Inflation Risk and the Private Investor: Saving is often not the best decision

Transcription

1 Inflation Risk and the Private Investor: Saving is often not the best decision February 2013

2 Inflation Risk and the Private Investor: Saving is often not the best decision Authors: Ronald A.M. Janssen, M.Sc., MFP, Head of Private Wealth Management Ortec Finance André van Vliet, Ph.D., Head of Insurance Risk Management Ortec Finance Introduction Current market developments are causing great anxiety among consumers. A persistent stream of negative news regarding the future of Europe, pension funds that are constantly (forced to) cut their benefit payments, the growing budget deficit and the now infamous fiscal cliff threatening the United States of America, as well as a host of other financial and economic problems, are a continual threat. Such global developments also translate to the personal situations and decisions taken by consumers with regard to saving for wealth accumulation. Increasingly, people prefer to take lesser risks with their private equity for example by shifting to investment categories that appear secure. As a result, money is more often than not placed into a savings account. The client increasingly asks his or her bank about saving and vice versa, their advisor s recommendations generally sound the same. But is a saving account sound advice? And is it the right choice? Whether the advice is sound or not depends on the specific situation of the client and his or her individual long-term objectives. Clients with assets that must accumulate in order to realise their personal goals want to know how much they must invest and at what risk in order to achieve the desired objectives. The risk a consumer is not only willing but also able to take form crucial questions in this process. To answer these questions it is important to have insight into both the short-term and long-term risks. In practice, for the short term this can be translated to the fluctuation of a saving or investment solution and for the long term to the downward risk of the capital or income, or the probability that the goal will not be realised. Interestingly there is an important parallel with the issues pension funds are struggling with. In this article we primarily question whether saving is the best strategy to realise goals. Special attention is given to how you arrive at a sound analysis and what information should be considered in support of the investment decision. Clear goals Client centric is currently the slogan-of-choice for almost every (financial) service provider. But what does this really mean? Recently ample attention has been given to this topic. Take for example the publication from the Dutch Authority for Financial Markets (AFM) Leidraad Klant in Beeld (Guidelines for placing the client in the picture). This guideline once again pays attention, similar to the prior publication Leidraad Vermogensopbouw (Guidelines for Wealth Accumulation), to the client s goals. These guidelines are applicable to pension funds too as supervision transitions from control by the Dutch Central Bank (DNB) into controlling behavior by the AFM. There is a growing need to take inventory, prioritise and concretise the goals. This concretisation process is appealing because the advisor wants to and is required to demonstrate his (or her) added value, otherwise charging for their services will neither be understood nor accepted. The translation of risk to cash flows and wealth risk is an important theme for future advisory services (B. Smit, VA 2012). The client objective should be absolutely clear so that one can subsequently assess whether the product offered suits the specific client or not. In the European MiFID regulation and legislation in which Know Your Customer is such an important concept, this is often labeled suitability. 2

3 Important savings objectives of a private client could be: - College education for children - Additional pension income - Early (partial) retirement - Mortgage amortisation etc. With almost all long-term objectives, with the exception of mortgage amortisation, inflation plays an important role. The advisor often struggles with the manner in which he or she must deal with inflation. Should we communicate in nominal or real terms? In practice, it turns out that consumers almost always think in today s euros, in other words, in real terms. It is, after all, hard to imagine what a hamburger will cost in ten years time. It is therefore important to think of the objective in real terms. If the goal is familiar, the logical question that follows is how do you create a solid plan to reach this goal?. What strategy should be selected regarding the level of deposits and the level of saving or investment risk that is taken? This latter aspect is an important subject in discussions with the client. But what does risk mean in terms of the client s experience? What is risk? A lot has been said and communicated about risk, but nevertheless it still frequently turns out that the term risk has a completely different meaning for the various parties involved. If we really want to place the client at the centre of the advisory process then we also have to communicate in such a way that the client understands what is going on. It is therefore important to know what a client considers risk to be: 1) The downward risk of the wealth or income over a certain period, or what income can I truly count on? 2) The probability of failing to reach the desired pension? 3) The fluctuation (standard deviation) of the investment? It turns out that consumers find information about the first two expressions of risk much more important than the last one. Yet in practice risk is still very often translated to the standard deviation or the one-year risk of the investment. The standard deviation mainly gives insight into the short-term risk, whereas the downward risk over a certain period and the probability of failing to reach the pension objective, mainly gives insight into the long-term risks. It must be noted here that with long-term objectives inflation plays an important role. The longer the horizon the higher the inflation risk. The impact of inflation can be significant. If for example a bag full of groceries costs 100 Euro today then it will cost 135 euro in 15 years if you calculate with a modest inflation of 2%. Inflation therefore has a large impact on the ultimate investment decision. Case Study Almost every consumer under 65 years is nowadays dealing with a pension shortfall either due to multiple jobs changes or because the pension scheme is rendering an insufficient pension. The definition of a pension shortfall is that the desired (net) pension income is higher than the available or expected pension income (first pillar and second pillar, thus including general old-age insurance (AOW)). The gap must be closed. In the case study below the long-term objective is therefore building up an additional pension. 3

