Life-cycle investing demands tailored solutions
The future earning capacity of the workforce varies according to the profession and the individual. In the case of both collective DC schemes and individual life-cycle investment plans, this impacts the investment mix.
At the master class on life-cycle investing organized by Fondsnieuws, chief editor Cees van Lotringen placed the growing trend of personal pension accrual within a broad context. In his view, this is the result of global mega trends. In addition to the aging population, these include urbanization, the emergence of a middle class in emerging economies and technological developments. In Van Lotringen's opinion, they constitute a threat to the Dutch welfare state and pension system. "The government is already preparing for austerity. We will have to start putting more aside ourselves for our pensions."
In light of this necessity to fend for ourselves, how come life-cycle investing is not already much more popular? Life-cycle funds are an excellent way to deal with our increasing need to accrue an (extra) income for retirement. In addition, this is a manner of investing that can be adjusted to our life-cycle requirements (to pay off a mortgage, pay for our children's education or a long-cherished trip around the world), and is a good way to accrue assets within a set period without investors having to become unduly involved themselves. And the target group is broad, covering both DC scheme members and private individuals who wish to invest in the third pillar of pension supplementation. The speakers at the master class also share the view that this form of asset accrual is set to take off in earnest in the coming years.
Flexible and disciplined
Dirk van Ommeren, Investment Leader for DC solutions at BNP Paribas Investment Partners described the characteristic features of life-cycle investing. On the one hand, investors wish to make use of their relatively long investment horizon and benefit from the risk premium that equity investments in particular can offer. On the other hand, they want to reduce portfolio risk towards their fund's end date. The weight of the equities and other high-risk asset classes is reduced in stages in favor of less risky classes like government bonds and cash. At the beginning, the focus will therefore be on returns, and in time, a shift can be made towards greater security.
Flexibility is also a major feature of life-cycle investing, in addition to returns and security, according to Van Ommeren. The growth in assets can be subject to both positive and negative change, and investors may also wish to accrue a larger capital for personal reasons, or to bring forward the end date. This means that it has to be possible to adapt the size of deposits made in the fund according to new requirements or changes in market conditions. This requires flexibility, which life-cycle investing can offer.
Life-cycle investing also has the effect of instilling discipline; particularly where third-pillar pension supplementation is concerned. At the beginning of the last decade, reducing risk in stages for target-date fund investments had to be achieved by changing the portfolio's risk profile over time. However, this requires discipline on the part of investors themselves or their advisors. And this is where things can go wrong. Van Ommeren cites the example of a promised telephone call that never came from an advisor who assisted him when he was concluding his investment mortgage. Had he not taken action himself, he would still be investing in the same aggressive way now, despite the considerably shorter remaining lifespan.
Target-date funds 2.0
The target-date funds that were subsequently introduced perform this adjustment automatically. They were followed by 'guaranteed target-date funds' which provide final-capital assurance, but require higher deposits due to lower returns. In the case of collective schemes, these 'pre-packaged funds', as Van Ommeren calls them, with their 'one-size-fits-all' approach, disregard the differences in investors' risk perception and changing market conditions. An even more important constraint is that there is no optimal matching with the liabilities structure.
'The time has come for target-date funds 2.0 with an emphasis on tailored solutions'
For this reason, Van Ommeren thinks that the time has come for 'target funds 2.0' where the emphasis lies on tailored solutions. "In the case of DC investing, the funds have to focus much more on matching to ensure that an income is generated for the pension phase." Van Ommeren believes that what matters is not so much the investment risk over the lifespan, but rather the risk of inflation (the purchasing power of the accrued capital) and the interest-rate risk (the annuity that can be bought on the chosen retirement date). Modular investing - where the capital is allocated partly to a return portfolio and partly to a matching portfolio with the option of redistributing the allocation - offers the best options for taking this into account.
Financial capital versus earning capacity
Tom Steenkamp, CIO for Investment Solutions & Research at Robeco, takes a critical view of the sector: "The decisions surrounding the choice of investment mix often lack substantiation. Some providers of life-cycle solutions invest 100% in equities for young people; others start at 80%. While the precise percentages have a major impact on the end result, they are sometimes fixed by rule of thumb. We can improve the quality of these decisions by providing academic substantiation for the term 'future earning capacity' ".
Total assets are a combination of the future earning capacity (defined by Steenkamp as the present value of future savings) together with the pension reserve accrued thus far. The ratio of these two components in terms of the total assets changes over time, with the pension reserve (financial assets) generally increasing in size while the future savings portion declines. In Steenkamp's view, the optimal asset allocation (portfolio weighting of equities) is a constant percentage of the total assets. In practical terms, this means that if the volume of future savings is large relative to the current assets, more risk can be taken with the financial assets. In a later phase of life, when the financial assets have increased, but earning capacity has decreased, the level of risk should be reduced in the pension portfolio.
Like Van Ommeren, Steenkamp underlines the fact that the life-cycle path is not the same for everyone. Steenkamp asks the rhetorical question: "Should Wesley Sneijder invest for his pension in the same way as a university professor, assuming that they both have the same attitude to risk?" The football ace accrued a large amount of capital at a young age, but has an uncertain future in terms of his earning capacity. In the professor's case, the reverse is true. This means that Sneijder will have to invest a relatively large amount in a matching portfolio adjusted to interest-rate risk and inflation, and only a small amount in a return portfolio that is intended to ensure asset growth. The professor's job security allows him to invest more aggressively, which is convenient, as he has less accrued capital. So, in addition to a person's actual earning capacity, the assurance that this will remain intact is also very important.
'Future earning capacity affects current investment mix'
According to Steenkamp, this example illustrates that the approach to risk reduction through life-cycle investing differs for each profession. This difference can relate to the volume of accrued pension assets and job security as well as the link between salary growth and developments in the equity market. For most professions it is true that the shorter the investment horizon, the smaller the amount that should be invested in equities in order to reduce portfolio risk. However, this does not, for example, apply to market makers, whose salary depends heavily on what happens to the stock markets. As a result of the extreme uncertainty about their future earning capacity, they will not be able to invest in equities at the beginning of their career. Steenkamp: "A person's salary, salary growth, a scheme member's risk appetite, the volume of financial assets and the ratio of salary growth to return all have an impact on the optimal approach for the life-cycle portfolio. This differs from one person to another and should therefore theoretically be set individually."
Life-cycle investing is much more popular in the US than in Europe. Steenkamp: "The greater popularity of the DC culture in the US is also linked to legislation. It is one of the few forms of pension accrual in the US where employers cannot be made liable for any shortfall." In Europe, it is less likely that this type of 'stimulus' would be applied. However, Steenkamp believes that more favorable tax treatment could be positive. "At this point in time it is not possible to continue investing in a collective second-pillar DC scheme after the retirement date. A third-pillar scheme allows this, but this is an option that is not widely used. DB schemes allow continued investment. A change should be made here to create a level playing field for the benefit of DC scheme members."