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Retirement Investing - September 26, 2016

Thoughts and Afterthoughts on the JOIM-Oxford-EDHEC Retirement Investing Conference

Lionel Martellini, Professor of Finance, EDHEC Business School, Director, EDHEC Risk Institute

Lionel Martellini, Gifford Fong & Tim Jenkinson

A few weeks after the JOIM-Oxford-EDHEC Retirement Investing Conference took place at the Saïd Business School, University of Oxford on 11, 12 and 13 September 2016, I would like to reflect upon some of the many insightful discussions that took place on that occasion, and share some thoughts and afterthoughts with you about the event.

From the collective opinion of all parties involved, participants and speakers alike, the conference was a great success with over 70 professionals in attendance, including individuals from investment and wealth management companies, banks, institutional investors and academics. Our mandate was to feature the best of the current state-of-the-art, which has an immediate as well as a future impact on the practice of retirement investing. The remarkable level of engagement from all participants, which was facilitated by the format of the conference, made it uniquely enjoyable and instructive for all.

The conference started on a high note with a String Quintet concert performed by the Arch Sinfonia, an ensemble created by Chloë van Soerterstede, and supported by ERI Scientific Beta since its debuts in 2012. This wonderful concert by five young and talented musicians was followed by dinner and a keynote speech by Bob Merton from MIT, Nobel Prize winner in economics for his work on option pricing theory. In his typical inspiring and enthusiastic style, Bob talked about the potential to significantly improve income benefits from retirees’ assets by using life annuities and reverse mortgages. The focus of the discussions was on creating an efficient design structure that works effectively across geopolitical borders, which included marketing of the products and providing large and reliable funding sources for them. The Q&A session with participants extended long into the evening, after the formal session was over, with Bob gracefully taking the time to answer all of the questions raised by the audience.

The main conference started on the 12th with a panel discussion on new developments in retirement investing, moderated by Liam Kennedy (Editor-In-Chief of Investment & Pensions Europe), Mark Fawcett (CIO of NEST Corporation), Bob Merton (from MIT) and myself as panellists.

Liam opened the floor with a synopsis of the regulatory retirement landscape in the UK and beyond, as well as the challenges posed to defined benefit (DB) and defined contribution (DC) pension plans throughout the world by a combination of exceedingly low rate levels, structural underfunding and growing concern about the diminishing size of risk premia in the years ahead.

Mark Fawcett followed with an analysis of the retirement challenge from the DC perspective. He emphasised that the move from DB to DC implies that investment risk and longevity risk are shifted from sponsors to individuals. While individuals may or may not have the capacity to bear those risks, they certainly are not equipped to manage those risks, suggesting that our industry needs to continue the move from individualised DC to institutional DC, where many, if not all aspects, of the accumulation and decumulation phases are professionally managed, allowing members to benefit from economies of scale, incorporation of the latest investment technology and helping people avoid the mistakes caused by our behavioural biases. He then moved on to describe his view of what the institutionalised model looks like for the mass market, with a focus on default funds, which alleviates the need for mass market education and engagement, with operations designed to reduce frictional costs for the benefits of the plan members.

Bob Merton followed with his academic perspective on the retirement investing challenge. He emphasised that with DB and all other forms of retirement systems except DC, the expressed goal of the outcomes for a good retirement is a standard of living represented by a stream of income, protected against inflation. However, during the accumulation period in DC, the information provided to members by regulation and provider practice is focused on the value of the accumulation and not the stream of income it can provide. Bob pointed out that this is fundamentally the wrong measure of progress for the member in that it provides the wrong description of what the risk-free asset for DC is and therefore, what the risky assets for DC are. In particular, focusing on the volatility of the value of the accumulation, instead of the income that can be bought in retirement, leads to a de facto definition of the risk-free asset as a short-maturity government bond. Given the global evolution of interest rates over the last 9 years to date, it is becoming painfully clear that wealth accumulation is not an adequate representation for retirement income accumulation. He pointed out that DC must develop standardised means for measuring the price of the risk-free asset and make this the primary number reported to members for determining risk suitability, on the premise that if we measure risk incorrectly, we cannot possibly manage it well.

