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Goals-based
Investing
collective
insightinsight into SA INVESTING from leading professionals
ci
January 2015
Collective Investments Jan 2015 - Goals Based Investing
26 Start saving with the end in mind
29 The end of the world as we know it
32 Aligning assets with their owners
34 Why do we all fall down?
37 How smart is your investment strategy?

40 This time it’s personal
COLLECTIVE INSIGHT 29 JANUARY 2015 25
COLLECTIVE INSIGHT
T
he investment industry continues to be
challenged on how it defines performance,
how it delivers value and how it measures
success. Combine this with an increased regulatory
oversight that focuses on what is actually being
achieved on behalf of the clients and it’s clear that
the industry needs to have a major rethink of its value
proposition.
Certainly one way to enhance that value
proposition is for the industry to evolve to a point
where it begins to frame performance in terms
of the investor’s objectives, so-called “personal
performance”. There are several barriers to delivering
more personal performance, not least of which is an
institutionalised reliance on outdated constructs.
The current system has been built around a concept
of performance that is defined relative to market
indices, consulting quadrants, performance surveys,
rock-star stock pickers and revered research analysts.
The investor doesn’t usually figure into the equation
– and this needs to change.
Andrew Bradley of Old Mutual Wealth
comments: “When money is managed in the
traditional way the manager is either focused on
beating a theoretical benchmark, beating their peers
or managing the portfolio within some notional risk
appetite. None of these particularly resonate with the
investor’s individual lifestyle and investment goals.
This is the key difference between the conventional
Editorial Introduction
Nerina Visser
ETF strategist
and adviser
Contents
Please send any feedback and suggestions to cabota@aforbes.co.za.
Finweek publishes Collective Insight quarterly on behalf of the South African investment community. The views expressed herein do
not necessarily reflect those of the publisher. All rights reserved. No part of this publication may be reproduced or transmitted in any
form without prior permission of the publisher.
approach to managing money and a goals-based
approach. A goals-based approach provides no
guarantee of better performance, but it does
significantly increase the probability of alignment
between the investor’s objectives and their portfolio
construction and ultimate performance.”
Robert C. Merton is one of the authorities
on this new approach to investing – and also a
Nobel laureate. We are priviliged in this edition
to have him as a co-author on one of the articles,
alongside Shaun Levitan, entitled Why do we all
fall down?. They explain why it is so critical to
apply this approach in the context of retirement,
or otherwise risk getting your investment strategy
entirely wrong. By understanding that not meeting
your goal for retirement is the real problem, the
whole focus of risk management changes.
Merton’s is the fourth article in this Collective
Insight. Before that, for those who are new to the
topic, we have introductions to the concept from
Ronald N. King and Abigail Munsami. Then
Deslin Naidoo and Ainsley To provide us with
overviews of some key concepts in the industry
which need to change to accommodate goals-
based investing. Later in the edition, we have
an article from Petri Greeff with a powerful
analogy of how company strategy echoes goals-
based investing, as well as a history of goals-based
investing – which is older than you think – from
Anne Cabot-Alletzhauser, which concludes with
what it will take for the approach to become widely
adopted in the industry.
In future, success – in terms of returns – will
be defined differently. Truly sustainable returns
– those that meet investors’ individual goals –
must start with a deep understanding of the value
components that are meaningful to the investor.
But in order for the investor to fully appreciate
– and be willing to pay for – those returns, the
value components delivered and the fees charged
must be transparent.
Over time, this new model for success will
help to improve the alignment of interests across
all industry participants, provide incentives for
streamlining delivery models and reduce barriers
to healthy decision-making. We trust that this
edition will assist in that process. Enjoy! ■
Convenor
Anne Cabot-
Alletzhauser
Head of Alexander
Forbes Research
Institute
Editorial
Advisory
Committee
Vanessa Bell
Director,
Jonathan Mort Inc
Delphine Govender
Chief Investment
Officer, Perpetua
Investment Managers
Petri Greeff
Head of Strategy and
Research, Riscura
Patrice Rassou
Head of Equities,
Sanlam Investment
Management
Heidi Raubenheimer
Independent Research
Consultant
Sangeeth Sewnath
Deputy Managing
Director, Investec
Asset Management
Di Turpin
Independent Consultant
Nerina Visser
ETF Strategist
and Adviser
Muitheri Wahome
Head of Investment
Products, Investment
Solutions
Start saving with the end in mind
COLLECTIVE INSIGHT
26 COLLECTIVE INSIGHT 29 JANUARY 2015
W
hen I grew up my
parents had a drawer
full of brown envelopes
w it h w ord s l i k e
‘clothing’, ‘food’ and ‘savings’ scratched
across the front. Every payday they’d tuck
cash into those brown envelopes to cover
the family’s monthly expenses. They
would start with the most critical and
move down to the ‘nice-to-haves’. This
was their system for managing money:
not very sophisticated, but they always
knew where they stood financially.
Ironically, the new
programmes use the
same kind of logic:
they manage money, in
part, by dividing it into
a variety of spending
and saving categories.
The ‘envelope system’ was common in
the era before computer-based money
management programmes. Ironically,
the new programmes use the same kind
of logic: they manage money, in part, by
dividing it into a variety of spending and
saving categories.
These practices persist because they’re
consistent with the way most people
think about their money. People tend
to regard their wealth not as a lump
sum, but as distinct amounts needed
to meet individual goals in life. This
has led to the emergence of the ‘goals-
based investing’ concept. This approach
to wealth management emphasises
investing with the objective of attaining
specific life goals rather than focusing on
generating the highest possible portfolio
return or beating the market.
The practice of goals-based investing
is generally still in its infancy among
advisers, but there are some advisers who
are embracing this approach and leaving
traditional approaches behind. The
traditional school of thought generally
focuses on outperforming the market
while staying within the investor’s
threshold for risk.
Goals-based investing applies a
specific investment strategy, tailored to
a client’s specific goals, to the individual’s
asset pool. This encourages investors to
talk about the goals they’ve identified
to date and also challenges them to
think bigger and dig deeper. Once all of
their dreams are on the table, they can
prioritise and set timelines – a process
that drives the individual to think
even more carefully about the relative
importance and urgency of each goal.
The idea behind goals-based
investing is that investors should set
specific, personal goals that they want to
achieve and should then structure their
investment plans around those goals.
With goals-based investing, instead
of worrying about hitting conceptual
benchmarks, investors can set goals that
resonate with and make sense to them.
The power of a goals-based approach
lies in its ability to highlight how realistic
a goal is relative to your risk preferences
and the investment opportunities
available. It also underscores the
importance of separating needs and
wants.
Most investors are willing to assume
a higher level of risk to gain additional
potential return with money set aside
for a vacation home (a ‘want’) than
Ronald King
HEAD OF TECHNICAL
SUPPORT, PSG WEALTH
King has a B.Com LLB LLM Adv
PDFP and an MPhil in Future
Studies. He is the author of a
number of books.
Abigail Munsami
JUNIOR LEGAL ADVISER,
PSG WEALTH
Her previous experience includes
a significant number of years at
the Constitutional Court.
She holds an LLB degree
Collective Investments Jan 2015 - Goals Based Investing
COLLECTIVE INSIGHT
28 COLLECTIVE INSIGHT 29 JANUARY 2015
with money they’ve set aside for college
tuition for a child (a ‘need’). After all, if
the additional risk taken with the money
set aside for the vacation house results in
losses, the investor could always forgo
the second home or downsize their plans.
However, they might not be so quick
to let go of plans to fund their child’s
college tuition.
As advisers and investors shift focus
to goal-oriented investment approaches,
a new perspective on risk and portfolio
construction is emerging. Advisers are
questioning conventional thinking on
asset allocation and beginning to pursue
new portfolio strategies that can better
help their clients pursue the returns
needed to achieve critical financial goals,
while also seeking to protect current assets
from a loss. This asset/liability-matching
process ensures that investments are
chosen to be more in line with a specific
goal and investment time frame than with
a specific risk profile. It doesn’t require
new investment products, just a new
approach to how existing investments are
structured to achieve this new goal.
With both investors and their advisers
willing to make the move to goals-based
investing, one could assume that the
transition would be relatively easy. But the
hard truth is that going from agreement
in theory to acceptance in practice will
take a concerted effort from both parties.
Advisers worldwide are aware of the need
to enhance their knowledge and skills to
better meet the changing needs of clients.
Topping the list of subjects that advisers
are looking to deepen their knowledge
of, are investment strategies that are
more explicitly target-enhanced, income
generation and capital protection.
Goals-based investing is gaining
increased traction, as it makes the
principles of investing more tangible and
relatable. It also once again underscores
the value of appropriate financial advice,
as financial advisers will have to know
their clients well and interact with them
regularly for goals-based investing to work
properly. ■
As exercise is to a fitness plan, healthy contributions are usually the
most difficult part of getting retirement-fit; it means having less of
your salary in your pocket because you are saving more. As with a
6am gym session, increasing or maintaining a high level of contributions is a lot easier when
you have fewer commitments – no children to get to school, no 7am meeting with the CEO.
Similarly, for many, saving at the start of their career may be easier, as they have fewer
financial commitments like mortgages. There may be other financial commitments such as
paying off student loans, but there is a significant benefit of compound interest that makes
saving more when you’re younger far more easy on your pocket than saving at far higher
rates later on to compensate.
Preserving your savings
This requires discipline – like not tucking into that piece of chocolate-fudge cake at the
back of the fridge. While Treasury is looking at ways to discourage us from dipping into our
retirement savings excessively when changing jobs or being retrenched, current legislation
still allows us to “stick a hand in the cookie jar”. The majority of trustees surveyed in the
2014 Sanlam Benchmark Survey consider lack of preservation to be the most critical mistake
members of retirement funds are making with their savings, and the same survey showed
that 71% of members admit to taking some or all of their benefits in cash when changing jobs.
Healthy contribution
Choosing appropriate investments
The final component, investment choice, is akin to eating correctly. Earlier on in your savings
journey you want to have high exposure to growth assets – just like you need that first cup
of coffee in the morning. Later on you will need to temper your investments and preserve
capital – akin to low GI foods to sustain you. There are a number of solutions that have been
developed to assist members to invest appropriately, so that they are taking on appropriate
risk at the appropriate time of their savings journey. As with a prescribed eating plan, you
need to ensure that your selection is appropriate to your own circumstances.
Fitness plan component	 Retirement savings component
• Exercise	 • Healthy contributions
• Avoid temptation	 • Preserving your savings
• Eat correctly	 • Choosing appropriate investments
Like any fitness
plan, there are
components to
retirement savings:
3
SOURCE: Rhoderic Nel, FASSA Chief Executive Sanlam Employee Benefits and
Mayuri Reddy, Actuarial Specialist Sanlam Employee Benefits
How to get retirement-fit
COLLECTIVE INSIGHT
COLLECTIVE INSIGHT 29 JANUARY 2015 29
M
odern portfolio theory
(MPT) has been the
cornerstone of investment
practice for more than 50
years. Underlying this framework is the
concept of the rational investor, whose
sole objective is wealth maximisation.
