White Papers

CPI Plus 3.5% – A better approach for retirees

05/08/2013

Greg Cooper

Greg Cooper

CEO Schroders Australia / Global Head of Institutional

Simon Doyle

Simon Doyle

Head of Fixed Income & Multi-Asset

Background

The purpose of superannuation is ultimately to provide a degree of financial security in retirement and reduce pressure (or reliance) on the age pension. Financial security will come from a combination of an appropriate contribution rate, investment strategy, drawdown rate and insurance.

In prior papers we have addressed the issues of a traditional asset allocation framework from both an accumulation and decumulation perspective, particularly with reference to maximising the consistency of money weighted outcomes for individuals. Clearly, after a period of accumulation, the process of decumulation and the investment strategy adopted will have a large bearing on the duration of drawdowns, the size of those drawdowns and the consistency with which different member cohorts will achieve similar outcomes.

Consequently, the decumulation process, and in particular, the type of investment offerings available to those approaching and in retirement is a very important part of the overall superannuation process.

However, while the type of investment offerings to pre-retirees has been quite well defined by the superannuation industry (albeit, well defined does not mean correct, but that is another debate), partly as a function of the relatively small size of the post retirement market, the structure of the investment offering to retirees is still in its infancy.

In this paper we consider a more specific strategy that aims to maximise the duration and consistency of drawdowns, in a lower risk framework than that for those in the earlier stages of accumulation. Such a strategy is particularly relevant for those approaching retirement and in the drawdown phase.

Objectives in retirement

The principal objective of retirees is generally to maintain a particular standard of living for a given period of time. Merton offers the following general criteria for good retirement plan design for individuals:

  1. Offers robust, scalable, low cost investment strategies that maximise the chances of achieving the retirement income goal using all available assets.
  2. Manage the risks of not achieving that goal.
  3. Be effective for unengaged participants.
  4. Provides meaningful information and choices with easy implementation for those who do engage on their progress to achieving the retirement income goal.

Unfortunately, achieving the above goals is not simple for most individuals as there is a degree of uncertainty in retirement planning as a result of the two principal risks:

  1. Longevity risk – the risk of outliving their retirement benefit capital or suffering a substantial fall in living standards as a result of drawdowns being too large relative to the length of time in retirement.
  2. Investment risk – fluctuations in retirement income stream as a result of unexpected investment earnings (particularly on the downside) impacting the capital.

Generally, retirees attempt to control for these risks through the choice of investment strategy and the level of asset withdrawal. Alternative strategies are available for helping retirees to manage these risks as shown below.

Chart 1: Risks for retirees

 

Source: Schroders

While the above represents a simplified schematic of the risks, in reality even “nil” investment risk strategies can have significant risks. For example, they may be expressed in nominal rather than real terms, or depending on longevity, carry significant refinancing (or credit) risks.

In addition, the lower the degree of risk, the higher the likely cost to a retiree of a given solution, which will ultimately lead to a lower standard of living than might otherwise have been obtainable.

Finally, we would note that most people do not have the necessary level of financial expertise required to make complex investment decisions over long periods of time and varying degrees of uncertainty.

In this paper we are particularly focussed on how we can build better investment strategies to reduce risk. We define a “reduction in risk” as being able to achieve greater certainty of the outcome. This effectively means greater certainty on the duration of an income stream AND greater certainty on the inflation adjusted value of those income stream amounts.

We would argue that such an outcome is achievable using the “allocated pension” approach common with retirees today, provided the investment strategy selected is appropriate for the outcomes desired.

Why reducing investment risk is important

The nature of the savings and disavings process is such that money weighted outcomes (which is what individuals receive) can and do vary quite significantly from time weighted outcomes (which are typically reported as the long term return).

To highlight this issue, we show below the progression of a member balance for a given drawdown policy and average earning rate, but where the sequencing of the earning rate differs. Given that it is not just the post-retirement phase that matters we have conducted our analysis to also incorporate the final 5 years of the accumulation process. We have assumed a member in the final 5 years pre-retirement continues to make contributions of 12% of salary through that last five years and then sets a drawdown rate of 60% of their then final salary. The scenarios we consider are a constant earning rate of CPI+3.5% together with alternating periods of CPI+3.5% plus or minus 6.5%. The results are shown in Chart 2. Note “pos” means the first period is plus 6.5% and “neg” means the first period is minus 6.5%. We have chosen 1, 3 and 5 year periods for comparison.