I had the privilege to follow Bob Merton and I chose to emphasise how the modern (and academically grounded) retirement investment paradigm that is slowly but surely emerging allows for a striking and enlightening comparison between the DB and DC contexts. I described the commonalities as follows. In both cases, asset owners (pension funds or individuals) need dedicated investment solutions, as opposed to off-the-shelf products. The proper paradigm for framing these investment solutions is the Liability-Driven Investing (LDI) paradigm in DB, which admits an exact counterpart, the Goal-Based Investing (GBI) Paradigm in DC. In both cases, success and failure is measured in terms of assets relative to liabilities (known as the funding ratio in DB or the funded ratio in DC). Similarly, and as emphasised by Bob, the risk-free asset in both cases is not T-Bills, but a dedicated liability-hedging portfolio (LHP) in DB or, equivalently, a dedicated retirement goal-hedging portfolio (GHP) in DC. Finally, constraints and objectives can be defined as minimum/target funding ratio levels in DB or, equivalently, essential/aspirational retirement goals (expressed in terms of funded ratio levels or in terms of replacement income levels) in DC.

Overall, the main takeaway point from the panel discussion was perhaps that the massive transfer of risks from states and corporations to individuals, which has taken place over the last 10 to 20 years in the most developed countries, ultimately implies a historical responsibility for the investment industry to provide individuals with cost-efficient DB type pay-offs in DC-type environments. These pay-offs can be best thought of as non-linear pay-offs designed to generate reasonably good probabilities of achieving target levels of (inflation-linked, or at least cost-of-living-adjusted) replacement income, subject to securing minimum levels of replacement income, and also of course subject to budget constraints.

The panel discussion was followed by a series of academic presentations, with a formal discussion often led by a practitioner and a Q&A session to conclude. I gave the first presentation of the day, entitled Customisation versus Mass Production in Retirement Investment Management: Addressing a “Tough Engineering Problem”. In that presentation, I emphasised that while many off-the-shelf retirement products are currently produced on a large scale, the challenge for the investment management industry is to offer scalable forms of dedicated retirement solutions. The presentation was focused on showing how suitable financial engineering techniques can be used foster efficient mass-customisation in retirement investment management. I also stressed that we are currently at the confluence of historically powerful forces, and that we have reasons to believe our industry is finally about to experience a true industrial revolution, involving (1) mass production, which can be achieved with smart factor indices, for an efficient harvesting of risk premia across and within asset classes, (2) mass-customisation, which can be achieved, as shown in my presentation, with one or two fund(s) per age group, to be re-launched on average 4-5 times over 20 years, as well as (3) mass-distribution, which can be achieved with the emergence of digital tools for facilitating the dialogue with individuals on retirement solutions.

In the afternoon, Marty Leibowitz from Morgan Stanley, gave a talk entitled Funding Ratio Flaws. In this talk, he demonstrated that the pension community has come to rely on the “Funding Ratio” (the ratio of Assets to Liabilities) as a guide to the health of DB plans. However, he argued that this metric is vulnerable to a number of basic misconceptions. At the outset, liabilities are typically discounted by a rate that represents something less than a full risk-free defeasance of the projected benefit payments. Rather removed from this problem, an even more serious issue is that the funding ratio itself is not subject to any reserving or downward adjustment for the riskiness of the stated (or allocation-implied) investment strategy. Marty went on to describe the problems that can result from these misspecifications and indicated various approaches for developing improved metrics.