As such, investment strategies focused
on maximising return have been
popularised throughout the world,
with investment performance being the
ultimate factor in portfolio selection.
In 1979, Daniel Kahneman and
Amos Tversky published their seminal
paper titled Prospect Theory: An analysis
of Decision under Risk. This work led to
a key criticism of the rational investor
premise of MPT: that investors make
different risk choices dependent on the
financial objective and its impact on
their wealth. The work of Kahneman,
together with mixed results from
traditional finance, was a catalyst to
the development of a more holistic
framework commonly known as goals-
based investing.
This framework allows
an individual to:
1.	 Define and prioritise (multiple)
unique savings objectives over
different horizons.
2.	 Differentiate their capacity to take
risk for each objective.
3.	 Establish specific success criteria
for each objective.
4.	Adapt and restructure their
strategy as time and circumstances
change.
This provides a very intuitive financial
planning framework for individuals
and financial advisers to design more
appropriate financial solutions. Since
2008, investments have been under
scrutiny – from governance frameworks
to fees to remuneration. The UK Retail
Distribution Review implemented in
2013 resulted in a substantial change
in how financial advisers operate in the
UK. Similar legislation has been tabled
for South Africa. As a result the value
(and remuneration) of an adviser has
been put under the spotlight.
Goals-based investing shifts the
typical investment conversation from
best performing products towards
establishing the correct financial
outcomes. Determining the correct
goals, managing to meet those goals,
maximising the probability of success,
and helping the client understand the
impact, would naturally lead to better
financial behaviour and outcomes.
Charles Ellis, doyen of investment
consulting, in his article The Rise
and Fall of Performance Investing,
describes investment management
as “two hands clapping” – one based
on price discovery and the other on
values discovery. Price discovery is the
process of identifying pricing errors
not yet discovered by other investors
and generating additional performance
– the realm of an asset manager. Values
discovery is the process of determining
each client’s realistic objectives with
respect to various factors and designing
the appropriate strategy – the realm of
the adviser/liabilities manager/asset
allocator.
What Ellis is reminding us of is that
for investing to be truly effective, it has
to include both an asset management
focus and a liability focus. Over the
years, a performance focus has tended
to drown out the liability or goal target
of the investment.
However, goals-based investing
should not be an elaborate advisory
framework that leads to the same old
products. The investment strategies that
are needed to effectively execute a goals-
based approach require newer thinking
and skill sets for the financial services
industry. Where MPT created efficient
portfolios using return and volatility,
alternate forms of ‘efficient’ portfolios
need to be developed.
Global peers have taken different
approaches to solving this problem.
The four most popular
investment strategies
(sometimes used in
combination) are
summarised below.
1. Construct portfolios that achieve
predefined investment outcomes. Map
clients based on their interactions with
their adviser to these portfolios. This
approach is more cost-effective and can
be used in conjunction with technology-
driven distribution. It approximates
client expectations and is a more
commoditised offering.
2. Define underlying building block
strategies that can be combined to create
unique risk-controlled outcomes. This
creates a more individualised solution
with better controlled outcomes while
remaining cost-effective.
3. Use dynamic asset allocation to change
the asset strategy mix of an individual
portfolio, based on market movements,
risk levels and maximising the probability
of achieving target objectives. As the
goal has greater certainty of being met,
these portfolios will reduce the risk they
take. This is similar to the liability-
driven investment strategies that are
used by institutional pension fund assets.
This is also the approach discussed by
Nobel laureate Robert Merton in our
centrepiece article.
The end of the world as we know it
COLLECTIVE INSIGHT
30 COLLECTIVE INSIGHT 29 JANUARY 2015
4. Start with the existing assets of the
individual and then build a dynamically
managed optimal portfolio that could
include an infinite range of assets and
securities.
Despite differences
to the design of these
goals-based investment
strategies, three things
remain constant across
the approaches:
1.	 The emphasis and focus must be on
managing risk.
2.	 The underlying investment strategy
must be relevant and structured to
the objective.
3.	 Success must be measured against
the goal and not traditional market-
related performance benchmarks.
Goals-based investing will also bring
changes to traditional financial adviser
toolboxes. Risk profile questionnaires
will soon become obsolete. Establishing
a risk tolerance is no longer sufficient in
a world of multiple financial objectives.
A good adviser would need to establish
a more comprehensive risk assessment
for his client.
A common fallacy perpetuated
by financial advisers is that most
investment goals are translated into an
inflation + real return target. Intuitively
it makes sense: if your liabilities are
linked to inf lation, then a return
greater than inflation must put you in
a better position. However, financial
mathematics and investment pricing
are not always linear.
For example: assume it is one year
before your retirement. You have saved
enough to purchase an inf lation-
linked annuity that will cover your
required expenses for the rest of your
life. Assume inflation remains stable
over the year at 6% but real rates
declined by 1%. You are invested in
an ‘inflation + 3%’ strategy which
returns 9% in line with its performance
expectations. Does this mean you can
buy the inflation-linked annuity? A 1%
decline in real rates will increase the
price of an annuity by over 12%. If real
interest rates decline as they have over
the past 10 years, you, like many people
across the globe experienced, will most
likely not meet your goal. This further
emphasises the need for the investment
strategies of GBI to match with the
advice framework.
Goals-based investing brings with it
the ability for an individual to take care
of their financial health. Its intuitive
nature allows for a greater participation
in charting your financial emancipation,
while having a more meaningful
relationship with your wealth and a
more constructive engagement with your
financial services provider.
As the REM song goes: “It’s the end
of the world as we know it... and I’ll be
fine”; with the changes to the world of
financial advice we are probably going
to be better off. ■
Deslin Naidoo
Head: Investment Research
Naidoo is responsible for the
investment research function at
Alexander Forbes. He designs,
manages and oversees all
AF-branded investment products.
What investment return do I need to achieve my goal?
• Buy new car
• Pay for children’s
education
• Go on holiday, etc
Assume goal is
to pay deposit
on first home
Goal
Cost
Achieve
goal in
5 years
• By when do I want to
achieve my goal?
• What is the cost now?
• What will it be in
5 years’ time?
Timeframe
Assume a goal
of R200 000
Lump Sum Recurring Combination
I only want to make a large
upfront investment.
I don’t have any savings
now, but I can afford to
make monthly payments.
I have some savings, but I wish
to also make monthly payments.
i.e. I have R115 000. i.e. I can afford R2 300 p.m.
i.e. I have R80 000 and can
afford R2 300 p.m.
R200 000
R100 000
Now 5yrs4yrs1yr 2yrs 3yrs
R0
R200 000 R200 000
R100 000 R100 000
Now Now5yrs 5yrs4yrs 4yrs1yr 1yr2yrs 2yrs3yrs 3yrs
R0 R0
Required Investment return
11.4% p.a.
Required Investment return
14.8% p.a.
Required Investment return
7.3% p.a.
To achieve 11.4% p.a. one can
invest in a moderate portfolio
(40%-60% equities).
To achieve 14.8% p.a. one can
invest in an aggressive portfolio
(90%+ equities).
To achieve 7.3% p.a. one can
invest in a conservative portfolio
(10%-30% equities).
Collective Investments Jan 2015 - Goals Based Investing
32 COLLECTIVE INSIGHT 29 JANUARY 2015
COLLECTIVE INSIGHT
T
he investment industry exists to serve asset owners, for whom
retirement is an income challenge, not a return challenge. You
can’t retire on a good Sharpe Ratio and you can’t eat alpha.
And unlike the maximisation of returns, a defined goal in
the form of an income target is both achievable and controllable, which
makes it much more suitable as an anchor for an investment process.
Using goals as a reference point for success would make for some
interesting changes compared to a traditional investment process
focused on maximising return. What follows is an analysis of four key
ideas that will require attention if goals-based investing is to succeed.
Investment risk
vs savings risk
Traditional risk-profiling
techniques are still defining risk
based on return metrics and not with
reference to annuitisation. In a 2014
study on how savers think about
risk, the Pensions Institute at CASS
business school in the UK found
that while traditional risk-profiling
questionnaires accurately captured
attitudes towards investment risk,
they were thoroughly inconsistent in
terms of defining clients’ attitudes
towards savings risk; clients across the
spectrum of Cautious to Adventurous
all gave equivalent responses to
questions on savings risk.
Is it prudent to suggest that
a client has a high capacity for
investment risk-taking if they are
not willing or able to accept a large
shortfall of their retirement goals?
The study also found a significant
amount of “reckless conservatism”:
only 12% of savers disagreed that
missing their savings goals was
more acceptable than taking
investment risk. If we define risk as
the likelihood of falling short of that
income replacement target, then it
follows that risk attitudes should be
determined by a client’s flexibility on
the magnitude of shortfall.
Control and
accountability
Asset owners delegate to advisers
who delegate to fund managers
who ultimately leave the capital with
company management. With this level
of intermediation it is impossible for
the ultimate asset owner to attribute
accountability on a returns basis.
Emphasising outcome-based selection
criteria such as “the number of previous
clients an adviser has helped achieved
their goals” is a more relevant measure
of investment success. Compensation on
this basis will also better align interests in
terms of reducing costs and incentivise
asset retention over asset gathering for
fiduciaries.
For the large majority of savers, the
most significant factors determining
investment success are their savings
rate, how long they work until retirement
and their future retirement spending −
all of which are normally within a client’s
control. This will shift the emphasis of
accountability for reaching their goals
onto their own actions, avoiding over-
reliance on investment returns and
reducing unnecessary emotional pain
from having unrealistic expectations of
financial markets. Saving more has the
direct consequence of increasing your
investment pot, whereas taking more
investment risk by no means guarantees
higher returns.
Short-termism
Wealth accumulation is a multi-
year and often multi-decade process.
Basing decision-making on a long-term
goal can remove the unwanted side
effects of investor short-termism. While
it is not a secret that the majority of
active mutual funds underperform their
benchmarks, the annual DALBAR study* has
estimated that end investors compounded
underperformance through attempting to
time entry and exit into the mutual funds:
from 1984-2013, the average
investor in US equity funds
annualised 3.69%vs 11.11%
for the SP, a “behaviour
gap” of almost
8%per annum.
This is particularly significant as the knock-
on effects of investor behaviour on the
whole economy can be profound. A longer-
term focus from asset owners filters through
to the behaviour of asset management
companies, with less manager turnover and
less style drift due to immediate concerns
over outflows. In turn, a less transient
shareholder base in companies relieves the
pressure for corporate short termism at
the management level − an NBER survey
in 2004 found the majority of corporate
management would not proceed with a
profitable long-term project if it meant
missing consensus earnings forecasts
for the quarter! More earnings accretive
investments would ultimately lead to better
long-term returns for shareholders.