4 Initial criteria for the case: Age Mr. Fisher 42 Available capital Expected return savings account 3.2% Monthly premium 500 Expected inflation 2% Extra savings (room) 150 / month Interest rate on pension date 3% Pension date 67 year The goal of Mr. Fisher in this case is to have additional pension benefits for a period of 15 years (starting from the pension date) of approximately annually. He will then have sufficient income to retire comfortably. Wealth is accrued over a period of 25 years and on the pension date this wealth must be converted into annual pension payments based on the interest rate at that moment. In the table below a number of saving and investment alternatives are displayed through which Mr. Fisher can accrue extra capital. With respect to bonds we have accounted for an expected starting return of 2.1% that will rise to 4.2% in the long term. The returns in the table below are not calculated but measured, because the latter corresponds with the effective annual return that can be realised over the long term. The difference in return between the various investment profiles is greater for the calculated return but will be smaller for the measured return due to the damping effect of the volatility and diversification. Risk profile Saving Bonds Equity Geometric return after costs Standard deviation Savings account 100% 0% 0% 3,2% 1,5% Defensive investment 0% 75% 25% 5,2% 7,7% Neutral investment 0% 50% 50% 5,8% 12,8% Offensive investment 0% 25% 75% 6,0% 18,4% Table 1: Investment profiles (returns are determined taking correlations into account) Financial plan based on expected return and expected inflation In the case study, three risk factors play a role, namely the investment risk, the interest rate risk (the interest rate level impacts the pension benefits that are purchased on the pension date) and the inflation risk. In drawing up a financial plan one usually starts with an expected return and an expected inflation percentage. First, the return needed to achieve a certain goal is calculated. Then one must determine which risk profile is best suited to achieving this return. However clients often fail to understand that taking the expected return as a starting point will only give a 50% probability that the intended goal will be achieved! This sobering statistic however is often unbeknown to many clients. When we do not take into account the risks that are taken, Mr. Fisher s savings account will accrue an additional pension of annually for a period of 15 years. Here we assess a 3.2% return on the savings account in the accrual period (long-tem expectation) which will amount to total assets of on the pension date. If however we take expected inflation into account, which in our opinion is vital, then Mr. Fisher must accrue in order to receive real additional pension benefits of annually. To arrive at this amount, a return of at least 5.9% per year is required. In executing the financial plan the difference between taking the (expected) inflation into account or choosing not to, is enormous. It basically comes down to the difference between saving through the assumed safe savings account or investing with a very offensive risk profile. Mr. Fisher has indicated 4

5 that he has the ability to save an additional 150 per month. This information can possibly be included in the analysis as well. In the above-mentioned exercise, we have not yet accounted for the investment risk, the inflation risk and the interest rate risk and therefore lack insight in the downward risk. Including downward risk A sound financial plan should take into account both risk and return. And we are not referring to the 1-year risk that is measured by the standard deviation, but to the multi-year risk that the client s goal will be achieved. The way to show risk and return simultaneously is by means of scenario analysis. In such an analysis the financial plan will be put through a large number of economic scenarios and the uncertainty of the investment return, interest rate and inflation, will be included in the correct relationship. For the investment selection, not only is the expected inflation important but also the uncertainty of future inflation levels. If you have a realistic goal on a long term horizon then it is better to invest in real assets and not just in nominal bonds for example. Boudoukh en Richardson (1993) show that over the period the historic correlation between stock/equity returns and inflation was negative at an investment horizon under a year, insignificant for an investment horizon of 1 year, and significantly positive for an investment horizon longer than five years. Adding shares for part of the portfolio will result in a positive contribution to the risk-return ratio, especially in relation to a real goal. The longer the horizon is, the more important a role this will play. In addition, the interest rate risk on the pension date is also an important factor. At an interest rate of 8% you can receive much higher pension payments than at an interest rate level of 2%. And the correlation with investments and inflation play an important role here as well. When inflation is high, the probability of a high interest rate is also greater. Back to Mr. Fisher s case. In the table below the results are presented for four alternatives. The expected (real) pension income that Mr. Fisher could receive is taken as a measure for the return. Both the inflation rate and the interest rate at which pension rights can be purchased are taken into account. As a measure of the risk, we look at the pension income that Mr. Fisher can achieve with 95% certainty. If we want to put greater emphasis on the risk dimension, we could increase this certainty to 97.5% or 99%. Table 2: return and risk of four alternatives for pension accrual Table 2 shows that the savings account is not the safest way to realise additional pension. While the standard deviation of the 1-year return is the lowest for the savings solution (see Table 1), in terms of the desired pension income, the choice for the savings account is for a lower expected pension income as well as a lower almost certain pension income. 5

