It is an essential source for cohesive retirement investment strategies based on the accumulation and decumulation of wealth viewed as a continuum. He compares and contrasts his strategies with those of traditional investments used for retirement, such as target date funds, balanced mutual funds and annuities. He suggests launching new forms of retirement investment solutions that better serve the purpose of generating replacement income than existing products with a retirement label.
Enormous challenges in acquiring adequate savings for retirement face almost all working people. Individuals must consider a myriad of variables, from estimating the cost of retirement to assessing how long retirement funding is needed. It is also essential to recognize that public pension systems are inadequate to support the lifestyle that retirees desire and demand.
Lionel Martellini, professor of finance, and Vincent Milhau, research director, both at the EDHEC-Risk Institute in Nice, France, created this accessible guide, which is distinguished by a solid mathematical basis. They define coherent investment strategies, based on risk tolerance and a precise time horizon, which combine the phases of accumulation and decumulation of wealth. Their strategy differs from the quest for the “retirement number” or targeted wealth. Rather, it is based on an investment strategy in accumulation whose objective is to generate a replacement income determined by targeted expenditure, according to the principles of investment based on the objectives.
The authors begin their analysis with a discussion of pension systems, focusing on the United States, the United Kingdom and France. They break down the systems into three pillars:
- The universal core of pension coverage, which meets basic consumption needs in retirement (the social security system).
- Public or private occupational pension plans that require compulsory membership (defined benefit plans).
- Voluntary plans, such as defined contribution plans
Each pillar is associated with a number of positives and negatives that set the stage for the authors to launch their strategies. They take into account the burden that an aging population will place on social security, the underfunding of defined benefit pension plans and the possibility that people will go bankrupt in retirement if their savings are insufficient. Finally, the possibility of surviving its well-planned economies also exists.
The authors acknowledge the abundance of traditional investment solutions for funding retirement (eg, target date funds, mutual funds with many defined investment objectives and risk parameters, and annuities). They then raise many questions when examining these vehicles, such as the insufficiency of retirement income, in the case of target date funds and mutual funds, and the rigidity of the structure and the costs associated with annuities. Retirement investing is further complicated by the persistence of low or non-positive interest rates globally. Market volatility at retirement is another challenge. Spending only interest, a specified percentage of principal, or a combination of interest and a pre-determined percentage of principal proves to be a weak course of action, based on varying interest rates and principal values. What should an investor do?
A differentiator of Martellini and Milhau’s strategy is the introduction of the retirement bond. What is a retirement bond? It is a liquid asset that can be replicated using bonds and other interest rate products and generates cash flow over the stated retirement period. A simple way to look at the retirement bond option is to look at the phases of a person’s life—for example, 20 years of saving for retirement and 20 years of spending during retirement. The pension obligation is an essential part of a true long-term investment strategy — 40 years, in this case — that includes a performance-oriented portfolio. It is becoming a building block for new forms of balanced funds and target date funds.
Unlike a regular bond, a retirement bond has a deferred start date for interest payments. It has no principal payment at maturity as it spreads interest payments and principal repayment over time so that the annuity is constant. Alternatively, it can be adjusted for the cost of living to generate a pattern of increasing cash flow over the investor’s retirement years.
How is a pension bond constructed and priced? The authors provide clear answers, based on constructing a basket of zero-coupon bonds with staggered maturities in an arbitrage-free framework. During this discussion, they admit that their strategy is not unique (see page 25).
What could go wrong with this strategy? The risk of short-term losses is always present. To guard against this risk, the investor must use an appropriate portfolio insurance strategy. Consider the impact on asset value of bearish stock markets in 2000, 2002, 2008 and 2011, as well as less severe declines in 2015 and 2018. The authors discuss the positive impact of frequent rebalancing on the gap risk, aimed at preventing the portfolio from going “under the floor”. They also discuss the impact of using a stop-gain decision, whereby an income stream can be secured at any point in the accumulation phase by transferring assets into the pension obligation.
Why is this type of strategy so important to consider right now? American workers born after 1970 (and workers in other countries covered in the book’s introduction) must rely on their own retirement savings for the bulk of their retirement funding. The 2020 annual report on the state of U.S. Social Security and Medicare programs said both face long-term funding shortfalls within currently scheduled benefits and funding: 2030s due the rapid aging of the population. By 2035, trust fund reserves will be depleted and continued tax revenues will be sufficient to pay only 76% of planned benefits. Additionally, these projections do not reflect the potential effects of the COVID-19 pandemic on U.S. Social Security and Medicare programs. The key message is that all individuals should start saving for retirement as early and as much as possible – and make the necessary adjustments to investment policy, armed with a full understanding of the implications of their choices.
There isn’t much missing from this compact and comprehensive guide, although I would have liked a more detailed discussion of ‘later in life’ income coverage, defined as life beyond expectation. of life. Furthermore, an index is clearly needed, especially for references to classic portfolio theorists such as Malkiel, Markowitz, Merton and Modigliani (“the 4 Ms”). Nevertheless, the appendices and references provide excellent tools for further research. This book is for all investment professionals and anyone interested in creating approaches and products that allow clients to fully fund their future long before retirement.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.