Aligning assets
with their owners
Gallo Images/Thinkstock
COLLECTIVE INSIGHT
COLLECTIVE INSIGHT 29 JANUARY 2015 33
Subjective objectives
Modern portfolio theory and efficient
frontiers are extremely impersonal (I have
yet to come across any wealth manager who
finds it practical to quantify each client’s utility
into indifference curves). This is where many
off-the-shelf solutions such as target date
funds or ‘glidepath’ strategies are also not
fit for purpose. If you start with high-equity
allocations and simply shift to bonds as you
age, you will miss out the bulk of potential
returns for long-term clients by having
investment risk too low when they have the
largest amount invested (closer to retirement),
thus over a client’s lifetime the majority of
their assets are invested at too low a risk.
Traditional glidepaths also fail to take into
account the personal nature of cash flows.
The biggest asset on a young investor’s
balance sheet is the deferred income of their
human capital. For the majority of young
professionals, their salary shares similar
characteristics to an equity: inflation-linked,
vulnerable to a recession, uncertain over the
long term.
If the majority of the individual’s investment
portfolio is also in equities, then tail events
such as financial crises and the ensuing
unemployment would create the need to cash
in savings to substitute for lost salary, a forced
liquidity event that ends up with the investor
selling out of equities at a cyclical low point.
The traditional reasoning that young investors
have more ‘time to recover’ does not take
into account these idiosyncrasies in client
circumstances and targeting higher volatility
in a bid to maximise return would not help this
young client meet their objective.
Minimising shortfall risk for this type
of young investor would instead suggest
allocating to assets less correlated to equities
initially and increasing equity exposure to
replace the deferred asset of their human
capital as it converts to cash over time – another
example of how a goals-based approach better
aligns a portfolio to its owner’s needs.
Ainsley To
Analyst, Credo Capital
To is an analyst for the multi-
asset team at Credo Capital,
under taking cross-asset
research in asset allocation as
well as fund selection. Prior
to Credo, he also worked at
Stamford Associates, Fidelity
and Bloomberg. To has been a
CFA charterholder since 2014.
Each investor has their own savings desires
and future consumption needs – thus assets
under management (AuM) should not be
thought of as a total dollar amount but as
a collection of the individual goals of every
saver underlying those assets. Today the
over specialisation at every level of financial
intermediation has created a wedge of
multiple, divergent incentives between asset
owners and their savings. Removing these
layers of agency problems requires a structure
which aligns managers of capital with the
asset owner’s ultimate goal – incentives need
to be personalised. Compensation based
on achievement of client-specific goals
(net of fees), including claw-back clauses
would provide a much closer alignment of
interests than flat management fees. Demand
from end-clients for accountability based
specifically on reaching their own goals will
remove the current ‘heads, I win; tails, you
lose’ dynamic of incentives within investment
management, and the rest will follow.
“Never, ever, think about something else
when you should be thinking about the power
of incentives.” – Charlie Munger ■
*DALBAR’s 20th Annual Quantitative Analysis
of Investor Behaviour 2014.
Conclusion
“ “
Emphasising outcome-based selection criteria
such as ‘the number of previous clients an
adviser has helped achieve their goals’ is a
more relevant measure of investment success.
W
hy do we all
fall down?”
Recently, one
of us was asked
this question by a four-year-old child after
the umpteenth performance of ‘Ring a ring
a rosies’. Children have an ability to ask
excellent questions that we often brush off
or simply dismiss. Sometimes we become
so accustomed to something that we fail
to question why, or have forgotten why, we
actually do it.
Defined contribution
investment strategies
To a large extent, this is the case with the
typical investment strategies utilised in
defined contribution (DC) schemes. We
are constantly presented with ‘evolutions’
to strategies that have been around for
many years, but do we ever take a step back
to question their overall appropriateness?
The cornerstone of most DC strategies
is a focus on how we can maximise
accumulated savings (or reduce their
variability).
Sometimes we need to be reminded
that the primary concern of the DC
fund members is (and always has been)
whether they will have sufficient income
in retirement to live comfortably.
A good retirement is measured by the
standard of living you want in retirement;
a standard of living is not defined by a pot
of money, but a stream of income. The
savings needed when you retire is the
amount needed to sustain the standard
of living which you have become used to
enjoying in the latter part of your working
life. That is an income goal; it’s not a
wealth goal.
While National Treasury discussion
34 COLLECTIVE INSIGHT 29 JANUARY 2015
COLLECTIVE INSIGHT
“
Why do we all fall down?
papers, and consulting approaches,
may make references to concepts like a
replacement-ratio objective (a measure
that expresses income in retirement as
a proportion of a member’s salary), the
actual investment strategies conceived do
not in fact focus on them (other than the
initial mention).
Investment statements that members
receive focus on return and volatility.
These in turn drive investor behaviour.
They are not measured in terms of
the members’ investment goals or the
likelihood of meeting them. Members
should not be focusing on how many rands
they have in their account, but how many
‘income units’ they have.
Life-stage investing
The most popular investment strategy is
a life-stage approach to investing. Simply
put, younger members are invested in
more aggressive portfolios targeting higher
returns (i.e. portfolios with more equity)
and are phased down to more conservative
portfolios (i.e. portfolios with more cash
and fixed income) as they approach
retirement. At no point is the member’s
personal circumstances catered for. The
only member-specific information used is
their expected time until they retire.
The entire framework is essentially
predicated on an assumption that investors
become more conservative as they
approach retirement and wish to reduce
the volatility of their fund credit.
When you consider behavioural
motivations, it is not hard to understand
why such an investment approach has
found favour.
Goals-based investing
Our thinking should evolve to consider
the obligations or goals of the individual
member and design an appropriate
investment approach that targets these.
Gallo Images/Thinkstock
Collective Investments Jan 2015 - Goals Based Investing
36 COLLECTIVE INSIGHT 29 JANUARY 2015
COLLECTIVE INSIGHT
Rather than regarding the member’s
fund credit as the liability, we should
be measuring the liability as the cost
of securing an appropriate inflation-
linked income stream for the member
at retirement. This is analogous to the
traditional defined benefit plans where
the member was guaranteed an income at
retirement based on their salary and tenure
with the retirement plan.
This change in formulation results in a
significantly different investment strategy.
Consider the investment strategy that
focuses on preserving a fund credit in the
year before retirement. While history is
not an indication of future performance,
we consider how two different investment
strategies would have fared for a member
if the past five years of investment returns
are used as a proxy.
The benefits of a more conservative
cash-based strategy are apparent if your
objective is to preserve the accumulated
savings.
But if we consider the reality that the
retirement savings are intended to be
used to provide an ongoing inflation-
linked income stream, the results are very
different.
The graph reflects that inflation-linked
bonds are now the optimal investment for
anindividualwishingtosecureagivenlevel
of income in retirement. This is because
annuity prices are driven by changes in
interest rates. The cash investment is a very
poor choice of investment.
Of course, investments are never
simple and we need to consider whether
the individual might need to actually
increase their equity exposure to provide
the maximum likelihood of affording a
reasonable income benefit, or reflect the
reality that a member may make use of
the tax-free withdrawal of some of the
savings at retirement. This can easily be
incorporated into a framework reflecting
meaningful goals.
So what should members
of a defined contribution
plan be invested in?
The investment strategy should optimally
allocate the member’s assets to a mixture of
risky assets (such as equities) and risk-free
assets (which is not cash!). The allocation
Shaun Levitan
COO, Colourfield
Liability
Solutions
Shaun Levitan is
the Chief Operating
Officer of Colourfield
Liability Solutions,
a business that is
exclusively dedicated
to delivering liability-
driven investment
solutions.
Robert C Merton
DistinguisHEd
Professor of
Finance, MIT
SLOAN SCHOOL OF
MANAGEMENT
Robert C. Merton is also
Professor Emeritus at
Harvard University and
was awarded a Nobel
Prize in Economic
Sciences in 1997 for his
work on derivatives.
Conclusion
It’s convenient and tempting to dismiss a
four year old’s question about ’ring a rosie’
by saying it’s just a silly nursery rhyme and
we shouldn’t pay too much attention to the
words. The reality, though, is that it describes
the Black Plague in England centuries ago,
with the final verse of “we all fall down”
referring to the inevitable death due to the
disease. Conversely, it is also tempting for
a retirement fund member to assume that
his/her default DC fund investment strategy
is well thought out (when closer analysis in
many instances suggests otherwise). By
identifying meaningful goals and asking the
right questions, we can help prevent our
members from all falling down. ■
SOURCE: Colourfield Liability Solutions
to each should change over time so as to
maximise the likelihood of achieving the
investment goal. The devil remains in the
details, but the key differences to current
frameworks are that risk is defined as the
possibility of not achieving the required
retirement income, and the risk-free asset
is defined with reference to a deferred
inflation-linked annuity.
Cash Inflation-linked bonds
Change in value of Fund Credit
5%
0%
-5%
Jan10
May11
Mar10
Jul11
May10
Sep11
Jul10
Nov11
Sep10
Jan12
May13
Sep12
Jan14
Nov10
Mar12
Jul13
Nov12
Mar14
Jan11
May12
Sep13
Jan13
May14
Sep14
Mar11
Jul12
Nov13
Mar13
Jul14
Nov14
Change in value relative to annuity price movements
5%
0%
-5%
Jan10
May11
Mar10
Jul11
May10
Sep11
Jul10
Nov11
Sep10
Jan12
May13
Sep12
Jan14
Nov10
Mar12
Jul13
Nov12
Mar14
Jan11
May12
Sep13
Jan13
May14
Sep14
Mar11
Jul12
Nov13
Mar13
Jul14
Nov14
COLLECTIVE INSIGHT
COLLECTIVE INSIGHT 29 JANUARY 2015 37
I
have been involved with building
and implementing investment
strategies for various clients for
over a decade now. Some of these
clients are investors with a long-term
focus like pension schemes and life
insurers, while others are investors with
a short-term focus like general insurers
and trusts. All of them have investment
goals that they would like to achieve.
For example, the pension scheme would
like to see its members retire with the
lifestyle they expected, while the insurer
would like to be commercial while
putting shareholder capital to work.
Therefore, when it comes to building
investment strategies, these goals form
the foundation on which the strategy is
built and its success measured.
This brings me to goals-based
investing. The phrase might be new, but
the concept is not. It has been around
for a number of years in the pension
world in the form of liability-driven
investment or LDI. I recall attending
the first conference on LDI hosted in
Amsterdam in 2004, where Dutch and
Nordic pension funds spoke about how
they apply LDI principles within the
goals set by their regulatory framework
which is essentially a solvency framework
for pension funds.
