as a glide path that reduces the allocation to risky assets as the individual approaches and moves through retirement. (See section 7.2 for a brief discussion.) Under this strategy the investment portfolio is not dependent on the path of risky outcomes that have been experienced in the assets (or indeed the liabilities). In reality, individuals using such an approach will modify their investment, savings and consumption choices in response to unfolding conditions over their life, but the strategy itself does not respond in this way. Armed with projected cash flows (typically deterministic) and assumed stochastic returns (typically annual) derived from long term return and risk assumptions (typically mean-variance) the individual s adviser is able to demonstrate to the client the range of wealth outcomes that could be expected over time. For the purpose of illustration, we demonstrate a strategy whereby a risky portfolio of assets is rebalanced annually to an invariant asset allocation (i.e. we do not bother with a glide path). We also assume time invariant economic conditions that are consistent with a mean real rate of net return of 3.6% per annum before retirement (after fees and superannuation tax) and 4.6% per annum in retirement (tax free, after fees). The respective annual standard deviations are 11.9% and 13.6%. We also assume that these rates of return are log normally distributed and are serially independent. These assumptions are clearly simplistic as they do not incorporate (a) time variance of risk premia, (b) long term mean reversion and (c) non-normal return distributions, all of which are evident in many asset prices. Sophisticated models used for real investment strategy should include these attributes, but the simplistic approach outlined above is satisfactory for the demonstration of the issues in this paper. We plot the median, 1st and 99th percentile outcomes for such a strategy applied to the same individuals described in Section 5.1. We also redraw the value of a strategy matched by a CPI annuity and quantify a metric labelled probability of running out of money. Its meaning is self evident, but is formally defined later in the paper. In addition to these wealth charts, we show the 99th, 95th and 75th percentiles of the shortfall to the desired $3, retirement income that the individual will experience. Clearly, in practice, should an individual experience poor investment outcomes or live too long he will see his money running out and may adjust consumption behaviour many years in advance. We have made no attempt to model this reaction. Last saved: 2 September 28 12:46 PM P 15 of 4

16 Risky investment strategy with no guarantees commencing at Value of CPI annuity Risky strategy: median Risky strategy: percentile 1 Risky strategy: percentile 99 Wealth $ Probability of running out of money 13% Risky investment strategy with no guarantees; Commencing at 5 35 percentile 99 percentile 95 3 percentile 75 Income Shortfall $ Last saved: 2 September 28 12:46 PM P 16 of 4

17 Some observations: The median outcome of this strategy allows the individual to virtually live off real investment returns during retirement, leaving a level of wealth at death (at any ) not significantly diminished since retirement. The 1st percentile is clearly worse than the matched strategy as the individual runs out of wealth by 77. This is of course, balanced by upside risk, which is demonstrated by wealth growing to very high levels; the 99th percentile goes off the scale used in this chart before retirement. Clearly, the investor has choices along the way if extreme outcomes occur (good or bad). Many people unwittingly increase their standard of living when wealth is available and would spend at a higher rate than planned if the means were available. And in the case of bad outcomes, the investor would tighten their belts (at least to some extent) to make their money last longer. But the downside risk is clearly evident. The chart shows that there is a 1:1 chance of this individual running out of money by 77. How he reacts to this risk can be complex, and will involve considerations of attitudes to relying on social security, relying on family, standards of living etc. The immediate jumps to $3, in the shortfall chart shows the stark consequence of running out of money. The outcomes for other cases (commencing at 65 and 75) for this strategy are set out in the following charts. Once again, we assume that the assets available to such people are those available to purchase a CPI annuity. Risky investment strategy with no guarantees commencing at Value of CPI annuity Risky strategy: median Risky strategy: percentile 1 Risky strategy: percentile 99 Wealth $ Probability of running out of money 14% Last saved: 2 September 28 12:46 PM P 17 of 4

18 Risky investment strategy with no guarantees; Commencing at percentile 99 percentile 95 3 percentile 75 Income Shortfall $ Risky investment strategy with no guarantees commencing at Value of CPI annuity Risky strategy: median Risky strategy: percentile 1 Risky strategy: percentile 99 Wealth $ Probability of running out of money 21% Last saved: 2 September 28 12:46 PM P 18 of 4

19 Risky investment strategy with no guarantees; Commencing at percentile 99 percentile 95 3 percentile 75 Income Shortfall $ It is easy to take pot shots at the assumptions behind this sort of modelling, but to do so ignores the fact that this approach allows advisers to help their clients understand two key issues: the relationship between current wealth levels, planned savings and retirement income expectations the notion of risk This paper is not the place to critically evaluate this type of modelling. But it does beg an important question, which can be very difficult to answer: What happens if my returns experience just happens to be the 1 in 1 chance of falling below the bottom of your range? This modelling tells me I will run out of money and the investment strategy you are proposing does nothing to guarantee that I won t. The two strategies modelled in the following subsections describe some of the solutions that may be made available to deal with this critical issue. 5.3 Strategy 3: Using Insurance with Embedded Guarantees In the USA, Japan and some European countries it is possible to purchase various combinations of life insurance products with embedded guarantees. These guarantees are provided by the life office; they are not dynamic hedging strategies such as CPPI discussed in Section 7.3. The policy holder essentially holds an insurance rider that pays out in circumstances where the underlying risky investment does not achieve specified floors. Behind the scenes the life insurance company will undertake various forms of hedging of its assets to man the mismatch risk with the asymmetric obligations associated with these riders. But from the point of view of the policy holder, downside risk below the floor(s) is converted from investment risk to counterparty risk to the insurance company. In other words, will the life insurance company be around and able to meet the guarantees if they trigger in the coming decades? Last saved: 2 September 28 12:46 PM P 19 of 4

