Edhec-Risk
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Retirement Investment Management - May 31, 2017

Mass Customisation versus Mass Production in Retirement Investment Management

Existing financial products marketed as “retirement investment solutions” do not meet the needs of future retirees, which involve securing their essential goals expressed in terms of minimum levels of replacement income (focus on safety), while generating a relatively high probability of achieving their aspirational goals expressed in terms of target levels of replacement income (focus on performance). Meaningful solutions should therefore combine safety and performance to meet this dual objective.

This recognition is leading to a new investment paradigm, which has been labelled goal-based investing (GBI) in individual money management, where investors’ problems can be fully characterized in terms of their lifetime meaningful goals, just as liability-driven investing (LDI) has become the relevant paradigm in institutional money management, where investors’ problems are broadly summarized in terms of their liabilities.

A theoretical answer to the retirement investment problem is a dynamic goal-based investing strategy that maximizes the probability of reaching a target level of income (aspirational goal) while securing a minimum (essential goal). In practice, this strategy is hardly implementable, especially if full customisation is not possible.

Now, the effective challenge is mass customisation (as in customised investment solutions), which by definition is a manufacturing and distribution technique that combines the flexibility and personalisation of “custommade” solutions with the low unit costs associated with mass production. In other words, the challenge is indeed to find a way to provide a large number of individual investors with meaningful dedicated investment solutions.

The main contribution of this paper is to show that financial engineering can be used to address the “tough engineering problems” posed by the scalability requirements. Indeed, it is hardly feasible to launch a customised dynamic allocation strategy for each investor, and the challenge is to address the needs of a large number of investors through a limited number of funds. To this end, the authors extend portfolio insurance and dynamic core-satellite techniques to the retirement investing context. The solutions make use of a goal-hedging portfolio, which is intended to replicate the value of a deferred annuity, and a performance-seeking portfolio, the objective of which is to efficiently harvest risk premia in order to deliver long-term performance. The allocation to these two building blocks is a function of the risk budget, defined as the difference between the current portfolio value and a suitably chosen floor.

In this study, the authors demonstrate that it is possible to construct strategies scalable with respect to entry point levels, contribution levels and aspirational goals, which vary greatly across investors.

The authors also show that mass-customised retirement solutions perform better than traditional balanced or target-date funds in reaching investor’s goals and have an acceptably low opportunity cost with respect to their fully customised counterparts.

Dynamic goal-based investing principles can be used to design a parsimonious set of retirement investment strategies which meet the needs of individual investors preparing for retirement in that they secure an essential level of replacement income and also have good probabilities of generating much more replacement income than what they would have obtained by investing in annuities, and this is possible in a cost-efficient and reversible format. These goal-based investing principles can be applied to other goals relevant to a large class of investors and households, such as financing their children’s further education.


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