In LDI the investment goal is
defined by the financial liability created
by the fund rules of a defined benefit
(DB) pension scheme and the ability
of the assets to cover that liability or
expectations through the funding level.
Unlike South Africa, most pension
schemes in the rest of the world are still
DB schemes and LDI has remained the
exclusive tool used to set investment
strategy, especially after the global
financial crisis that sent funding levels
tumbling. Many schemes in Europe are
now attempting to achieve funded status
over a set time horizon on trajectories
referred to as their ‘flight path’ where
the scheme, for example, wants to be
90% funded in two years’ time with
90% probability, 95% funded in three
years’ time with 80% probability, etc.
Even though LDI was originally
developed around DB scheme liabilities,
over the years the concept of LDI in SA
has been generalised for other types of
clients like DC schemes, insurers and
trusts, building investment strategies
around these types of client goals. For
example, a defined contribution (DC)
scheme may not strictly have a liability
determined by the its fund rules, but
there is an expectation by the member
about the type of retirement product
they want to buy. It means that every
member in a DC scheme is, in essence,
running their own DB scheme, as
expressed in their targeted replacement
ratio.
Another example is where an
insurance client wanted their return
on capital to exceed the cost of capital
by some margin 75% of the time over a
one-year period. These are all examples
of generalised LDI or goals-based
investing approaches. But have LDI
and the broader goals-based investment
strategies worked for investors and what
message is there for investors interested
in goals-based investing? To answer
these questions, we need to draw an
analogy with another kind of strategy:
corporate strategy setting.
The parallels between setting
noticeable corporate strategy and setting
investment strategy are very noticeable.
How smart is your
investment strategy?
But have LDI and the
broader goals-based
investment strategies
worked for investors
and what message is
there for investors
interested in goals-
based investing?
GalloImages/Thinkstock
COLLECTIVE INSIGHT
38 COLLECTIVE INSIGHT 29 JANUARY 2015
A goals-based investment approach
continuing on the corporate strategy
analogy, I would summarise my message
to investors who already implemented
or who are thinking of implementing a
goals-based investment approach in the
following three points:
1. Think like a CEO about your
investments. What is your vision for your
investments? What do you want your
investments to achieve? A DB scheme
wants to pay liabilities as and when they
fall due. A DC scheme wants to provide
the retirement to members that they
expect. An insurer wants to maximise
return on shareholder capital in order
to be commercially competitive. Once
you have established what this vision for
your investments is, make sure that your
service providers also understand and
buy into your vision. This will ensure
alignment of interest between all parties.
2. Make sure your investment goals are
SMART, meaning specific, measurable,
attainable, relevant and time-bound. Too
many times an investor is too fuzzy about
their goals and this leads to confusion
and expectation gaps when investment
strategies get built, implemented and
monitored. A client once defined their
investment goals saying that they want
their return on their capital to exceed the
cost of their capital by at least 2% with a
75% probability over a one-year period.
That statement was so powerful, yet so
clear, that I had tears in my eyes.
3. You can’t manage what you can’t
measure. To manage your progress
in realising your vision you need to
measure on an ongoing basis whether
you are achieving the goals you set.
Think of it as keeping an eye on your
satnav: you don’t want to find out too
late that you should have turned left
instead of right, it wastes valuable
time and opportunity and you could
quickly end up in the dodgy part of
town. Measuring your investment
performance is obviously important, but
don’t forget to also check on how you
are measuring up to the goals you set. ■
Petri Greeff
Head of Research and
Strategy, Riscura
Greeff is responsible for safeguarding
academic rigour throughout RisCura’s research
processes, challenging existing investment
industry wisdom and promoting critical
thinking throughout the business. His approach
is to dig deep into scientific and financial theory,
examine problems from different angles and
take an academic standpoint on investment
challenges and asset/liability positions.
Now let’s apply the company strategy analogy
to say a DC pension scheme. As a board of trustees
your vision is to keep pensioners from eating cold
baked beans one day and therefore, one of your
goals is to deliver at least a targeted replacement
ratio of 75% for those members that have 40 years
of membership in the fund. Your measure of success
would be how many members retire with an actual
replacement ratio of 75% or more. At year-end,
you pull the statistics and see that 90% of retiring
members had a replacement ratio of 75% or more.
Were you successful in achieving your goal based
on your vision? Yes. Were you successful in beating
your peers’ performance numbers? Perhaps not.
But does it matter? No two pension schemes are
exactly the same. What is more important is that
as a board you have a vision and that you have put
down tangible goals to measure your progression
against as you move towards realising your vision
for the scheme. This same analogy could also be
applied to any other type of investor, whether you
are an insurer, a trust or even an individual.
Applying the pension fund analogy
Your measure
of success
would be how
many members
retire with
an actual
replacement
ratio of
75%or more.
APPLYING THE
CEO STRATEGY
You measure your success in applying
a corporate strategy in terms of how
well you achieved the goals that were
set and met based on your vision
statement over a period. For example,
you are the CEO of a company that
sells thingamajigs and your vision is to
be the number one online retailer of
these thingamajigs. Textbook company
strategy would tell you to set goals in
line with this vision. For example, one
of your goals could be to double your
online sales of thingamajigs by the end
of the year. Year-end comes and your
online sales have trebled. Were you
successful in achieving your goal based
on your vision? Yes, definitely. Were you
successful in beating your competitor’s
profit numbers? Perhaps not. But
does it matter? No two companies are
exactly the same and comparable on an
apples-for-apples basis. What is more
important is that as CEO you have set
yourself a vision and you have put down
tangible goals that you could measure
your progression against as you move
towards realising your vision. This is
ultimately your guiding principle.
Collective Investments Jan 2015 - Goals Based Investing
This time it’s personal
A
sset management can be
particularly powerful. Give
an asset manager a target,
a time frame and the
degree of certainty required of meeting
that target, and the fund manager
can generally deliver a reasonable
outcome. Turn that requirement into
a performance race – i.e. demand
that the fund manager outperform
their competitors in perpetuity – and
outcomes become decidedly more
random. Bottom line: as an investment
strategy, a goals-based framework has
a much higher probability of fulfilling
client needs than a performance-based
framework.
So, the question we need to address
is: if goals-based investing is so powerful
in re-enforcing all the right behaviours,
and so effective in terms of rebuilding
a critical level of trust and customer-
centricity, why are we still locked in a
never-ending performance race?
Over the last 15 years, goals-based
investing periodically appeared on
our doorstep and then, ever so quietly,
slinked off as the enthusiasm for it
waned. The two most notable time
periods occurred in the wake of the
financial crises of that period: post the
2002/03 market collapse and the global
financial crisis of 2008. Today, it is
creeping back into our vocabulary again
as a much more realistic investment
model to address investor needs, but
unless we understand what impediments
the industry faces in adapting a goals-
based framework, it will remain a
concept only.
How did we get here in
the first place?
‘Goals-based investing’ bears a striking
resemblance to the type of trust fund
management practices employed by
COLLECTIVE INSIGHT
40 COLLECTIVE INSIGHT 29 JANUARY 2015
wealthy families from the 1950s to the
1970s. Trust fund companies saw their
fiduciary responsibility from a goals-
based perspective. Typically, the two
goals they would try to address would be
how to provide the dependent with their
basic day-to-day income requirements
and then how to structure the residual
funds to maximise the wealth transfer
to the next generation.
The key point is that, to meet these
very different goals, two very different
portfolios were structured – the first
portfolio used an optimal fixed-income
blend to match the dependent’s cash flow
requirements. The second portfolio used
higher risk growth assets that reflected
the specific investment interests or risk
appetite of the family or individual.
But by the end of 1970s, the global
stage would be set for a very different
investor. Investing would no longer
remain the prerogative of the wealthy.
Four factors were
instrumental in
effecting this change:
1. Stronger regulatory protections for
mutual funds (unit trusts) meant that
these investment vehicles could provide
safe, cost-effective vehicles for smaller
investors wishing to access the markets.
2. The stagflation of the 1970s threw
into question the viability of the
conservative, liability-driven investment
strategies that were the hallmark of
trust companies. The search for yield
was on, and that meant venturing out of
conventional investment comfort zones,
with the emphasis shifting to equities
and international investments.
3. Fuelling the growth of this emerging
industry was a massive marketing
campaign. Financial services companies
GalloImages/Thinkstock
Anne Cabot-Alletzhauser
Head of the Alexander Forbes Research Institute
Cabot-Alletzhauser heads up the Alexander Forbes Research Institute
– an initiative that looks at the full spectrum of issues that confront the
savings and investment sector for South Africa in particular and Africa
in general.
Prior to that, she was an asset manager and CIO for 32 years,
managing pension fund assets in North America, Japan, the UK,
Europe and South Africa. In 1994, Cabot-Alletzhauser pioneered the
development of the multi-manager management approach of pension
fund management that has become the hallmark of that industry today.
COLLECTIVE INSIGHT
COLLECTIVE INSIGHT 29 JANUARY 2015 41
began to organise their distribution
models around selling clients products
(unit trusts), and not just investment
ideas.
4. Finally, with the emergence of 401k
plans in the US in 1980, responsibility
for developing an effective investment
strategy to meet retirement funding now
fell on the shoulders of the guy on the
street.
The democratisation of the investment
markets had become a reality – but how
well equipped was the industry to meet
the challenge?
To service an exponentially expanding
market, the industry needed to be able
to commoditise solutions and simplify
answers. While unit trusts provided
a way to commoditise the investment
strategy, tailoring solutions to meet
a specific client requirement couldn’t
be commoditised. Technology simply
hadn’t evolved to that level at that point.
How then should investors select
their investment strategies?
Performance comparisons proved to
be the simplest to sell and the easiest to
comprehend. This also simplified both
the performance reporting message and
the advisory message.
Essentially, the shift away from a
goals-based model owes much to the
technological limitations that made it
unfeasible to provide customised solutions
to a massively expanded consumer base.
A further complication was that the
unitisation framework employed by a
unit trust made it next to impossible to
provide any form of cash flow matching
or liability driven type of solution to this
broad mass of investors. Finally, asset
classes themselves were limited in scope.
Inflation-linked bonds, for example, don’t
really become viable, liquid investments
until the early 2000s. This meant that
the only means asset managers had to
address such challenges as keeping pace
with cost of living increases, or the cost of
future annuitisation would be to increase
the fund’s exposure to higher risk/
higher return assets such as equities or
international assets and hope this would
build up an adequate cushion.
Today, all of those impediments have
been overcome. Technology and asset
strategy breadth have evolved to the
point where we can offer cost-effective
solutions that both dynamically assess an
individual’s asset/liability shifts and then
create the right investment mix to meet
those funding goals over the required
timeframe. But while the way is now
there, we, as an industry, still need to deal
with the will.