6 Now the question is how to determine the desired risk profile. By the 1-year risk of the allocation at the start, or by insight into return and risk on the pension date? In our opinion, insight into return and risk on the pension date is much more relevant than the current volatility when dealing with a pension objective. Many questionnaires and profile assessments have not been adjusted for this insight. What is stated here gives a realistic picture of Mr. Fisher s income risk. Now we must focus on how Mr. Fisher comes to the right decision. What is the ambition level, with what monetary inlay, and at what risk? Strategy and communication Ideally, consumers do not want to run any risk while their advisors want to offer sound advice and manage the expectations of their clients correctly. The problem is that people make certain decisions, yet fail to fully grasp which goal or objective they want to (and can) realise. When they, for example, save for unforeseen expenses in the short term, then the savings account is a good solution; but for solid pension payments in the long term there are clearly better alternatives. Research has shown that consumers will start saving more or investing when they recognise that the probability that they will reach their objective is small. Choices therefore depend to a large degree on the information provided and the various options offered. Consumers want to know how high their monthly pension payments will be, whether that is sufficient, and what they can do to secure the desired level. The question is what information is needed to correctly assess financial advice and make the right decision. Too much information has its disadvantages as well. It is important to keep in mind how people think. Inflation for example, is a difficult subject because we know that consumers almost always calculate in today s Euros. Let us therefore at least communicate in today s Euros as well. An alternative and more coherent approach is to show both nominal and real values, making clear what the difference between the two is. In the graph below the results are shown for Mr. Fisher s case given various investment profiles. We assume that the capital at this moment is in the savings account and the risk attitude equates to a neutral profile. The objective is a desired real pension income of from the age 67 onward. Besides the risk profile that best matches the risk attitude, both a more defensive and a more offensive profile are shown. 6

7 Figure 1: comparison of various investment profiles in relation to the desired pension income The pension forecasts based on the savings account and taking into consideration inflation are not rosy. If Mr. Fisher accepts more loss in a year (for example with a defensive profile), he can improve the forecasts and also limit the downward risk. The ultimate choice therefore evolves around a risk and return consideration. The defensive profile has the lowest downward risk on the pension date. The consumer can choose a higher risk profile when he or she strives for higher return and thereby accepts the extra risk coming with the volatility of the return. An alternative is to simply save more. In the example below we assume an additional monthly deposit of 150 by Mr. Fisher. 7

8 Figure 2: case with additional 150 deposit per month In figure 2 the forecasts are quite good for the three investment profiles. The savings account is the most risky with respect to the probability of reaching the goal. There is a high degree of certainty that the savings account will not deliver sufficient pension income. By choosing a defensive or neutral investment profile both the expected pension income and the almost certain pension income can be improved. The ultimate choice will depend on the risk attitude and ability or willingness to save extra. But it is clear that the savings account in this scenario is not the optimal choice! Communicating the monitoring to customers can be further simplified using for example only a traffic light or a weather report image. When the client wants to know more, a more detailed report can be given. Before making a decision it is important to take into account the relationship between risk and return, in order to come to a deliberate selection. 8

9 Conclusion Many people choose a savings account or saving via income tax box 3 in order to provide capital entirely or partly for their pension. Most people nowadays choose for the safest option of a savings account. Depending on the ambition level or desired accrual, the savings account is seldom the best choice. A savings account does offer the lowest volatility in the short term (in terms of standard deviation), but the multi-year risk in terms of pension income or additional payments that can ultimately be generated, is often greater than alternatives in which wealth accrual takes place via investments. For real pension goals in the long term it is better to (partly) invest in risk-bearing securities that are related to the real economy. This balancing between risk in the short term and risk in the long term is for a private citizen comparable to the balancing challenges that many pension funds currently face. When calculations are only done based on expected return and expected inflation, it is difficult to make a good decision. We quickly see how the required return is directly translated to an investment profile, without addressing the risk that accompanies it. To gain simultaneous insight into risk and return, the same scenario analysis techniques used by institutional asset managers can be applied. Then it is possible to make a deliberate choice based on the expected pension income and the probability that one or multiple goals will be achieved. It is crucial that the client has a realistic picture of return and risk. Scenario analysis results can contribute to a simple and clear communication about risk and return, allowing for sound management of the client s expectations. References Boudoukh, J. & M. Richardson (1993), Stock Returns and Inflation: A Long-Horizon Perspective, The American Economic Review, 83 (5), B. Smit (2012), Beleggingsadvisering: huidige risico denken en kostenstructuren zijn een barrière voor centraal stellen van het belang van de klant. 9

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