Chart 2: The impact of volatility on investment outcomes

Source: Schroders. Starting balance at age 55 is 7 times salary (reasonable for a 12% accumulation rate throughout a full working career) and contributions to age 60 are at 12% of salary which is indexed with inflation + 1%. Inflation is 3%, earning rate is 6.5%. Drawdown amount from age 60 set at 60% of final salary and indexed with inflation.

Unsurprisingly, it shows that while the average earning rate across all scenarios is constant:

  1. The greater the “length” of the volatility period, the greater the dispersion in results;
  2. The first period being a “negative” volatility period has a greater impact on the duration of drawdowns that is possible than the first period being a positive volatility period.

The variance of +/-6.5% was chosen as it results in a portfolio with broadly equivalent real return and volatility in the traditional sense (not dissimilar to a traditional balanced fund). Clearly as this number is reduced, the differential between the outcomes will reduce and the opposite occurs as the volatility is increased. However, even a reduction in the volatility figure to 3.5% still results in a material difference between outcomes (e.g. 4 additional drawdown years for the 5 year scenarios).

In addition, Chart 3 shows the difference in the balance after 15 years (representing a reasonable period into the drawdown process) of drawdown from the base case (which assumes a constant earning rate with no volatility) how a varying level of volatility impacts the results.

Chart 3: The impact of volatility on investment outcomes

Source: Schroders, Starting balance at age 55 is 7 times salary (reasonable for a 12% accumulation rate) and contributions to age 60 are at 12% of salary which is indexed with inflation + 1%. Inflation is 3%, earning rate is 6.5%. Drawdown amount from age 60 set at 60% of final salary and indexed with inflation. Results above show difference in balance at age 75 between given scenario and base case of no volatility in earning rate. A result below -100% means that the drawdown strategy had resulted in a negative balance.

We can see from Chart 3 that not only are the differences in results potentially very large as we introduce greater periods of volatility and the greater the volatility the greater potential difference, but interestingly where the first period was a negative variance, the difference in results was somewhat greater than when the first period was a positive variance. Bearing in mind investors have little choice in the issue of whether first year returns will be positive or negative, this is an important finding.

Ultimately, there are two primary drivers in reducing investment risk to enable individuals to achieve better retirement outcomes across different time periods:

  1. The absolute level of real returns through time;
  2. Controlling the level of volatility of those return streams to minimise “sequencing risk”.

Do traditional investment approaches work?

It is our observation that the two most common investment approaches in the drawdown phase currently are traditional balanced strategies (sometimes combined with a minimum cash level) and/or more conservative balanced style strategies.

Given the comments and our analysis detailed above around path dependency, we have analysed whether historically either of these is the “best” option for retirees. Charts 4 and 5 show that based on real returns from a balanced strategy since 1922 more than 50% of the time a typical retirement drawdown strategy would have run out of money before the end of 20 years. However, in some cases the retiree is left with more money after 20 years than they started with (returns exceed drawdown). These periods typically relate to those who retired in the mid 1920’s, late 1970s and throughout the1980s (when subsequent returns were very good). In any case, 50% odds are not good enough when your retirement is at stake. Trustees could indeed question whether they would “sell” some of this upside for some cohorts to deliver better outcomes overall to all cohorts.

Charts 4 and 5: The history of drawdown scenarios

   

Source: Schroders, Datastream, Return series from 1922 to 2010, Balanced Fund proxy taken as 35% Aus equity, 30% global equity, 20% Aus bonds, 15% cash. Conservative Balanced Fund proxy taken as 12.5% Aus equity, 12.5% global equity, 45% Aus bonds, 30% cash. Indices - All ords, MSCI World ex Aus, S&P500, UBS Composite, Aust govt bond 10 year rates, RBA Cash rates, UBS Bank Bill index, ABS CPI.

Even for a conservative balanced strategy the odds are not significantly better. Based on a lower drawdown amount of 6% (which would extend the duration of drawdowns), more than 45% of the time the retiree ran out of funds within 20 years.

