Financial services providers have different ideas about the ideal way to structure your investments before and during retirement. Some place importance on the affordability of your expected lifestyle once retired.
Not all financial service providers are in agreement on the life stage approach to planning your finances for retirement. Financial services company acsis, which provides asset management services and products to top financial advisers around the country, is one such company. Instead, it uses a strategy based on the lifestyle you want in retirement.
Andrew Davison, the head of institutional asset consulting at acsis, says the key difference between acsis's lifestyle approach and the life stage model is that the acsis approach is based on the needs of the members, while the life stage model is based on the risk profile of the members.
"The life stage model aims to manage the members' ability to tolerate risk at different stages in their working lifetime whereas the lifestyle approach aims to get the members to retirement with enough money to support their lifestyle," Davison says.
He says the life stage model uses the age of the members to assess their investment risk profile. The premise is that young members, who have the luxury of a long time horizon, should take more investment risk; while older members, who have shorter time horizons, have a greater need for capital preservation, necessitating a lower-risk strategy.
The acsis lifestyle approach recognises that younger members can afford to, and should, take more risk in their investment strategy. But Davison says the lifestyle approach differs from the life stage model in that it attempts to take into account the retirement objectives of the members.
Davison says the lifestyle approach is an analysis of needs of individuals.
The analysis projects a person's retirement savings, together with future contributions, and then projects a targeted pension amount during retirement.
"The key objective for the members is to be able to maintain their standard of living or lifestyle in retirement. This objective, together with the projections, enables acsis to determine the minimum required return above inflation that each member will need to meet his or her objective over time."
Davison says the model provides you with realistic expectations as to the likely level of your pension at retirement and hence your ability to maintain your standard of living in retirement.
He says the life stage model is prone to creating false expectations because:
- You are given the impression that the model takes account of your needs at each stage. A life stage model, he says, has nothing to do with your needs - it merely adjusts for your risk tolerance based on your time horizon to retirement, ignoring the cost of your required lifestyle in retirement.
- Life staging takes no account of the past experience of the new members and simply slots them into a strategy based on their age. This means that members who move jobs may find themselves in a life stage model with very different transition ages and very different portfolios at each stage.
Your requirements
Davison says the lifestyle process starts with what you require in retirement. An important step in the process is a regular, annual review of your objectives and your investment, allowing adjustments for your actual past experience.
Davison uses this graph to illustrate what he sees as the pitfalls of the life stage approach and how the lifestyle approach attempts to address the life stage weaknesses.
Each blue dot on the graph represents a member of a fund. The horizontal axis shows the age of the member, ranging from the youngest members on the left to the oldest members on the right. The vertical axis shows the required real return of the members. As an example, the first blue dot on the left is a member aged 22 with a required annual investment return of about 4.5 percent above inflation.
He says the graph shows the reality of retirement savings for the majority of members. The younger members have very similar required returns that reflect the level of contributions as a percentage of salary and the limited effect of their past savings. The results of the older members begin to reflect their varied pasts, particularly when it comes to their discipline and diligence in saving for retirement.
The wide dispersion of required returns is a result of some fund members having saved diligently and preserved their retirement savings through their working lives, and others being less diligent, requiring much higher returns even though they are older and approaching retirement.
Davison says there are two key conclusions to be drawn from this:
- Younger retirement fund members, in general, need lower investment returns than the older members. He says a life stage model assumes that older members cannot afford to take risk and should target lower returns, ignoring the reality that they may need to target slightly higher returns, or at least start saving more if they wish to target lower returns. The lifestyle approach does not dictate that older members must take unnecessary risks, but instead informs them of the consequences of targeting lower returns.
- The lifestyle approach quantifies the reduction in your pension as a result of being too conservative in the years before retirement at a time when you may wish to preserve capital but where you require high returns.
Davison says a switch from an investment strategy earning inflation plus six percent a year to one earning inflation plus two percent a year 10 years before retirement would result in an average member suffering a 30-percent reduction in the amount of pension he or she could receive.
Not without risk
Rowan Burger, the head of institutional design at Stanlib and a leading researcher on retirement modelling, says that the lifestyle model also has risks for members.