In truth, perhaps the ultimate culprit to
why the goals-based concept failed after
the two post-crash attempts was the
fact that both crashes were followed by
massive rallies. Why bother changing
out of a good thing (or at least a highly
profitable one – for the industry), if the
performance game is working? In this
sense, the consumer was as guilty for
opting for the hope-the-manager-wins
option as the service provider was.
So, therein lays the challenge.
Effectively, the asset management
business model needs a complete
overhaul if goals-based investing is ever
to take hold. And if the consumer is
actually the one we care about here, it
must come right.
What needs to happen?
■ The advisory and asset management framework must change in tandem. It’s not
enough to ask clients what their investment goals are and then simply shoe-horn their
assets into performance-based unit trusts, hoping these strategies just might deliver
what’s required. The investment vehicles themselves must change so that targets
have a higher probability of being met.
■ The regulatory environment needs to support these types of solutions and not
confound their delivery. While Treating Customers Fairly (TCF) rightly requires us
to put clients’ requirements first (and ensure that investments are appropriate),
regulations that restrict essential asset class exposures, or require risk questionnaires
or performance reporting that do not reference a goals-based approach, can be
hugely problematic.
■ Performance measurement needs to change dramatically. Technological innovations
mean that we can cost-effectively provide even the smallest investor with some notion
as to whether they are meeting their investment goals and, if not, what types of
interventions could take place to get them on track. The place and time for an effective
‘robo-adviser’ solution has most decidedly come.
■ Overall, members of the industry need to rethink how they are helping their
clients by setting the right expectations and then continuously managing to those
expectations.
When all is said and done, hope is not an investment strategy. While top
performance is simply not attainable on a sustainable basis, meeting a specific goal
should be. Let’s get our clients to where they need to go! ■
Collective Investments Jan 2015 - Goals Based Investing

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Collective Investments Jan 2015 - Goals Based Investing

  • 1. Goals-based Investing collective insightinsight into SA INVESTING from leading professionals ci January 2015
  • 3. 26 Start saving with the end in mind 29 The end of the world as we know it 32 Aligning assets with their owners 34 Why do we all fall down? 37 How smart is your investment strategy? 40 This time it’s personal COLLECTIVE INSIGHT 29 JANUARY 2015 25 COLLECTIVE INSIGHT T he investment industry continues to be challenged on how it defines performance, how it delivers value and how it measures success. Combine this with an increased regulatory oversight that focuses on what is actually being achieved on behalf of the clients and it’s clear that the industry needs to have a major rethink of its value proposition. Certainly one way to enhance that value proposition is for the industry to evolve to a point where it begins to frame performance in terms of the investor’s objectives, so-called “personal performance”. There are several barriers to delivering more personal performance, not least of which is an institutionalised reliance on outdated constructs. The current system has been built around a concept of performance that is defined relative to market indices, consulting quadrants, performance surveys, rock-star stock pickers and revered research analysts. The investor doesn’t usually figure into the equation – and this needs to change. Andrew Bradley of Old Mutual Wealth comments: “When money is managed in the traditional way the manager is either focused on beating a theoretical benchmark, beating their peers or managing the portfolio within some notional risk appetite. None of these particularly resonate with the investor’s individual lifestyle and investment goals. This is the key difference between the conventional Editorial Introduction Nerina Visser ETF strategist and adviser Contents Please send any feedback and suggestions to cabota@aforbes.co.za. Finweek publishes Collective Insight quarterly on behalf of the South African investment community. The views expressed herein do not necessarily reflect those of the publisher. All rights reserved. No part of this publication may be reproduced or transmitted in any form without prior permission of the publisher. approach to managing money and a goals-based approach. A goals-based approach provides no guarantee of better performance, but it does significantly increase the probability of alignment between the investor’s objectives and their portfolio construction and ultimate performance.” Robert C. Merton is one of the authorities on this new approach to investing – and also a Nobel laureate. We are priviliged in this edition to have him as a co-author on one of the articles, alongside Shaun Levitan, entitled Why do we all fall down?. They explain why it is so critical to apply this approach in the context of retirement, or otherwise risk getting your investment strategy entirely wrong. By understanding that not meeting your goal for retirement is the real problem, the whole focus of risk management changes. Merton’s is the fourth article in this Collective Insight. Before that, for those who are new to the topic, we have introductions to the concept from Ronald N. King and Abigail Munsami. Then Deslin Naidoo and Ainsley To provide us with overviews of some key concepts in the industry which need to change to accommodate goals- based investing. Later in the edition, we have an article from Petri Greeff with a powerful analogy of how company strategy echoes goals- based investing, as well as a history of goals-based investing – which is older than you think – from Anne Cabot-Alletzhauser, which concludes with what it will take for the approach to become widely adopted in the industry. In future, success – in terms of returns – will be defined differently. Truly sustainable returns – those that meet investors’ individual goals – must start with a deep understanding of the value components that are meaningful to the investor. But in order for the investor to fully appreciate – and be willing to pay for – those returns, the value components delivered and the fees charged must be transparent. Over time, this new model for success will help to improve the alignment of interests across all industry participants, provide incentives for streamlining delivery models and reduce barriers to healthy decision-making. We trust that this edition will assist in that process. Enjoy! ■ Convenor Anne Cabot- Alletzhauser Head of Alexander Forbes Research Institute Editorial Advisory Committee Vanessa Bell Director, Jonathan Mort Inc Delphine Govender Chief Investment Officer, Perpetua Investment Managers Petri Greeff Head of Strategy and Research, Riscura Patrice Rassou Head of Equities, Sanlam Investment Management Heidi Raubenheimer Independent Research Consultant Sangeeth Sewnath Deputy Managing Director, Investec Asset Management Di Turpin Independent Consultant Nerina Visser ETF Strategist and Adviser Muitheri Wahome Head of Investment Products, Investment Solutions
  • 4. Start saving with the end in mind COLLECTIVE INSIGHT 26 COLLECTIVE INSIGHT 29 JANUARY 2015 W hen I grew up my parents had a drawer full of brown envelopes w it h w ord s l i k e ‘clothing’, ‘food’ and ‘savings’ scratched across the front. Every payday they’d tuck cash into those brown envelopes to cover the family’s monthly expenses. They would start with the most critical and move down to the ‘nice-to-haves’. This was their system for managing money: not very sophisticated, but they always knew where they stood financially. Ironically, the new programmes use the same kind of logic: they manage money, in part, by dividing it into a variety of spending and saving categories. The ‘envelope system’ was common in the era before computer-based money management programmes. Ironically, the new programmes use the same kind of logic: they manage money, in part, by dividing it into a variety of spending and saving categories. These practices persist because they’re consistent with the way most people think about their money. People tend to regard their wealth not as a lump sum, but as distinct amounts needed to meet individual goals in life. This has led to the emergence of the ‘goals- based investing’ concept. This approach to wealth management emphasises investing with the objective of attaining specific life goals rather than focusing on generating the highest possible portfolio return or beating the market. The practice of goals-based investing is generally still in its infancy among advisers, but there are some advisers who are embracing this approach and leaving traditional approaches behind. The traditional school of thought generally focuses on outperforming the market while staying within the investor’s threshold for risk. Goals-based investing applies a specific investment strategy, tailored to a client’s specific goals, to the individual’s asset pool. This encourages investors to talk about the goals they’ve identified to date and also challenges them to think bigger and dig deeper. Once all of their dreams are on the table, they can prioritise and set timelines – a process that drives the individual to think even more carefully about the relative importance and urgency of each goal. The idea behind goals-based investing is that investors should set specific, personal goals that they want to achieve and should then structure their investment plans around those goals. With goals-based investing, instead of worrying about hitting conceptual benchmarks, investors can set goals that resonate with and make sense to them. The power of a goals-based approach lies in its ability to highlight how realistic a goal is relative to your risk preferences and the investment opportunities available. It also underscores the importance of separating needs and wants. Most investors are willing to assume a higher level of risk to gain additional potential return with money set aside for a vacation home (a ‘want’) than Ronald King HEAD OF TECHNICAL SUPPORT, PSG WEALTH King has a B.Com LLB LLM Adv PDFP and an MPhil in Future Studies. He is the author of a number of books. Abigail Munsami JUNIOR LEGAL ADVISER, PSG WEALTH Her previous experience includes a significant number of years at the Constitutional Court. She holds an LLB degree