While this is not the place to explore in detail the reasons why outcomes have been so varied, it does serve to highlight what we consider to be ongoing issues with the current methodology behind portfolio construction. In particular we would make the points that:

  1. Valuations do matter in determining longer term returns (see Bogle (1991) , Campbell & Shiller (2001) etc)
  2. Risk is not annualised standard deviation of returns, the pretence of the Markowitz model and the underlying basis on which much academic work on portfolio construction has been written. See for example Veld (2006)

This highlights the need to be mindful of medium term volatility of returns as the impact on individual investment outcomes can be significant.

Consequently, it is very important to minimise downside volatility for the older demographic. While a simple model is to reduce the exposure of this demographic to risky assets, the episodic nature of equity market returns makes this problematic - with periods of high returns being followed by periods of low returns. If the period of high equity market returns is at the end of an individual’s career, this model of reducing their exposure to this asset class toward the end of their career has the potential to severely limit the individual’s ability to accumulate a lump sum for retirement. We addressed this in detail in a recent paper “Life Cycle Funds - Just Marketing Spin” .

Taking the view that some retirees may have already adopted a more conservative strategy, Chart 6 shows the duration of drawdowns historically under a conservative balanced approach. While quite clearly the volatility of outcomes is reduced (relative to a balanced strategy), they remain substantial with a historical range of 10 to nearly 35 years. Interestingly, the minimum outcome isn’t particularly different from the more aggressive balanced approach which has a minimum of 9 years drawdown.

Chart 6: How long will my drawdown last?

Source: Schroders, Global Financial Data. Assumes initial drawdown of 6% of capital at end of year and indexed thereafter with inflation. Investment return based on stylised conservative balanced fund with fixed strategic asset allocation of 12.5% global equity, 12.5% Australian equity, 45% Australian bonds and 30% cash. Drawdowns commence in year stated and go until 1 January 2012 or when balance reaches $0.

More generally the fact that asset class risks are not stable through time makes any approach to reducing risk that is premised on a fixed relationship between asset class exposures flawed. Rather, the emphasis should be on reducing the incidence of downside volatility not necessarily a particular pre-determined asset allocation that bears no relationship to forward looking returns. This is particularly the case today when we consider the collapse in bond yields over the last 30 years or so. Allocating significant assets to bonds may not turn out to be as “conservative” as hoped.

Chart 7: Long term bond yields

Source: Schroders, Global Financial Data

This would suggest that for plans dominated by an ageing demographic structure, downside risk management is very important. However, it could be argued that this should be the status quo no matter what the demographic breakdown of a plan. Given members of all demographics will generally be present, tilting the fixed asset allocation to suit the dominant demographic will raise intergenerational transfer issues.

Managing to a return objective and not to a fixed asset allocation will help to minimise the impact of the episodic nature of returns from equity markets and therefore the fixed asset allocation model. Importantly, this would reduce the impact the lucky year of birth has had on historical results.

What is the optimal approach?

The above ideas highlight some substantial shortcomings in the way portfolio construction has been approached for at least the last 3 decades, particularly for those approaching and in the drawdown phase. In our view, an alternative approach should be considered to overcome these constraints and deliver to investors the sorts of outcomes they genuinely require, and fit with the criteria described by Merton in the opening:

- Be robust through time and market conditions, scalable and low cost;
- Manage the risks of not achieving that goal by providing greater outcome certainty (in real terms);
- Be an effective solution for different cohorts (and so better in dealing with disengaged members);
- Be part of a broader range of possible solutions that is consistent and easy to explain.

Analysis of alternatives

In prior papers we have discussed the very long term outcomes of a typical investment approach . From the perspective of an investor requiring some form of drawdown over time, we would suggest that outcomes of between CPI +1[(-2) was not found] (being cash-like and in line with the RBA’s target) and CPI+5% (as a growth balanced strategy) are the likely lower and upper bounds of any long term investment strategy. Presenting alternatives to retirees that are framed in terms of real outcomes is also likely to be easier to explain and understand.

We have compared three alternative diversified investment strategies from the perspective of an individual entering the drawdown phase, being the balanced and conservative balanced strategies alongside a theoretical strategy that delivers CPI + 3.5% p.a. consistently. In particular we have examined the distribution of outcomes for the length of the drawdown period, where drawdowns commence anytime 1930 through to 1990 for the more conservative balanced strategy versus the CPI+3.5% portfolio in the Chart 8.

Chart 8: Comparison of drawdown periods for a conservative strategy

Source: Global Financial Data, Schroders. Assumes initial drawdown of 6% of lump sum and indexed with CPI thereafter. Drawdowns run until 1 January 2012 or when balance reaches $0.