20 There are many flavours of such products, including simple versions that underpin asset values during the accumulation phase to those that guarantee a withdrawal benefit for life. Many of these products have a guaranteed amount that ratchets if, at certain dates such as policy anniversaries, the underlying asset values exceed the guaranteed amount. These tend to be very popular with clients and their advisers, but do cost more, give more upside, but may not be as cost effective as possible in protecting the downside. Also, investors and their advisers do not tend to value guarantees that protect inflation. This is one reason why most of these products are expressed in terms of nominal values (i.e. not inflation adjusted). Another reason is that the difficulty for the life office in hedging uncertain future inflation can mean that true inflation protected products are rare. In this section we model how the use of popular insurance products of this type can help to mitigate, the shortfall between available retirement income and desired retirement income. In the next section we devise a potential improvement that may provide more effective protection. In this section we model: An individual in his accumulation phase purchases a Guaranteed Minimum Accumulation Benefit (GMAB) rider for 15 years with a guaranteed amount uplifted by 3% pa to approximate maintaining the real value of this wealth by retirement. This 3% uplift is a proxy for inflation and tends not to be popular (as it is more expensive than guaranteeing nominal account values). This rider is assumed to cost 1.1% per annum of the amount guaranteed 6. The rider during this phase has no ratchets. We have assumed that the further savings before retirement are not protected, but real life strategies could include this. On retirement the individual then purchases a rider that guarantees, to the extent possible, a retirement income of $3, (in today s dollars) for life by purchasing a Guaranteed Minimum Withdrawal Benefit (GMWB) of 6% for life, with annual ratchets of the nominal balance of the assets in retirement. This is not a guaranteed real income and, in some cases, it will fall short of the desired income. If the real value of assets at retirement are lower than $5, (i.e. required to deliver $3,), a partial guarantee is purchased. We deduct a cost for these products of 1.3% per annum of the amount guaranteed from 65 and.92% from 75. For consistency, the same underlying investment strategy as used in Section 5.2 is applied to the underlying investments. The same two charts (wealth and shortfall) are produced for each of the three s at commencement. We also produce a third type of chart being the distribution of top-up that is paid by the insurance company. Last saved: 2 September 28 12:46 PM P 2 of 4

21 GMAB and nominal GMWB with ratchets; Commencing at Value of CPI annuity Risky strategy: percentile 99 Risky strategy: percentile 5 Risky strategy: percentile 1 Wealth $ Probability of running out of money 23% The chart above shows: The probability of running out of money in this case is 23%, much higher the 14% for the previous strategy without guarantees. This is due to the cost of the guarantees that are paid out of the assets. The cost of the guarantees can also be seen in the median wealth outcome, which shows a distinct droop over time. The bequeathment to the kids will be reduced, but they may not need to financially support their parent in old. The kick up at retirement in the 1st percentile is evident. This is due to the GMAB paying off in some cases. Last saved: 2 September 28 12:46 PM P 21 of 4

22 GMAB and nominal GMWB with ratchets; Commencing at 5 35 percentile 99 percentile 95 3 percentile 75 Income Shortfall $ The shortfall chart above shows that the guarantees in retirement are insufficient to provide the full desired retirement income of $3,. This is because, at retirement, the individual will often have not grown sufficient wealth to purchase a GMWB to protect the full $3, required. And the increasing slope of the shortfalls show the impact of purchasing a nominal GMWB rather than one that protects for inflation over the drawdown period. Last saved: 2 September 28 12:46 PM P 22 of 4

23 GMAB and nominal GMWB with ratchets; Commencing at percentile 99 percentile 95 percentile 75 Income Topup $ This additional chart shows the top ups that the insurance company will need to make to meet the obligations of the insurance contracts. As expected, it has two bumps. The first is at retirement when the guarantees associated with the GMAB kick in. Then after 1 to 15 years in retirement when the GMWB guarantees start to be called upon. The other interesting feature of this chart is the windfall payments that can occur due to the fact that the GMWB, whilst nominal, is subject to annual ratchets. In some scenarios excellent returns immediately after retirement will ratchet the GMWB considerably. Should these scenarios then exhibit periods of poor investment returns underlying assets will fall to zero. At that time the heightened guarantees will kick in. The following charts show this strategy applied to individuals commencing at s 65 and 75. Last saved: 2 September 28 12:46 PM P 23 of 4

24 GMAB and nominal GMWB with ratchets; Commencing at Value of CPI annuity Risky strategy: percentile 99 Risky strategy: percentile 5 Risky strategy: percentile 1 Wealth $ Probability of running out of money 24% GMAB and nominal GMWB with ratchets; Commencing at percentile 99 percentile 95 3 percentile 75 Income Shortfall $ Last saved: 2 September 28 12:46 PM P 24 of 4

25 GMAB and nominal GMWB with ratchets; Commencing at percentile 99 percentile 95 percentile 75 Income Topup $ GMAB and nominal GMWB with ratchets; Commencing at Value of CPI annuity Risky strategy: percentile 99 Risky strategy: percentile 5 Risky strategy: percentile 1 Wealth $ Probability of running out of money 29% Last saved: 2 September 28 12:46 PM P 25 of 4