He says there are two main risks in retirement planning. The first is that taken in maximising returns; the second is the risk of not having saved enough. This can be as a result of inadequate contributions and investment returns, but is also as a result of such things as periods of unemployment and cashing in retirement savings along the way, and unforeseen issues, such as tax changes that affect expected investment returns.
He says the problem with the lifestyle approach is that it simply adjusts to the unforeseen second group of risks by increasing the first risk, namely the volatility of the investment, after the fact.
"The change in investment strategy of increasing the first risk to counter the second risk may require impossible real returns," Burger says. He says that any investment target of more than six percent after deducting inflation and costs is unrealistic over a long period.
Another problem is that the lifestyle model requires ongoing advice.
"Lifestyle may work if all retirement fund members had access to cheap, competent financial planners who could accurately model retirement savings and risks," Burger says.
A well-considered life stage model should be available for the majority of members, and the flexibility of lifestyling for those who are more sophisticated and have access to the appropriate advice, he says.
Sarika Modi of Alexander Forbes Asset Consultants, says that, historically, life stage modelling meant that retirement fund members were offered a single investment strategy that migrated them to more conservative portfolios as they approached retirement, and in some cases ended in an all-cash or bond portfolio. This approach used the age of the member as the criterion for profiling risk and therefore determining the riskiness of the member's investment strategy, and stopped at retirement (it did not look through into the retirement years).
However, life stage approaches have moved so far along from those days that it becomes inappropriate to paint the old and new with the same brush.
"It is critical in any open discussion to make the distinction between the old and new life stage models. Few will argue with the concept that younger members can afford to, and should, take on risk in their investment strategy. Therefore a high-growth investment strategy is adopted throughout the member's earlier years in both the old and new models," Modi says.
New models
Modi says the new life stage models focus on the needs of a member throughout his or her lifetime. The key objective is for members to maintain their standard of living or lifestyle throughout retirement.
In particular, the new models are designed so that, as members approach retirement, their pre-retirement investment strategies are aligned with the particular investment strategies they will elect in their post-retirement years.
For example, if you know you are going to invest in a high-growth portfolio within an investment-linked living annuity (Illa) after retiring, you would be channelled into a high-growth portfolio through your pre-retirement years. This means there will be no reduction in investment risk before retiring and, instead, there is an alignment of pre- and post-retirement investment strategies.
The more sophisticated life stage models also incorporate an advice, education and communication framework to assist members in deciding which investment strategy (or annuity product) is best suited for their unique needs in their retirement years. As a consequence, retirement fund members have realistic expectations about the likely level of their income in retirement and are better equipped to tailor their investment strategy in the years before retirement to most suitably meet their needs.
Modi says a common criticism is that "life stage models result in a reduction in the ultimate pension benefit because of a move to more conservative portfolios before retirement". She says within many new life stage models even the conservative growth portfolios closer to retirement target returns in excess of inflation, with 30 to 40 percent of the portfolio invested in capital growth assets.
"While such portfolios offer a reduction in risk, they still provide acceptable inflation-beating returns, in contrast to the conservative portfolios in the old life stage model, which may not have had capital growth assets.
"For some members, there is a preference for a conservative investment strategy before and after retirement, either because their income needs are likely to be met with this strategy or because they place a high emphasis on reducing risk. This level of flexibility is accommodated within the new life stage models and has recently been highlighted by many members as appropriate for them, given the level of losses they could otherwise have faced in the recent market downturn," she says.
Modi says it is important that, with the appropriate communication, trustees and members are made aware of the impact (looking at risk and return) that a chosen investment strategy will have on their ultimate benefit.
She says life stage models do use age as a proxy for risk in the absence of having all the required information about what each member's requirements are and what assets he or she has.
She says that the new life stage models have an improved default option compared with the old "balanced or smooth bonus" default that used to apply equally to all members, and are further enhanced by members engaging a financial planner and setting an appropriate asset allocation based on their needs in retirement - taking into account their current levels of assets.
"The unfortunate reality is that most members are not able to access such advice either due to it being unaffordable or unavailable, or due to apathy on the part of the member," Modi says.
This article was first published in Personal Finance magazine, 4th Quarter 2009. See what's in our latest issue