By Vincent Milhau, Research Director, EDHEC-Risk Institute
Individuals need flexicurity in retirement solutions
Uncertain perspectives for the first two pillars of pension systems
It is now commonly acknowledged that financing retirement is a concern for many individuals, as evidenced by numerous press articles describing the economic difficulties faced by pension systems, as well as calls from political decision-makers to undertake necessary but painful reforms to keep them sustainable. Those who have tried to estimate their replacement income – the income that they will receive from all sources after they retire – may have realised how difficult it is to get a precise number, given the uncertainty over the future rules governing public and private pension arrangements as well as the benefits that these plans will deliver. Uncertainty is magnified for young individuals, who have longer horizons. Older individuals in the transition from work life to retirement may come up with a more accurate forecast, but this exercise more often than not reveals that they will not be able to maintain their lifestyle after retirement, with retirement income levels typically much lower than their pre-retirement wage levels.
Unfunded pay-as-you-go systems, such as Social Security systems in the United States and France, are under strong pressure because of demographic imbalances and the roll-over of persistent public deficits. Public and private occupational pension plans can be relied upon as additional sources of replacement income in retirement, but they increasingly tend to be defined-contribution, as opposed to defined-benefit, arrangements. As a result, participants are left with little certainty about their future benefits. Overall, and in view of increasing longevity and the current underfunded status of many pension plans, the most likely scenario is a decrease in the benefits provided by the first and second pillars of the retirement system. In this context, it becomes critically important for individuals to call on the third pillar, and to make voluntary savings to supplement their public and occupational retirement income.
A household finance problem with unsatisfactory solutions
This situation raises two fundamental questions: how much should one save for retirement, and how should one invest such savings? These are by no means easy questions, particularly for individuals who are not familiar with basic investment concepts. To bypass the difficult question of how to invest, it is tempting to rely on pre-packaged investment products promoted by professional asset managers. Popular retirement products include simple balanced funds, which maintain a constant mix between asset classes, and also target date funds, which gradually shift from equities towards bonds and cash. Providing individuals with a one-stop access to diversified funds applying systematic rule-based allocation strategies is certainly better than leaving them follow their sentiment or market trends, and surrender to their behavioural biases. These products, however, suffer from a number of severe limitations. In particular, they neither secure, nor explicitly intend to secure, any minimum level of replacement income, and their investment strategy, which is based solely on an investor’s risk aversion and/or age, completely ignores changes in market conditions.
An extreme approach to the investment decision problem is to rule out any risk taking and to go for safe assets only. That said, while conventional wisdom holds that cash and sovereign bonds are the perfect examples of safe assets, it turns out that they are not safe in the retirement context. Indeed, a random portfolio of fixed-income or money market instruments will not deliver a stable stream of income starting at an individual’s retirement age and for his/her lifetime. Basic asset pricing theory allows us to calculate the price to pay in exchange for one dollar of replacement income every year for a set period of time (say 20 years) in retirement. This is calculated as a function of the investor’s retirement date and the current level of interest rates. Like a regular bond price, this price moves on a day-to-day basis due to the passage of time (as retirement date approaches) and because interest rates fluctuate. Neither cash nor a standard bond index tracks this price accurately, so an investor who chooses these vehicles would have no guarantee of having stable income in retirement and could experience a loss in the purchasing power of his/her savings in terms of replacement income.
Products that deliver a fixed level of replacement income do exist, namely in the form of annuities. However, such products are in low demand because of their lack of transparency and flexibility. For instance, an annuity purchase is usually irreversible, meaning that the annuitant cannot recover the annuitised capital if he/she must go through an event that generates large expenses (e.g. a serious health problem) or simply if he/she wants to take advantage of other investment opportunities during the accumulation phase. Security is also a double-edged sword. The level of income is fixed at the purchase date, so it cannot decrease, but nor will it increase, even if financial markets perform well or if the price of one dollar of replacement income decreases. In short, annuities offer the security that target date funds and fixed-income instruments lack, but they lack flexibility and have no upside potential.