  • 6. COLLECTIVE INSIGHT 28 COLLECTIVE INSIGHT 29 JANUARY 2015 with money they’ve set aside for college tuition for a child (a ‘need’). After all, if the additional risk taken with the money set aside for the vacation house results in losses, the investor could always forgo the second home or downsize their plans. However, they might not be so quick to let go of plans to fund their child’s college tuition. As advisers and investors shift focus to goal-oriented investment approaches, a new perspective on risk and portfolio construction is emerging. Advisers are questioning conventional thinking on asset allocation and beginning to pursue new portfolio strategies that can better help their clients pursue the returns needed to achieve critical financial goals, while also seeking to protect current assets from a loss. This asset/liability-matching process ensures that investments are chosen to be more in line with a specific goal and investment time frame than with a specific risk profile. It doesn’t require new investment products, just a new approach to how existing investments are structured to achieve this new goal. With both investors and their advisers willing to make the move to goals-based investing, one could assume that the transition would be relatively easy. But the hard truth is that going from agreement in theory to acceptance in practice will take a concerted effort from both parties. Advisers worldwide are aware of the need to enhance their knowledge and skills to better meet the changing needs of clients. Topping the list of subjects that advisers are looking to deepen their knowledge of, are investment strategies that are more explicitly target-enhanced, income generation and capital protection. Goals-based investing is gaining increased traction, as it makes the principles of investing more tangible and relatable. It also once again underscores the value of appropriate financial advice, as financial advisers will have to know their clients well and interact with them regularly for goals-based investing to work properly. ■ As exercise is to a fitness plan, healthy contributions are usually the most difficult part of getting retirement-fit; it means having less of your salary in your pocket because you are saving more. As with a 6am gym session, increasing or maintaining a high level of contributions is a lot easier when you have fewer commitments – no children to get to school, no 7am meeting with the CEO. Similarly, for many, saving at the start of their career may be easier, as they have fewer financial commitments like mortgages. There may be other financial commitments such as paying off student loans, but there is a significant benefit of compound interest that makes saving more when you’re younger far more easy on your pocket than saving at far higher rates later on to compensate. Preserving your savings This requires discipline – like not tucking into that piece of chocolate-fudge cake at the back of the fridge. While Treasury is looking at ways to discourage us from dipping into our retirement savings excessively when changing jobs or being retrenched, current legislation still allows us to “stick a hand in the cookie jar”. The majority of trustees surveyed in the 2014 Sanlam Benchmark Survey consider lack of preservation to be the most critical mistake members of retirement funds are making with their savings, and the same survey showed that 71% of members admit to taking some or all of their benefits in cash when changing jobs. Healthy contribution Choosing appropriate investments The final component, investment choice, is akin to eating correctly. Earlier on in your savings journey you want to have high exposure to growth assets – just like you need that first cup of coffee in the morning. Later on you will need to temper your investments and preserve capital – akin to low GI foods to sustain you. There are a number of solutions that have been developed to assist members to invest appropriately, so that they are taking on appropriate risk at the appropriate time of their savings journey. As with a prescribed eating plan, you need to ensure that your selection is appropriate to your own circumstances. Fitness plan component Retirement savings component • Exercise • Healthy contributions • Avoid temptation • Preserving your savings • Eat correctly • Choosing appropriate investments Like any fitness plan, there are components to retirement savings: 3 SOURCE: Rhoderic Nel, FASSA Chief Executive Sanlam Employee Benefits and Mayuri Reddy, Actuarial Specialist Sanlam Employee Benefits How to get retirement-fit
  • 7. COLLECTIVE INSIGHT COLLECTIVE INSIGHT 29 JANUARY 2015 29 M odern portfolio theory (MPT) has been the cornerstone of investment practice for more than 50 years. Underlying this framework is the concept of the rational investor, whose sole objective is wealth maximisation. As such, investment strategies focused on maximising return have been popularised throughout the world, with investment performance being the ultimate factor in portfolio selection. In 1979, Daniel Kahneman and Amos Tversky published their seminal paper titled Prospect Theory: An analysis of Decision under Risk. This work led to a key criticism of the rational investor premise of MPT: that investors make different risk choices dependent on the financial objective and its impact on their wealth. The work of Kahneman, together with mixed results from traditional finance, was a catalyst to the development of a more holistic framework commonly known as goals- based investing. This framework allows an individual to: 1. Define and prioritise (multiple) unique savings objectives over different horizons. 2. Differentiate their capacity to take risk for each objective. 3. Establish specific success criteria for each objective. 4. Adapt and restructure their strategy as time and circumstances change. This provides a very intuitive financial planning framework for individuals and financial advisers to design more appropriate financial solutions. Since 2008, investments have been under scrutiny – from governance frameworks to fees to remuneration. The UK Retail Distribution Review implemented in 2013 resulted in a substantial change in how financial advisers operate in the UK. Similar legislation has been tabled for South Africa. As a result the value (and remuneration) of an adviser has been put under the spotlight. Goals-based investing shifts the typical investment conversation from best performing products towards establishing the correct financial outcomes. Determining the correct goals, managing to meet those goals, maximising the probability of success, and helping the client understand the impact, would naturally lead to better financial behaviour and outcomes. Charles Ellis, doyen of investment consulting, in his article The Rise and Fall of Performance Investing, describes investment management as “two hands clapping” – one based on price discovery and the other on values discovery. Price discovery is the process of identifying pricing errors not yet discovered by other investors and generating additional performance – the realm of an asset manager. Values discovery is the process of determining each client’s realistic objectives with respect to various factors and designing the appropriate strategy – the realm of the adviser/liabilities manager/asset allocator. What Ellis is reminding us of is that for investing to be truly effective, it has to include both an asset management focus and a liability focus. Over the years, a performance focus has tended to drown out the liability or goal target of the investment. However, goals-based investing should not be an elaborate advisory framework that leads to the same old products. The investment strategies that are needed to effectively execute a goals- based approach require newer thinking and skill sets for the financial services industry. Where MPT created efficient portfolios using return and volatility, alternate forms of ‘efficient’ portfolios need to be developed. Global peers have taken different approaches to solving this problem. The four most popular investment strategies (sometimes used in combination) are summarised below. 1. Construct portfolios that achieve predefined investment outcomes. Map clients based on their interactions with their adviser to these portfolios. This approach is more cost-effective and can be used in conjunction with technology- driven distribution. It approximates client expectations and is a more commoditised offering. 2. Define underlying building block strategies that can be combined to create unique risk-controlled outcomes. This creates a more individualised solution with better controlled outcomes while remaining cost-effective. 3. Use dynamic asset allocation to change the asset strategy mix of an individual portfolio, based on market movements, risk levels and maximising the probability of achieving target objectives. As the goal has greater certainty of being met, these portfolios will reduce the risk they take. This is similar to the liability- driven investment strategies that are used by institutional pension fund assets. This is also the approach discussed by Nobel laureate Robert Merton in our centrepiece article. The end of the world as we know it
  • 8. COLLECTIVE INSIGHT 30 COLLECTIVE INSIGHT 29 JANUARY 2015 4. Start with the existing assets of the individual and then build a dynamically managed optimal portfolio that could include an infinite range of assets and securities. Despite differences to the design of these goals-based investment strategies, three things remain constant across the approaches: 1. The emphasis and focus must be on managing risk. 2. The underlying investment strategy must be relevant and structured to the objective. 3. Success must be measured against the goal and not traditional market- related performance benchmarks. Goals-based investing will also bring changes to traditional financial adviser toolboxes. Risk profile questionnaires will soon become obsolete. Establishing a risk tolerance is no longer sufficient in a world of multiple financial objectives. A good adviser would need to establish a more comprehensive risk assessment for his client. A common fallacy perpetuated by financial advisers is that most investment goals are translated into an inflation + real return target. Intuitively it makes sense: if your liabilities are linked to inf lation, then a return greater than inflation must put you in a better position. However, financial mathematics and investment pricing are not always linear. For example: assume it is one year before your retirement. You have saved enough to purchase an inf lation- linked annuity that will cover your required expenses for the rest of your life. Assume inflation remains stable over the year at 6% but real rates declined by 1%. You are invested in an ‘inflation + 3%’ strategy which returns 9% in line with its performance expectations. Does this mean you can buy the inflation-linked annuity? A 1% decline in real rates will increase the price of an annuity by over 12%. If real interest rates decline as they have over the past 10 years, you, like many people across the globe experienced, will most likely not meet your goal. This further emphasises the need for the investment strategies of GBI to match with the advice framework. Goals-based investing brings with it the ability for an individual to take care of their financial health. Its intuitive nature allows for a greater participation in charting your financial emancipation, while having a more meaningful relationship with your wealth and a more constructive engagement with your financial services provider. As the REM song goes: “It’s the end of the world as we know it... and I’ll be fine”; with the changes to the world of financial advice we are probably going to be better off. ■ Deslin Naidoo Head: Investment Research Naidoo is responsible for the investment research function at Alexander Forbes. He designs, manages and oversees all AF-branded investment products. What investment return do I need to achieve my goal? • Buy new car • Pay for children’s education • Go on holiday, etc Assume goal is to pay deposit on first home Goal Cost Achieve goal in 5 years • By when do I want to achieve my goal? • What is the cost now? • What will it be in 5 years’ time? Timeframe Assume a goal of R200 000 Lump Sum Recurring Combination I only want to make a large upfront investment. I don’t have any savings now, but I can afford to make monthly payments. I have some savings, but I wish to also make monthly payments. i.e. I have R115 000. i.e. I can afford R2 300 p.m. i.e. I have R80 000 and can afford R2 300 p.m. R200 000 R100 000 Now 5yrs4yrs1yr 2yrs 3yrs R0 R200 000 R200 000 R100 000 R100 000 Now Now5yrs 5yrs4yrs 4yrs1yr 1yr2yrs 2yrs3yrs 3yrs R0 R0 Required Investment return 11.4% p.a. Required Investment return 14.8% p.a. Required Investment return 7.3% p.a. To achieve 11.4% p.a. one can invest in a moderate portfolio (40%-60% equities). To achieve 14.8% p.a. one can invest in an aggressive portfolio (90%+ equities). To achieve 7.3% p.a. one can invest in a conservative portfolio (10%-30% equities).
