Global risks, structural market changes and economic events have resulted in a need to design, construct and manage the retirement fund solution very differently for the future.
The first principle of investing says we should invest for the long term. Although the investment market is riddled with uncertainty, certain tried-and-tested principles can help investors boost their chances for long-term success. If your time horizon allows it, a focus on the future with an eye toward long-term investment can increase the likelihood of retiring more comfortably. People tend to live longer than ever before, therefore, the importance of long-term investing becomes even more important.
The problem is that the focus often becomes too short term, risk is not clearly defined or understood, and we get swayed by our emotions, making it an increasingly difficult task to remain invested or stick to a plan that is designed for the longer term. As a result, behavioural biases creep in, leading to irrational decisions.
We have done an enormous amount of research focusing on understanding the detrimental effect that reaction to short-term risk events, regret, the age-old peer-relative focus and a focus on historical returns have on investor decision making and consequently, investment returns.
Short-term irrational decision making and behavioural biases can have a detrimental effect on longer-term return outcomes for an investor in different market conditions. Investors tend to make more irrational decisions during periods of crises as well as during periods when markets do not deliver on the handsome return they perhaps have seen during the past. This behaviour erodes significant value. Our research shows that on average, this behaviour destroys about 1% per year of value.
How do we solve for our inherent biases, and what does this retirement fund for the future look like?
The key is to have a clearly defined objective and a firm understanding from all parties (client, consultant and investment manager) of what the expectations are in terms of investment horizon, risk management focus and the resultant return objective. The client objective should, therefore, be front and centre of the solution.
Where retirement fund members are in their life cycle and journey to retirement defines the objective.
For younger members, the focus is about the accumulation of capital to ultimately increase the purchasing power of a post-retirement income, as opposed to members closer to retirement, where the focus is on preserving the purchasing power of the capital that was built up over the years of retirement fund contributions.
The choice of the post-retirement income solution also plays an essential role in defining what is meant by the term ‘purchasing power’. It is imperative that the advice processes are directly interlinked to the investment proposition to ultimately deliver on the client goal in the most effective way.
An investment strategy or appropriate retirement fund solution can then be designed, constructed and managed in a way to deliver on the overall objective. It is, therefore, vital to understand risk in an appropriate and relevant way because the way we deal with risk depends on how we define risk. Risk should be appropriately defined relative to the holistic objective and client goal.
Risk tolerance is about knowing where the line is drawn between acceptable and unacceptable outcomes. Risk tolerance should ideally reflect an investor’s ability to take risk, and not the willingness to tolerate risk. If willingness is lower than ability, huge opportunity costs may be incurred. Willingness to take risk is often wrongfully driven by emotions, peer pressure and herd behaviour as well as perhaps a misunderstanding of objectives. Risk should be proportional to the outcome required.
With the focus on increasing the purchasing power of a post-retirement income for members in a retirement fund, the investment strategy’s ability to deliver on real returns (returns above inflation) is essential. In an age of inflation, the challenges associated with the management of retirement funds to deliver significant real returns are considerable. For many years, it meant retirement funds were limited to investing primarily in government securities, listed equity and perhaps some additional debt and fixed interest instruments.
Changing market conditions – and the need to maintain a high enough rate of return – have resulted in evolving retirement plan rules to allow investments in most asset classes, including alternative assets and real assets like infrastructure, renewable energy, direct property, and private equity.
These asset classes are not only beneficial from a perspective of diversification and risk management in a holistic and robust multi-asset-class solution, but it also allows exposure to investments that can deliver on yields and returns that are different to the traditional asset classes. This exposure is required to increase the ability of the solution to outperform inflation. These asset classes also allow retirement fund members to invest in companies that support sustainability and to have a real, meaningful effect on the economy from a socially responsible perspective.
The ongoing coronavirus crisis has amplified the growing calls for resilient and adaptable infrastructure that effectively can operate during moments of crisis. Given this significant opportunity, it is imperative that we too look to embark on infrastructure investment programmes that strive to provide infrastructure that is sustainable, technologically advanced and resilient. It is the financially, environmentally and socially responsible thing to do for the world.
Responsible investment practices resonate with our outcome-based investing philosophy, and resonate with the alignment of our clients’ long-term goals to positively influence the world they will retire to – a definite requirement for a retirement fund solution focused on the future.
When designing that solution to deliver on the holistic client goal, all the different asset classes and components of the investment strategy need to be aligned, including the global component.
The global component can be up to a third of the retirement fund solution, and it is not something you can neglect. It is another piece of the same puzzle. We believe that, by following a fully integrated process of co-creation with your global investment provider we make sure the total solution is world class and aligned to deliver on the intended client goal.
The retirement fund for the future is an integrated process but with the client goal as the most important part of the solution.
One size does not always fit all, but cost-effectiveness, sustainability and non-traditional asset classes are all key in a world of lower yields and longevity of retirement fund members.