The EDHEC-Princeton Goal-Based Investing Index Series
At EDHEC-Risk Institute, we believe that individuals should not have to choose between security and flexibility. Improved forms of target date funds, which rely on goal-based investment principles applied to the retirement problem, can be promoted by the asset management industry to help individuals and households secure minimum levels of replacement income while generating upside exposure in the context of liquid and reversible investment products. It is also our conviction that several recent and ongoing innovations make it possible to apply goal-based investing principles to a much broader population of investors than the few traditional clients who can afford customised mandates or private banking services. These innovations are the mass production of cost-efficient indices, the mass customisation of strategies and the mass distribution of investment advice and vehicles through digital tools like robo-advisors. Progress in financial engineering and digital technologies should be combined with a sound investment philosophy committed to the achievement of client goals. In a nutshell, this context creates an opportunity to provide genuine investment solutions, as opposed to off-the-shelf products, to individuals preparing for retirement.
As part of its focus on welfare-improving forms of investment solutions, EDHEC-Risk Institute conducted rigorous research on the foundations and the implementation of goal-based investing strategies in a research chair sponsored by Merrill Lynch over the course of 2014-15. Mass customisation issues were also studied in a 2017 piece of research focused on the retirement investment problem. A whole new step towards facilitating the implementation of these concepts was recently taken with the launch of the EDHEC-Princeton Goal-Based Investing Index Series in May 2018, in partnership with the ORFE Department of Princeton University. These indices provide a living illustration of the concepts introduced in previous articles and publications, and they have a dedicated page on EDHEC-Risk Institute new website, where their performance and composition are published.
There are in fact two families of EDHEC-Princeton Goal-Based Investing Indices. The Goal Price Index series represents the price of one dollar of replacement income for various retirement dates. As some investors may be interested in withdrawing their capital at retirement, as opposed to receiving a stream of income, a specific version of the Goal Price Indices represents the price of one dollar of capital at retirement. These indices help investors answer the question: what is the purchasing power of my savings in terms of retirement income or wealth? This is a good first step towards establishing whether or not they are on track to achieve their objectives. The second family consists of the actual Goal-Based Investing Index series, which represents the performance of goal-based investing strategies designed to increase the purchasing power of invested contributions while securing a minimum level of retirement income or wealth. To achieve their dual objective, these strategies make use of a mixture of a performance-seeking portfolio and a retirement goal-hedging portfolio, which is a replicating portfolio for what has been labelled a “retirement bond”, which delivers a fixed level of income or wealth. Retirement bonds could be issued by sovereign states as an additional instrument to finance their deficit, as explained in a press article published in the French daily paper Le Monde. The investment policy is based on transparent rules, and combines features of the proven technique of dynamic portfolio insurance and of the popular target date funds, so that these strategies can be regarded as “risk-controlled target date funds”. The foundation paper of the indices describes the strategies and their building blocks in detail and shows how effectively this revisited form of target date funds achieves its goals compared to traditional target date funds.
The launch of the EDHEC-Princeton Goal-Based Investing Index series is a joint initiative between a research centre internationally recognised for the quality and the relevance of its work on risk and asset management and one of the most respected academic institutions in the world. Through their combined expertise, the partners hope that they can foster interest in the investment industry for the launch of new forms of retirement investment solutions, which will eventually contribute to making finance useful again for all, and particularly for individual investors.
Related publications, from the least to the most technical:
A web article in the FT Adviser on the need for improved retirement investment solutions
An executive summary of the properties of EDHEC-Princeton Goal-Based Investing Index series
The detailed foundation paper of the EDHEC-Princeton Goal-Based Investing Index series
The construction rules of the EDHEC-Princeton Goal Price Index series and the EDHEC-Princeton Goal-Based Investing Index series.
Visit also our webpage dedicated to “Investment Solutions in Institutional and Individual Money Management” to read more publications on goal-based investing.
 See also the Princeton ORFE website at https://orfe.princeton.edu/research/financial-mathematics.