  • 10. 32 COLLECTIVE INSIGHT 29 JANUARY 2015 COLLECTIVE INSIGHT T he investment industry exists to serve asset owners, for whom retirement is an income challenge, not a return challenge. You can’t retire on a good Sharpe Ratio and you can’t eat alpha. And unlike the maximisation of returns, a defined goal in the form of an income target is both achievable and controllable, which makes it much more suitable as an anchor for an investment process. Using goals as a reference point for success would make for some interesting changes compared to a traditional investment process focused on maximising return. What follows is an analysis of four key ideas that will require attention if goals-based investing is to succeed. Investment risk vs savings risk Traditional risk-profiling techniques are still defining risk based on return metrics and not with reference to annuitisation. In a 2014 study on how savers think about risk, the Pensions Institute at CASS business school in the UK found that while traditional risk-profiling questionnaires accurately captured attitudes towards investment risk, they were thoroughly inconsistent in terms of defining clients’ attitudes towards savings risk; clients across the spectrum of Cautious to Adventurous all gave equivalent responses to questions on savings risk. Is it prudent to suggest that a client has a high capacity for investment risk-taking if they are not willing or able to accept a large shortfall of their retirement goals? The study also found a significant amount of “reckless conservatism”: only 12% of savers disagreed that missing their savings goals was more acceptable than taking investment risk. If we define risk as the likelihood of falling short of that income replacement target, then it follows that risk attitudes should be determined by a client’s flexibility on the magnitude of shortfall. Control and accountability Asset owners delegate to advisers who delegate to fund managers who ultimately leave the capital with company management. With this level of intermediation it is impossible for the ultimate asset owner to attribute accountability on a returns basis. Emphasising outcome-based selection criteria such as “the number of previous clients an adviser has helped achieved their goals” is a more relevant measure of investment success. Compensation on this basis will also better align interests in terms of reducing costs and incentivise asset retention over asset gathering for fiduciaries. For the large majority of savers, the most significant factors determining investment success are their savings rate, how long they work until retirement and their future retirement spending − all of which are normally within a client’s control. This will shift the emphasis of accountability for reaching their goals onto their own actions, avoiding over- reliance on investment returns and reducing unnecessary emotional pain from having unrealistic expectations of financial markets. Saving more has the direct consequence of increasing your investment pot, whereas taking more investment risk by no means guarantees higher returns. Short-termism Wealth accumulation is a multi- year and often multi-decade process. Basing decision-making on a long-term goal can remove the unwanted side effects of investor short-termism. While it is not a secret that the majority of active mutual funds underperform their benchmarks, the annual DALBAR study* has estimated that end investors compounded underperformance through attempting to time entry and exit into the mutual funds: from 1984-2013, the average investor in US equity funds annualised 3.69%vs 11.11% for the SP, a “behaviour gap” of almost 8%per annum. This is particularly significant as the knock- on effects of investor behaviour on the whole economy can be profound. A longer- term focus from asset owners filters through to the behaviour of asset management companies, with less manager turnover and less style drift due to immediate concerns over outflows. In turn, a less transient shareholder base in companies relieves the pressure for corporate short termism at the management level − an NBER survey in 2004 found the majority of corporate management would not proceed with a profitable long-term project if it meant missing consensus earnings forecasts for the quarter! More earnings accretive investments would ultimately lead to better long-term returns for shareholders. Aligning assets with their owners Gallo Images/Thinkstock
  • 11. COLLECTIVE INSIGHT COLLECTIVE INSIGHT 29 JANUARY 2015 33 Subjective objectives Modern portfolio theory and efficient frontiers are extremely impersonal (I have yet to come across any wealth manager who finds it practical to quantify each client’s utility into indifference curves). This is where many off-the-shelf solutions such as target date funds or ‘glidepath’ strategies are also not fit for purpose. If you start with high-equity allocations and simply shift to bonds as you age, you will miss out the bulk of potential returns for long-term clients by having investment risk too low when they have the largest amount invested (closer to retirement), thus over a client’s lifetime the majority of their assets are invested at too low a risk. Traditional glidepaths also fail to take into account the personal nature of cash flows. The biggest asset on a young investor’s balance sheet is the deferred income of their human capital. For the majority of young professionals, their salary shares similar characteristics to an equity: inflation-linked, vulnerable to a recession, uncertain over the long term. If the majority of the individual’s investment portfolio is also in equities, then tail events such as financial crises and the ensuing unemployment would create the need to cash in savings to substitute for lost salary, a forced liquidity event that ends up with the investor selling out of equities at a cyclical low point. The traditional reasoning that young investors have more ‘time to recover’ does not take into account these idiosyncrasies in client circumstances and targeting higher volatility in a bid to maximise return would not help this young client meet their objective. Minimising shortfall risk for this type of young investor would instead suggest allocating to assets less correlated to equities initially and increasing equity exposure to replace the deferred asset of their human capital as it converts to cash over time – another example of how a goals-based approach better aligns a portfolio to its owner’s needs. Ainsley To Analyst, Credo Capital To is an analyst for the multi- asset team at Credo Capital, under taking cross-asset research in asset allocation as well as fund selection. Prior to Credo, he also worked at Stamford Associates, Fidelity and Bloomberg. To has been a CFA charterholder since 2014. Each investor has their own savings desires and future consumption needs – thus assets under management (AuM) should not be thought of as a total dollar amount but as a collection of the individual goals of every saver underlying those assets. Today the over specialisation at every level of financial intermediation has created a wedge of multiple, divergent incentives between asset owners and their savings. Removing these layers of agency problems requires a structure which aligns managers of capital with the asset owner’s ultimate goal – incentives need to be personalised. Compensation based on achievement of client-specific goals (net of fees), including claw-back clauses would provide a much closer alignment of interests than flat management fees. Demand from end-clients for accountability based specifically on reaching their own goals will remove the current ‘heads, I win; tails, you lose’ dynamic of incentives within investment management, and the rest will follow. “Never, ever, think about something else when you should be thinking about the power of incentives.” – Charlie Munger ■ *DALBAR’s 20th Annual Quantitative Analysis of Investor Behaviour 2014. Conclusion “ “ Emphasising outcome-based selection criteria such as ‘the number of previous clients an adviser has helped achieve their goals’ is a more relevant measure of investment success.
  • 12. W hy do we all fall down?” Recently, one of us was asked this question by a four-year-old child after the umpteenth performance of ‘Ring a ring a rosies’. Children have an ability to ask excellent questions that we often brush off or simply dismiss. Sometimes we become so accustomed to something that we fail to question why, or have forgotten why, we actually do it. Defined contribution investment strategies To a large extent, this is the case with the typical investment strategies utilised in defined contribution (DC) schemes. We are constantly presented with ‘evolutions’ to strategies that have been around for many years, but do we ever take a step back to question their overall appropriateness? The cornerstone of most DC strategies is a focus on how we can maximise accumulated savings (or reduce their variability). Sometimes we need to be reminded that the primary concern of the DC fund members is (and always has been) whether they will have sufficient income in retirement to live comfortably. A good retirement is measured by the standard of living you want in retirement; a standard of living is not defined by a pot of money, but a stream of income. The savings needed when you retire is the amount needed to sustain the standard of living which you have become used to enjoying in the latter part of your working life. That is an income goal; it’s not a wealth goal. While National Treasury discussion 34 COLLECTIVE INSIGHT 29 JANUARY 2015 COLLECTIVE INSIGHT “ Why do we all fall down? papers, and consulting approaches, may make references to concepts like a replacement-ratio objective (a measure that expresses income in retirement as a proportion of a member’s salary), the actual investment strategies conceived do not in fact focus on them (other than the initial mention). Investment statements that members receive focus on return and volatility. These in turn drive investor behaviour. They are not measured in terms of the members’ investment goals or the likelihood of meeting them. Members should not be focusing on how many rands they have in their account, but how many ‘income units’ they have. Life-stage investing The most popular investment strategy is a life-stage approach to investing. Simply put, younger members are invested in more aggressive portfolios targeting higher returns (i.e. portfolios with more equity) and are phased down to more conservative portfolios (i.e. portfolios with more cash and fixed income) as they approach retirement. At no point is the member’s personal circumstances catered for. The only member-specific information used is their expected time until they retire. The entire framework is essentially predicated on an assumption that investors become more conservative as they approach retirement and wish to reduce the volatility of their fund credit. When you consider behavioural motivations, it is not hard to understand why such an investment approach has found favour. Goals-based investing Our thinking should evolve to consider the obligations or goals of the individual member and design an appropriate investment approach that targets these. Gallo Images/Thinkstock
  • 14. 36 COLLECTIVE INSIGHT 29 JANUARY 2015 COLLECTIVE INSIGHT Rather than regarding the member’s fund credit as the liability, we should be measuring the liability as the cost of securing an appropriate inflation- linked income stream for the member at retirement. This is analogous to the traditional defined benefit plans where the member was guaranteed an income at retirement based on their salary and tenure with the retirement plan. This change in formulation results in a significantly different investment strategy. Consider the investment strategy that focuses on preserving a fund credit in the year before retirement. While history is not an indication of future performance, we consider how two different investment strategies would have fared for a member if the past five years of investment returns are used as a proxy. The benefits of a more conservative cash-based strategy are apparent if your objective is to preserve the accumulated savings. But if we consider the reality that the retirement savings are intended to be used to provide an ongoing inflation- linked income stream, the results are very different. The graph reflects that inflation-linked bonds are now the optimal investment for anindividualwishingtosecureagivenlevel of income in retirement. This is because annuity prices are driven by changes in interest rates. The cash investment is a very poor choice of investment. Of course, investments are never simple and we need to consider whether the individual might need to actually increase their equity exposure to provide the maximum likelihood of affording a reasonable income benefit, or reflect the reality that a member may make use of the tax-free withdrawal of some of the savings at retirement. This can easily be incorporated into a framework reflecting meaningful goals. So what should members of a defined contribution plan be invested in? The investment strategy should optimally allocate the member’s assets to a mixture of risky assets (such as equities) and risk-free assets (which is not cash!). The allocation Shaun Levitan COO, Colourfield Liability Solutions Shaun Levitan is the Chief Operating Officer of Colourfield Liability Solutions, a business that is exclusively dedicated to delivering liability- driven investment solutions. Robert C Merton DistinguisHEd Professor of Finance, MIT SLOAN SCHOOL OF MANAGEMENT Robert C. Merton is also Professor Emeritus at Harvard University and was awarded a Nobel Prize in Economic Sciences in 1997 for his work on derivatives. Conclusion It’s convenient and tempting to dismiss a four year old’s question about ’ring a rosie’ by saying it’s just a silly nursery rhyme and we shouldn’t pay too much attention to the words. The reality, though, is that it describes the Black Plague in England centuries ago, with the final verse of “we all fall down” referring to the inevitable death due to the disease. Conversely, it is also tempting for a retirement fund member to assume that his/her default DC fund investment strategy is well thought out (when closer analysis in many instances suggests otherwise). By identifying meaningful goals and asking the right questions, we can help prevent our members from all falling down. ■ SOURCE: Colourfield Liability Solutions to each should change over time so as to maximise the likelihood of achieving the investment goal. The devil remains in the details, but the key differences to current frameworks are that risk is defined as the possibility of not achieving the required retirement income, and the risk-free asset is defined with reference to a deferred inflation-linked annuity. Cash Inflation-linked bonds Change in value of Fund Credit 5% 0% -5% Jan10 May11 Mar10 Jul11 May10 Sep11 Jul10 Nov11 Sep10 Jan12 May13 Sep12 Jan14 Nov10 Mar12 Jul13 Nov12 Mar14 Jan11 May12 Sep13 Jan13 May14 Sep14 Mar11 Jul12 Nov13 Mar13 Jul14 Nov14 Change in value relative to annuity price movements 5% 0% -5% Jan10 May11 Mar10 Jul11 May10 Sep11 Jul10 Nov11 Sep10 Jan12 May13 Sep12 Jan14 Nov10 Mar12 Jul13 Nov12 Mar14 Jan11 May12 Sep13 Jan13 May14 Sep14 Mar11 Jul12 Nov13 Mar13 Jul14 Nov14
