In Practice February 12, 2015

Helping Participants See Stages of Retirement

We’re all going to live a lot longer. What should retirement plan advisers tell their plan sponsor clients about preparing plan participants?
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First, says Jan Holman, director of adviser education at Thornburg Investment Management, plan advisers should advise their plan sponsor clients that no retirement discussion is complete without pulling in longevity.

“Retirement, retirement, retirement,” Holman says. “We’ve focused on that nonstop, but now it’s more like graduating from high school or college. Retirement is an event, but it’s not the whole thing.”

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The industry needs to look at retirement more holistically, Holman tells PLANADVISER. As people live longer—and some will even live into their 90s and older—their approach to life as well as to portfolio allocations will likely change. “These are the things they need to help their employees become aware of,” she says. “It’s a different way of life, and a different way of looking at things. Your life isn’t going to end at age 67.”

These longer lifespans will mean factoring health considerations, which may change the amount people put away for retirement to meet health care costs. Some people may want to consider long-term care policies, since a critical health event could wipe out the majority of retirement funding.

Portfolio structure is a key part, Holman says, and withdrawal strategies are crucial. “Accumulation is easy, compared with withdrawal strategies,” she says. A portfolio needed to last for a long life must have sufficient liquidity to produce dollars for distribution. High-quality investments are needed to produce income and have an opportunity to increase that income over time. “Bond investments provide stability, but you get what you get,” Holman observes.

Perhaps even better than bonds are high-quality, dividend-paying stocks. Global dividend portfolios may also be desirable for their ability to pay higher dividends over time. Holman points out that foreign companies are more inclined to pay higher dividends than those in the U.S., because the focus here is share price and appreciation, rather than what is being distributed to shareholders. For this reason, the portfolio should include some global dividend-yielding investments.

Helping participants carve out a spending policy is a good discussion to have, Holman feels. People have two choices, one that is a lifestyle spending policy in which the investor withdraws a set sum of money each year, increasing every year by the rate of inflation. This is not as good as an endowment spending policy, she observes, adding, “You want the money to last as long as possible.”

Spending Rates

The first step is to decide on a spending rate, for example, 5% of a $1 million portfolio. Every year, the investor bases an annual spending amount on 90% of the previous year’s amount, with a small percentage of the current value of the portfolio added on. The benefit of this approach is that the investor is managing withdrawal amounts in a disciplined way. “You don’t just take 5% of the whole portfolio,” Holman explains. “It reflects to some extent the value of the underlying portfolio, and injects discipline for what you have to do when the portfolio is down.”

On the softer side, Holman suggests bringing in speakers to address participants on the actual life that they can live in retirement. Richard Leider, author of books about living with purpose, and AARP’s Life Reimagined website are two possibilities, Holman says.

“If you’re going to incorporate a discussion of longevity into what you’re talking to plan participants about, it has to be holistic,” Holman says. Some of the factors may be positive and tangible, such as the impact and effect an individual can have on others, with a library of information to draw on, to give back to society more broadly. Or people might be one of multiple generations of a family alive at the same time—giving a chance to serve and support younger generations.

The retirement business is easier when it just requires the services of an actuary, Holman says, but then the retirement investor’s soul is left out of the equation. “You can’t quantify quality of life and things like purpose,” she says. The financial services industry has concentrated on the nuts and bolts of investing. Such things as the value of starting early, compounding and time horizons have dominated the discussion, but longevity represents the more human aspects of retirement. “It’s not just a financial equation,” she says. “It’s also about helping people think consciously about what these dollars can mean in terms of their futures.”

Holman advises avoiding a single focus on numbers only, with a view toward raising participation rates. “If folks talked to their plan sponsor clients about bringing these other things into the discussion, I wouldn’t be surprised if plan participation rates increased, if done in a strategic and thoughtful manner,” she says. As people learn in different ways, by reading or watching videos, plan sponsors should use whatever communication tools will best reach participants to help them see the importance of thinking about the whole longevity puzzle.

The growing awareness of increased lifespans is pushing people to look beyond the money and ask how they’d like to live that part of their life. “I think the longevity discussion brings these choices into the equation,” Holman says. The numbers say we are likely to live longer—it’s just a reality.”