Contrasting the above more conservative approaches with a typical balanced fund, Table 1 shows the comparison of drawdown outcomes.

Table 1: Comparison of drawdown outcomes (1926-1990)

Duration of drawdowns (yrs) Balanced Conservative CPI + 3.5%
10%’ile 16.6 14.0 23.0
Lower Quartile 20.0 16.0 25.0
Average 28.7 21.2 25.7
Upper Quartile 33.0 26.5 27.0
90%’ile 47.0 32.0 29.0
Average Return, 1926-2012 (%p.a.) 9.6% 8.0% 8.1%

There are three observations we would make from the above analysis:

  1. By reducing the volatility of returns relative to inflation, the outcomes from the CPI+3.5% option are significantly better on average than the conservative option and the volatility of outcomes is massively reduced as the sequencing risk is better managed. That is, it is more robust.
  2. The CPI+3.5 (theoretical) portfolio delivers nearly the same upside as the conservative portfolio and an average outcome close to the balanced portfolio, however the interquartile range (upper-lower quartile) is only 2 years on the CPI+3.5% portfolio vs 10.5 years for the conservative portfolio and 13 years for the balanced portfolio. That is, it provides significantly greater certainty.
  3. The incidence of severely negative outcomes in the drawdown phase is removed through reducing the sequencing risk. The minimum (10%’ile) of the CPI+3.5% portfolio is better than the lower quartile outcomes for the other portfolios and better than the average outcome for the conservative portfolio.

Of course, managing to a CPI+ outcome requires a different investment approach to the fixed asset allocation approach of a traditional balanced or conservative portfolio. In order to generate lower volatility inflation relative outcomes, particular attention has to be paid to valuation and likely risk-adjusted returns of the underlying assets in the construction of the portfolio.

Conclusion

After a period of accumulation, the process of decumulation and the investment strategy adopted will have a large bearing on the duration of drawdowns, the size of those drawdowns and the consistency with which different member cohorts will achieve similar outcomes. These outcomes can vary significantly even when the chosen investment strategy is relatively stable.

For investors looking for a greater degree of certainty in their drawdown outcomes it is important to control sequencing risk as well as achieving an absolute real return through time.

The decumulation process, and in particular the structure of the offerings available to those approaching and in retirement, is a very important part of the overall superannuation process. Investors who are planning on adopting a more conservative portfolio would do well to consider an objective based portfolio targeting 3.5% over inflation relative to a more traditional conservative balanced strategy.

In particular a CPI+3.5% solution (combined with other outcome orientated solutions at different targets) provides:

  1. A better series of strategic choices for retirees that is easier to understand and implement in their retirement planning process;
  2. Can be applied simply to disengaged as well as engaged members and reduce the incidence of poor aggregate outcomes.
  3. Increases significantly the certainty of outcomes and so provides a much better opportunity to plan and in particular decide on a more robust drawdown strategy.

Appendix

Bibliography of prior research pieces on Objective Based Investment Strategies (and related topics) from Schroder Investment Management Australia Limited referred to in this paper. Copies available from Schroders on request:

2007, 2008, 2009, “CPI+5 White Paper”;
January 2009, “It’s about risk, not return”;
April 2009, “What price complexity”;
August 2009, “Keeping it simple, back to the future for Asset Allocation”
February 2011, “Complexity Adding Value”
August 2011, “Post Retirement – Time to Focus on the Endgame”
September 2011, “Life Cycle Funds – Just Marketing Spin”
March 2012, “Why SAA is Flawed”
April 2012, “Asset Allocation - How flexible do we need to be?”
May 2012, “Understanding the Journey to Retirement”
October 2012, “Risk Parity – No Free Lunch”
November 2012, “Avoiding the valuation traps in Strategic Asset Allocation”
February 2013, “Searching for the Holy Grail in Asset Allocation”
May 2013, “It’s not all about Income”

Data sources used in this paper

Data sourced from Global Financial Data:
- Australia Consumer Price Index
- Australia Total Return Bills Index
- Australia 10-year Government Bond Return Index
- GFD World Return Index
- Australia S&P/ASX 200 Accumulation Index
- S&P 500 Total Return Index (w/GFD extension)

Disclaimer

Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice.

Important Information:
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.