  • 15. COLLECTIVE INSIGHT COLLECTIVE INSIGHT 29 JANUARY 2015 37 I have been involved with building and implementing investment strategies for various clients for over a decade now. Some of these clients are investors with a long-term focus like pension schemes and life insurers, while others are investors with a short-term focus like general insurers and trusts. All of them have investment goals that they would like to achieve. For example, the pension scheme would like to see its members retire with the lifestyle they expected, while the insurer would like to be commercial while putting shareholder capital to work. Therefore, when it comes to building investment strategies, these goals form the foundation on which the strategy is built and its success measured. This brings me to goals-based investing. The phrase might be new, but the concept is not. It has been around for a number of years in the pension world in the form of liability-driven investment or LDI. I recall attending the first conference on LDI hosted in Amsterdam in 2004, where Dutch and Nordic pension funds spoke about how they apply LDI principles within the goals set by their regulatory framework which is essentially a solvency framework for pension funds. In LDI the investment goal is defined by the financial liability created by the fund rules of a defined benefit (DB) pension scheme and the ability of the assets to cover that liability or expectations through the funding level. Unlike South Africa, most pension schemes in the rest of the world are still DB schemes and LDI has remained the exclusive tool used to set investment strategy, especially after the global financial crisis that sent funding levels tumbling. Many schemes in Europe are now attempting to achieve funded status over a set time horizon on trajectories referred to as their ‘flight path’ where the scheme, for example, wants to be 90% funded in two years’ time with 90% probability, 95% funded in three years’ time with 80% probability, etc. Even though LDI was originally developed around DB scheme liabilities, over the years the concept of LDI in SA has been generalised for other types of clients like DC schemes, insurers and trusts, building investment strategies around these types of client goals. For example, a defined contribution (DC) scheme may not strictly have a liability determined by the its fund rules, but there is an expectation by the member about the type of retirement product they want to buy. It means that every member in a DC scheme is, in essence, running their own DB scheme, as expressed in their targeted replacement ratio. Another example is where an insurance client wanted their return on capital to exceed the cost of capital by some margin 75% of the time over a one-year period. These are all examples of generalised LDI or goals-based investing approaches. But have LDI and the broader goals-based investment strategies worked for investors and what message is there for investors interested in goals-based investing? To answer these questions, we need to draw an analogy with another kind of strategy: corporate strategy setting. The parallels between setting noticeable corporate strategy and setting investment strategy are very noticeable. How smart is your investment strategy? But have LDI and the broader goals-based investment strategies worked for investors and what message is there for investors interested in goals- based investing? GalloImages/Thinkstock
  • 16. COLLECTIVE INSIGHT 38 COLLECTIVE INSIGHT 29 JANUARY 2015 A goals-based investment approach continuing on the corporate strategy analogy, I would summarise my message to investors who already implemented or who are thinking of implementing a goals-based investment approach in the following three points: 1. Think like a CEO about your investments. What is your vision for your investments? What do you want your investments to achieve? A DB scheme wants to pay liabilities as and when they fall due. A DC scheme wants to provide the retirement to members that they expect. An insurer wants to maximise return on shareholder capital in order to be commercially competitive. Once you have established what this vision for your investments is, make sure that your service providers also understand and buy into your vision. This will ensure alignment of interest between all parties. 2. Make sure your investment goals are SMART, meaning specific, measurable, attainable, relevant and time-bound. Too many times an investor is too fuzzy about their goals and this leads to confusion and expectation gaps when investment strategies get built, implemented and monitored. A client once defined their investment goals saying that they want their return on their capital to exceed the cost of their capital by at least 2% with a 75% probability over a one-year period. That statement was so powerful, yet so clear, that I had tears in my eyes. 3. You can’t manage what you can’t measure. To manage your progress in realising your vision you need to measure on an ongoing basis whether you are achieving the goals you set. Think of it as keeping an eye on your satnav: you don’t want to find out too late that you should have turned left instead of right, it wastes valuable time and opportunity and you could quickly end up in the dodgy part of town. Measuring your investment performance is obviously important, but don’t forget to also check on how you are measuring up to the goals you set. ■ Petri Greeff Head of Research and Strategy, Riscura Greeff is responsible for safeguarding academic rigour throughout RisCura’s research processes, challenging existing investment industry wisdom and promoting critical thinking throughout the business. His approach is to dig deep into scientific and financial theory, examine problems from different angles and take an academic standpoint on investment challenges and asset/liability positions. Now let’s apply the company strategy analogy to say a DC pension scheme. As a board of trustees your vision is to keep pensioners from eating cold baked beans one day and therefore, one of your goals is to deliver at least a targeted replacement ratio of 75% for those members that have 40 years of membership in the fund. Your measure of success would be how many members retire with an actual replacement ratio of 75% or more. At year-end, you pull the statistics and see that 90% of retiring members had a replacement ratio of 75% or more. Were you successful in achieving your goal based on your vision? Yes. Were you successful in beating your peers’ performance numbers? Perhaps not. But does it matter? No two pension schemes are exactly the same. What is more important is that as a board you have a vision and that you have put down tangible goals to measure your progression against as you move towards realising your vision for the scheme. This same analogy could also be applied to any other type of investor, whether you are an insurer, a trust or even an individual. Applying the pension fund analogy Your measure of success would be how many members retire with an actual replacement ratio of 75%or more. APPLYING THE CEO STRATEGY You measure your success in applying a corporate strategy in terms of how well you achieved the goals that were set and met based on your vision statement over a period. For example, you are the CEO of a company that sells thingamajigs and your vision is to be the number one online retailer of these thingamajigs. Textbook company strategy would tell you to set goals in line with this vision. For example, one of your goals could be to double your online sales of thingamajigs by the end of the year. Year-end comes and your online sales have trebled. Were you successful in achieving your goal based on your vision? Yes, definitely. Were you successful in beating your competitor’s profit numbers? Perhaps not. But does it matter? No two companies are exactly the same and comparable on an apples-for-apples basis. What is more important is that as CEO you have set yourself a vision and you have put down tangible goals that you could measure your progression against as you move towards realising your vision. This is ultimately your guiding principle.
  • 18. This time it’s personal A sset management can be particularly powerful. Give an asset manager a target, a time frame and the degree of certainty required of meeting that target, and the fund manager can generally deliver a reasonable outcome. Turn that requirement into a performance race – i.e. demand that the fund manager outperform their competitors in perpetuity – and outcomes become decidedly more random. Bottom line: as an investment strategy, a goals-based framework has a much higher probability of fulfilling client needs than a performance-based framework. So, the question we need to address is: if goals-based investing is so powerful in re-enforcing all the right behaviours, and so effective in terms of rebuilding a critical level of trust and customer- centricity, why are we still locked in a never-ending performance race? Over the last 15 years, goals-based investing periodically appeared on our doorstep and then, ever so quietly, slinked off as the enthusiasm for it waned. The two most notable time periods occurred in the wake of the financial crises of that period: post the 2002/03 market collapse and the global financial crisis of 2008. Today, it is creeping back into our vocabulary again as a much more realistic investment model to address investor needs, but unless we understand what impediments the industry faces in adapting a goals- based framework, it will remain a concept only. How did we get here in the first place? ‘Goals-based investing’ bears a striking resemblance to the type of trust fund management practices employed by COLLECTIVE INSIGHT 40 COLLECTIVE INSIGHT 29 JANUARY 2015 wealthy families from the 1950s to the 1970s. Trust fund companies saw their fiduciary responsibility from a goals- based perspective. Typically, the two goals they would try to address would be how to provide the dependent with their basic day-to-day income requirements and then how to structure the residual funds to maximise the wealth transfer to the next generation. The key point is that, to meet these very different goals, two very different portfolios were structured – the first portfolio used an optimal fixed-income blend to match the dependent’s cash flow requirements. The second portfolio used higher risk growth assets that reflected the specific investment interests or risk appetite of the family or individual. But by the end of 1970s, the global stage would be set for a very different investor. Investing would no longer remain the prerogative of the wealthy. Four factors were instrumental in effecting this change: 1. Stronger regulatory protections for mutual funds (unit trusts) meant that these investment vehicles could provide safe, cost-effective vehicles for smaller investors wishing to access the markets. 2. The stagflation of the 1970s threw into question the viability of the conservative, liability-driven investment strategies that were the hallmark of trust companies. The search for yield was on, and that meant venturing out of conventional investment comfort zones, with the emphasis shifting to equities and international investments. 3. Fuelling the growth of this emerging industry was a massive marketing campaign. Financial services companies GalloImages/Thinkstock
  • 19. Anne Cabot-Alletzhauser Head of the Alexander Forbes Research Institute Cabot-Alletzhauser heads up the Alexander Forbes Research Institute – an initiative that looks at the full spectrum of issues that confront the savings and investment sector for South Africa in particular and Africa in general. Prior to that, she was an asset manager and CIO for 32 years, managing pension fund assets in North America, Japan, the UK, Europe and South Africa. In 1994, Cabot-Alletzhauser pioneered the development of the multi-manager management approach of pension fund management that has become the hallmark of that industry today. COLLECTIVE INSIGHT COLLECTIVE INSIGHT 29 JANUARY 2015 41 began to organise their distribution models around selling clients products (unit trusts), and not just investment ideas. 4. Finally, with the emergence of 401k plans in the US in 1980, responsibility for developing an effective investment strategy to meet retirement funding now fell on the shoulders of the guy on the street. The democratisation of the investment markets had become a reality – but how well equipped was the industry to meet the challenge? To service an exponentially expanding market, the industry needed to be able to commoditise solutions and simplify answers. While unit trusts provided a way to commoditise the investment strategy, tailoring solutions to meet a specific client requirement couldn’t be commoditised. Technology simply hadn’t evolved to that level at that point. How then should investors select their investment strategies? Performance comparisons proved to be the simplest to sell and the easiest to comprehend. This also simplified both the performance reporting message and the advisory message. Essentially, the shift away from a goals-based model owes much to the technological limitations that made it unfeasible to provide customised solutions to a massively expanded consumer base. A further complication was that the unitisation framework employed by a unit trust made it next to impossible to provide any form of cash flow matching or liability driven type of solution to this broad mass of investors. Finally, asset classes themselves were limited in scope. Inflation-linked bonds, for example, don’t really become viable, liquid investments until the early 2000s. This meant that the only means asset managers had to address such challenges as keeping pace with cost of living increases, or the cost of future annuitisation would be to increase the fund’s exposure to higher risk/ higher return assets such as equities or international assets and hope this would build up an adequate cushion. Today, all of those impediments have been overcome. Technology and asset strategy breadth have evolved to the point where we can offer cost-effective solutions that both dynamically assess an individual’s asset/liability shifts and then create the right investment mix to meet those funding goals over the required timeframe. But while the way is now there, we, as an industry, still need to deal with the will. In truth, perhaps the ultimate culprit to why the goals-based concept failed after the two post-crash attempts was the fact that both crashes were followed by massive rallies. Why bother changing out of a good thing (or at least a highly profitable one – for the industry), if the performance game is working? In this sense, the consumer was as guilty for opting for the hope-the-manager-wins option as the service provider was. So, therein lays the challenge. Effectively, the asset management business model needs a complete overhaul if goals-based investing is ever to take hold. And if the consumer is actually the one we care about here, it must come right. What needs to happen? ■ The advisory and asset management framework must change in tandem. It’s not enough to ask clients what their investment goals are and then simply shoe-horn their assets into performance-based unit trusts, hoping these strategies just might deliver what’s required. The investment vehicles themselves must change so that targets have a higher probability of being met. ■ The regulatory environment needs to support these types of solutions and not confound their delivery. While Treating Customers Fairly (TCF) rightly requires us to put clients’ requirements first (and ensure that investments are appropriate), regulations that restrict essential asset class exposures, or require risk questionnaires or performance reporting that do not reference a goals-based approach, can be hugely problematic. ■ Performance measurement needs to change dramatically. Technological innovations mean that we can cost-effectively provide even the smallest investor with some notion as to whether they are meeting their investment goals and, if not, what types of interventions could take place to get them on track. The place and time for an effective ‘robo-adviser’ solution has most decidedly come. ■ Overall, members of the industry need to rethink how they are helping their clients by setting the right expectations and then continuously managing to those expectations. When all is said and done, hope is not an investment strategy. While top performance is simply not attainable on a sustainable basis, meeting a specific goal should be. Let’s get our clients to where they need to go! ■