The Markets February 12, 2015

For Pensions, Active Investing Pays Off

Financial research and benchmarking provider CEM Benchmarking says its most recent report contains enough data to prove active investing is worthwhile for pension funds, if executed efficiently and effectively.
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As noted in the report, “Value Added by Large Institutional Investors Between 1992‐2013,” it is a widely held academic and investing industry belief that active investors have, on average, no real advantage over passive investors over the long term, and can even see worse performance over time due to higher fees. This view on investing strategy is rooted in the efficient market hypothesis, researchers explain.

Historically, a problem with testing the benefits of active versus passive investing is that the separation between alpha (market outperformance) and beta (market-attributable returns) is not always clear. “Where one set of benchmarks demonstrates a non‐zero alpha, another set can almost always be found that shows that the alpha is zero,” the report suggests.

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But while some say the question of active versus passive can’t be definitively answered, CEM Benchmarking believes the answer can be made clear by looking at enough information. To that end, the firm conducted extensive analysis on its pension performance data set, comprised of more than 6,600 data points drawn from a global set of defined benefit pension plans (along with a handful of sovereign wealth funds) spanning the 1992 to 2013 time period.

“Not only can we definitively answer the question of whether it is possible [to outperform with active management], we can also quantify to a large degree how these institutional investors do it,” CEM notes. “What advantages do they have? Where have they added value? Is the value added really alpha, or is it beta in disguise?”

The results are striking: Gross of investment management expenses, CEM says pension funds have secured 58 basis points of value added returns through alpha-seeking opportunities. Net of investment management fees and expenses the outperformance is much more muted, at 16 basis points of returns added. According to researchers, a deep regression analysis indicates that beating the market is rooted in active asset management paired with cost savings gained through scale and managing assets in‐house.

The result is nuanced further in the CEM report: “We emphasize that the standard deviation of the gross and net value added populations, at about 267 and 265 basis points, are large in comparison to the averages at 58 and 16 basis points gross and net, respectively. For any single pension fund, this result is likely just as important as the non‐zero average. The standard deviation indicates the range that a typical plan, with a typical active versus passive management ratio of 4:1, can expect their value added to stray from the average. So, while the long term average gross and net value added are decidedly non‐zero, in any given year many funds will trail their benchmarks, often by substantial margins.”

Report authors continue by explaining that, clearly, funds engaging in active management need to consider whether the potential gains are worth the risk quantified by the standard deviation.

Controlling Costs Leads to Better Alpha 

Pension plans vary widely in their construction, the report explains, including the amount of indexing used. Funds also vary according to things like asset scale, the amount of assets managed internally, the amount of assets managed actively, and the makeup of the asset mix.

All of these factors will impact the success of pension funds’ active investing value add efforts, the report says.  

“For example, indexing, managing assets internally, and increased scale are all expected to reduce costs and increase net value added (all other things being equal),” the report continues. “Attempts to beat the market by active management, by contrast, are expected to increase gross value added.”

Not surprisingly, researchers find the balance between enhanced gross value added from security selection, on one side, and diminished net value added from increased costs, on the other, determine whether active management is worthwhile. What’s more challenging than this realization is actually disentangling and quantifying these differences for a given pension fund, or for pensions in general.

To this end, researchers did a regression analysis on the gross and net value added for each pension fund in the large sample, according to a simple model which takes into account (i) the percent of each fund’s holdings that are internally managed; (ii) the percent of each fund’s holdings that are actively managed, (iii) the size of the funds; and (iv) a variable constant for each of the sample four regions.

CEM finds the following:

  • Pension funds increased their net value added by +7.6 basis points for every 10-fold increase in holdings due to lower investment management costs.
  • Funds increased their net value added by +22.1 basis points for by managing their assets in‐house due to lower investment management costs.
  • Funds increased their net value added by +38.7 basis points by actively managing their assets in an attempt to beat the market (note this is less than the +71.7 basis points gross due to investment management costs).
  • The regression constants themselves are also reduced going from gross to net value added since indexed investing, while inexpensive relative to active management, also has associated investment management costs.

Researchers conclude that all of this goes to show that, contrary to the efficient market hypothesis, pension funds have been able to beat the market consistently using elements of active management. However, fees associated with active management consistently eat up nearly 75% of the 58 basis points of gross value added, leaving only 16 basis points of net value added for stakeholders.

“This illustrates in stark terms why funds must measure and manage their costs,” the report concludes.

More information about obtaining or participating in CEM Benchmarking research is here.

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