August 2013
Schroders
CPI+3.5% – A better approach for retirees
Schroder Investment Management Australia Limited
Background
The purpose of superannuation is ultimately to provide a degree of financial security in retirement and reduce
pressure (or reliance) on the age pension. Financial security will come from a combination of an appropriate
contribution rate, investment strategy, drawdown rate and insurance.
1
In prior papers we have addressed the issues of a traditional asset allocation framework from both an
accumulation and decumulation perspective, particularly with reference to maximising the consistency of money
weighted outcomes for individuals. Clearly, after a period of accumulation, the process of decumulation and the
investment strategy adopted will have a large bearing on the duration of drawdowns, the size of those
drawdowns and the consistency with which different member cohorts will achieve similar outcomes.
Consequently, the decumulation process, and in particular, the type of investment offerings available to those
approaching and in retirement is a very important part of the overall superannuation process.
However, while the type of investment offerings to pre-retirees has been quite well defined by the
superannuation industry (albeit, well defined does not mean correct, but that is another debate), partly as a
function of the relatively small size of the post retirement market, the structure of the investment offering to
retirees is still in its infancy.
In this paper we consider a more specific strategy that aims to maximise the duration and consistency of
drawdowns, in a lower risk framework than that for those in the earlier stages of accumulation. Such a strategy
is particularly relevant for those approaching retirement and in the drawdown phase.
Objectives in retirement
The principal objective of retirees is generally to maintain a particular standard of living for a given period of
2
time. Merton offers the following general criteria for good retirement plan design for individuals:
1. Offers robust, scalable, low cost investment strategies that maximise the chances of achieving the
retirement income goal using all available assets.
2. Manage the risks of not achieving that goal.
3. Be effective for unengaged participants.
4. Provides meaningful information and choices with easy implementation for those who do engage on their
progress to achieving the retirement income goal.
Unfortunately, achieving the above goals is not simple for most individuals as there is a degree of uncertainty in
retirement planning as a result of the two principal risks:
3
1. Longevity risk – the risk of outliving their retirement benefit capital or suffering a substantial fall in living
standards as a result of drawdowns being too large relative to the length of time in retirement.
2. Investment risk – fluctuations in retirement income stream as a result of unexpec ted investment earnings
(particularly on the downside) impacting the capital.
1
See Appendix for a complete list
Robert C Merton, “The future of retirement planning”, CFA institute 2007 and 2008
3
For the purposes of this paper w e take living longer to be a financial risk for retirees – clearly living longer as a risk is a matter of
perspective!
2
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Generally, retirees attempt to control for these risks through the choice of investment strategy and the level of
asset withdrawal. Alternative strategies are available for helping retirees to manage these risks as shown
below.
Chart 1: Risks for retirees
Longevity Risk
Uninsured
Investment Risk
Full
Part
Nil
Various risk
level choices
in an allocated
pension
Part
Add “longevity insurance”
or a deferred annuity
Insured
Deferred
Annuity with
an Investment
choice
Control volatility of
investment outcome
Term
Annuities and
Guaranteed
Products
Lifetime
Annuities
Source: Schroders
While the above represents a simplified schematic of the risks, in reality even “nil” investment risk strategies can
have significant risks. For example, they may be expressed in nominal rather than real terms, or depending on
longevity, carry significant refinancing (or credit) risks.
In addition, the lower the degree of risk, the higher the likely cost to a retiree of a given solution, which will
ultimately lead to a lower standard of living than might otherwise have been obtainable.
Finally, we would note that most people do not have the necessary level of financial expertise required to make
complex investment decisions over long periods of time and varying degrees of uncertainty.
In this paper we are particularly focussed on how we can build better investment strategies to reduce risk. We
define a “reduction in risk” as being able to achieve greater certainty of the outcome. This effectively means
greater certainty on the duration of an income stream AND greater certainty on the inflation adjusted value of
those income stream amounts.
We would argue that such an outcome is achievable using the “allocated pension” approach common with
retirees today, provided the investment strategy selected is appropriate for the outcomes desired.