The last talk of the day was from Deborah Lucas, from MIT, who presented a paper entitled Hacking Reverse Mortgages. As explained by Bob Merton in his keynote address, reverse mortgages hold the promise of unlocking home equity to help meet retirees’ spending needs while allowing them to age in place. Despite the product’s potential as a significant source of liquidity and insurance, however, the reverse mortgage market has been slow to take off. In the U.S., the HECM — a product designed and administered by the federal government — dominates the market. Deborah has developed a valuation model for HECMs and used it to suggest an answer to the reverse mortgage puzzle: why is it that a seemingly useful and subsidised product is so unpopular? The analysis suggests a financial explanation may be an important component of the answer: the loans are expensive for borrowers. There is a government subsidy, but the benefits are largely captured by the guaranteed private lenders. She concluded her presentation with a discussion about some structural changes to the programme that could lower cost and improve the product’s functionality and appeal.

On the morning of 13 September, Magnus Dahlquist from the Stockholm School of Economics gave a talk entitled On the Asset Allocation of a Default Pension Fund. This talk focused on the optimal default fund in a DC pension plan. It began by analysing detailed data on individuals and their holdings inside and outside the pension system, and reported evidence of substantial heterogeneity among default investors in terms of labour income, financial wealth, and stock market participation. Magnus then presented a life-cycle consumption-savings model incorporating a DC pension account and realistic investor heterogeneity. Finally, he considered the optimal asset allocation for different realised equity returns and investors, and compared it with age-based investing. The main finding was that the optimal asset allocation leads to less inequality in pensions while it moderates the risks through active rebalancing.

This presentation was followed by a talk from Tim Jenkinson from the Saïd Business School, who presented a paper entitled Ask a Consultant? The Role of Investment Consultants in Pension Fund Governance. Investment consultants wield significant influence when it comes to the asset allocation decisions of pension fund trustees. Yet they also face conflicts of interest, and these are becoming more acute as investment consultancies offer asset management solutions via “fiduciary management”. This talk discussed the complex yet critical role that investment consultants play in institutional asset management, whether financial regulators should focus more attention on their activities, and shed light on recent research about whether investment consultants add value for pension funds.

After lunch, Mark Kritzman from Windham Capital gave a thought-provoking talk entitled Errors. The focus of this presentation was to describe the sources of estimation error in portfolio construction, including small-sample error, independent-sample error, mapping error, and interval error. Mark then introduced a non-parametric procedure for incorporating the relative stability of covariances into the portfolio formation process, and presented evidence that this procedure yields more stable portfolios than approaches that ignore errors or that rely on Bayesian shrinkage. The presentation was followed by an insightful discussion by Sanjiv Das from Santa Clara University, who took the time to code the procedure proposed by Mark, and reproduce some of the main results.

Finally, the last presentation of the day and of the conference was made by Elroy Dimson from London Business School. Elroy gave a highly entertaining and interesting presentation entitled Does Hiking Damage Your Wealth? He reported on an analysis of over a century of daily US returns together with 85 years of UK data to examine the immediate effect of rate hikes and cuts on stock and bond markets. He also looked globally at the impact of interest rate changes on equity and bond returns using annual data for 21 countries from 1900 to 2015. Using a trading strategy that avoids look-ahead bias, he compared returns over entire interest rate hiking and easing cycles for equities, bonds, bills, currencies, and risk premia. He finally analysed long-term returns from industry sectors and factors such as size, value, carry and momentum, and also studied real asset returns since 1900 on precious metals, collectibles and real estate. The main finding of the presentation was that in all cases, hiking cycles damage investor wealth compared to easing cycles.

On a personal note, I should perhaps conclude this account of an exciting two days filled with highly relevant discussions about retirement investing by touching on everything else that made this conference a unique experience. I would like in particular to allude to the ever magical atmosphere of Oxford, which is so conductive to in-depth thinking and knowledge dissemination. I would also like to mention the many valuable and privileged moments I was able to share with Bob Merton, including passionate discussions until 2:00 am in the halls of our hotel, as well as the many quality exchanges with Sanjiv Das, Elroy Dimson, Gifford Fong, Tim Jenkinson, Marty Leibowitz, Deborah Lucas, and others, about a range of highly interesting topics ranging from continuous-time finance to big mountain skiing! All in all, a very rich experience for each one of us involved.