Reduce your clients' retirement shortfall

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Stephen Nash from FIIG fixed income specialists says now is the time for advisers to act fast and rebalance their clients' portfolios:

While recent European data is crumbling as you read this, and China is fast slowing, we all hope that the US will carry the global economy. Such a hope is sustained by quantitative easing (QE) in most developed markets but, a warning; QE has created “bubbles” in all markets. While QE is forcing rates lower, it is forcing market participants into any equity that vaguely resembles a bond (via “known” dividend yields), to the degree that equity markets can now be seen to be very much in “bubble” territory.

Sure, QE has elevated bond prices and depressed yields, yet the influence on equities is bigger, stronger, and potentially much more dangerous for investors. Hence, the question for investors is not whether there is a “bubble” in bonds, but which “bubble” provides the best risk and return trade-off, and what is world “best practice” with regard to portfolio design.

 A better portfolio design relative to global best practice, typically means, in the case of Australia, more bonds and less equities, since Australians are typically overweight in equities relative to other developed markets, and underweight in bonds.

In this heady environment it is important to stand away from the euphoria and look at what investors are trying to achieve with superannuation savings. Here, we argue that the basic problem for investors is to ensure that inflation does not intervene, between the point of saving while working, on the one hand and spending in retirement, on the other hand.

We argue that inflation linked bonds trump other assets and come up as the best product to protect against inflation.

Best measure of purchasing power

Saving is the procedure of deferring spending, and the value of that deferment is best gauged by the CPI. If you think about your clients’ retirement in terms of an inflation linked liability, then the value of ILBs, as an asset, become manifest.

Global pension fund managers take the idea of a pension cash-flow as an inflation-linked liability very seriously, where the procedure is called “liability driven investing”, or “LDI”. Here, the asset, or the pension asset cash-flow, is selected relative to the underlying liability, or series of expenditures, which typically remain linked to the CPI. Several steps are involved in implementing the “LDI” strategy.

  1. Estimate liabilities: For an individual to follow the LDI strategy, the individual needs to estimate the spending required each year of their forthcoming retirement period, after assumptions regarding social security payments. This stream of spending, or expenditure, can be thought of as a stream of liabilities, which typically rises with inflation.
  2. Select assets to match liabilities: Given that the liability stream is now known, assets should be purchased to match that stream of inflation linked liabilities. This would typically mean purchasing a series of ILBs, and shorter dated bonds.
  3. Invest balance of funds in “growth”: If there is a surplus, then these funds should be carefully invested in so-called “growth” assets, like equities, commodities, gold, and housing.

This is not a procedure “dreamed up” by FIIG, but is a very important part of institutional investing worldwide and should not be ignored, as it makes a lot of sense. If major corporations need to report funding shortfalls, where liabilities are greater than assets, on the balance sheet, then one wonders why more Australians do not think about the strategy of their investments in a similar way; the need to report shortfalls brings problems out of the dark and help focus attention on the important issues.

Instead of buying growth assets and simply hoping that everything goes well, as seems to be the complacent attitude of most Australian super funds, this approach is much more measured and conservative. Specifically, before buying anything, you need to know the liability stream, and that can be estimated from monthly expenditure levels; it is not that hard to define.

Yes, there is room for “growth”, yet the room is measurable, and the risks are known; risk of underfunding your own retirement quickly becomes apparent.

Given the recent equity market outperformance, now would be a good time to rebalance your clients’ portfolio using the LDI approach. ILBs are the key to implementation of LDI in portfolios, since they provide the inflation insurance that can, if left uninsured, increase your clients’ retirement shortfall, where their liabilities outweigh their assets.