“Are we there yet?” Whether a trip across town or to a vacation destination, parents often try distraction to make a journey less tedious. Counting the number of white SUVs or the number of out-of-province licence plates may buy a few hours of amusement, particularly if a cash bounty is involved.
The investment journey has developed similar distractions. Benchmark-based strategies that dominate retail investing use a mix of indexes and were able to achieve the investor’s goals in the past (e.g., 25% for the S&P/TSX 60, 15% for the S&P 500, 15% for the MSCI EAFE, 45% for the FTSE/TMX Bond Index).
Discussions about under- or overweight exposures to countries, sectors or holdings have ensued. While understanding a portfolio manager’s thinking is important for client confidence, most of this dialogue has little to do with the client’s goal. By emphasizing near-term performance and current events, investors can be easily distracted from their long-term objectives, with hazardous consequences.
Seventy-six percent of the respondents in J.D. Power’s annual advisor satisfaction survey said advisors failed to do all of the following three steps in goals-based investing:
- help establish personal goals;
- implement a strategy to achieve them;
- monitor progress towards them.
Portfolios serve many purposes, but are part of the asset side of a personal balance sheet. Objectives like retirement or college for the kids represent negative cash flows, or liabilities. Over time, getting the two sides balanced is part of an advisor’s responsibility.
Pensions are a good example. To provide replacement income in retirement, a targeted return is established, using assumptions about contribution levels, inflation, mortality and other factors. Then, the advisor establishes an asset mix based largely on historical returns, as described above, and constructs the portfolio. The portfolio is periodically rebalanced to the initial asset mix. Investors wanting to take less risk, even when they have the time horizon to take more, can distort the portfolio they need.
If targets are unattainable, additional lump sums or periodic contributions can keep the portfolio tracking toward its objective. Periodic checks can determine if capital growth is on target, and course corrections can balance the liability of the desired pension stream and the accumulation of portfolio assets. It’s all fairly straightforward. But then, something odd often occurs. Beating the benchmark becomes the advisor’s near-singular focus. Some set a target to exceed the benchmark by a certain percentage (like 2% annually) over a period (often four years), and sometimes on a risk-adjusted basis.
Something has been forgotten in this process. The objective was to provide a pension. For a 30-year-old, that means considering the amount required to replace a percentage of today’s income starting at age 65 and continuing for the rest of her life, or until about age 85. What happens to this amount if interest rates rise? The discounted present value of the pension stream falls with higher rates.
Conversely, if rates fall, the value of the liability stream of pension payouts increases. The best offset to match this kind of liability is bonds, because if rates fall, bond prices rise with the liability; vice versa for rising rates.
A process called liability-driven investing (LDI) suggests choosing assets that will rise and fall with the liability stream. This is why, in the early days of pension plan design, only bonds were used. Today’s historically low interest rates have put tremendous pressure on pension plan solvency. The median solvency ratio of Mercer pension clients in Canada was 82% at the end of Q1 2016 (100% is fully funded) and the Mercer Pension Health Index, representing a hypothetical plan, stood at 90%.
Performance, for clients, is how they are doing relative to their goal. A funded ratio, like Mercer’s above, gives investors a true picture of their progress. The investment industry’s preoccupation with returns and rebalancing to the riskiest portfolio allowed by a client’s KYC loses connection with client goals and may distort asset allocation choices. There is scope to take risks to improve funded ratios, but they should always be considered within the balance between assets and liabilities.
Bringing it back to our roadtrip analogy, counting those SUVs is fine, and perhaps necessary to keep investors and advisors engaged. But doing so should not distract from the real purpose: getting to your destination. For your clients, the investment policy should be about their goals—not just the journey—and what we measure as performance should reflect these objectives.