Why reducing investment risk is important
The nature of the savings and disavings process is such that money weighted outcomes (which is what
individuals receive) can and do vary quite significantly from time weighted outcomes (which are typically
reported as the long term return).
To highlight this issue, we show below the progression of a member balance for a given drawdown policy and
average earning rate, but where the sequencing of the earning rate differs. Given that it is not just the post retirement phase that matters we have conducted our analysis to also incorporate the final 5 years of the
accumulation process. We have assumed a member in the final 5 y ears pre-retirement continues to make
contributions of 12% of salary through that last five years and then sets a drawdown rate of 60% of their then
final salary. The scenarios we consider are a constant earning rate of CPI+3.5% together with alternating
periods of CPI+3.5% plus or minus 6.5%. The results are shown in Chart 2. Note “pos” means the first period
is plus 6.5% and “neg” means the first period is minus 6.5%. We have chosen 1, 3 and 5 year periods for
comparison.
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Chart 2: The impact of volatility on investment outcomes
Balance in $ from alternative investment outcomes
2,000,000
1,500,000
1,000,000
Balance
500,000
0
-500,000
-1,000,000
-1,500,000
No Vol
1 year pos
1 year neg
3 year pos
3 year neg
5 year pos
5 year neg
-2,000,000
55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85
Age
Source: Schroders. Starting balance at age 55 is 7 times salary (reasonable for a 12% accumulation rate throughout a full w or king career)
and contributions to age 60 are at 12% of salary w hich is indexed w ith inflation + 1%. Inflation is 3%, earning rate is 6.5%. Draw down
amount from age 60 set at 60% of final salary and indexed w ith inflation.
Unsurprisingly, it shows that while the average earning rate across all scenarios is constant:
1. The greater the “length” of the volatility period, the greater the dispersion in results;
2. The first period being a “negative” volatility period has a greater impact on the duration of drawdowns that
is possible than the first period being a positive volatility period.
The variance of +/-6.5% was chosen as it results in a portfolio with broadly equivalent real return and volatility in
the traditional sense (not dissimilar to a traditional balanced fund). Clearly as this number is reduced, the
differential between the outcomes will reduce and the opposite occurs as the volatility is increased. However,
even a reduction in the volatility figure to 3.5% still results in a material difference between outcomes (e.g. 4
additional drawdown years for the 5 year scenarios).
In addition, Chart 3 shows the difference in the balance after 15 years (representing a reasonable period into
the drawdown process) of drawdown from the base case (which assumes a constant earning rate with no
volatility) how a varying level of volatility impacts the results.
Chart 3: The impact of volatility on investment outcomes
Difference in balance after 15 years for different volatility of earning
rates
60%
40%
8% Vol
6.5% Vol
20%
0%
-20%
-40%
-60%
-80%
-100%
-120%
1 year pos
1 year neg
3 year pos
3 year neg
5 year pos
5 year neg
Scenario
Source: Schroders, Starting balance at age 55 is 7 times salary (reasonable for a 12% accumulation rate) and contributions to age 60 are at
12% of salary w hich is indexed w ith inflation + 1%. Inflation is 3%, earning rate is 6.5%. Draw down amount from age 60 set at 60% of final
salary and indexed w ith inflation. Results above show difference in balance at age 75 betw een given scenario and base case of no volatility
in earning rate. A result below -100% means that the draw down strategy had resulted in a negative balance.
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We can see from Chart 3 that not only are the differences in results potentially very large as we introduce
greater periods of volatility and the greater the volatility the greater potential difference, but interestingly where
the first period was a negative variance, the difference in results was somewhat greater than when the first
period was a positive variance. Bearing in mind investors have little choice in the issue of whether first year
returns will be positive or negative, this is an important finding.
Ultimately, there are two primary drivers in reducing investment risk to enable individuals to achieve better
retirement outcomes across different time periods:
1. The absolute level of real returns through time;
2. Controlling the level of volatility of those return streams to minimise “sequencing risk”.
Do traditional investment approaches work?
It is our observation that the two most common investment approaches in the drawdown phase currently are
traditional balanced strategies (sometimes combined with a minimum cash level) and/or more conservative
balanced style strategies.
Given the comments and our analysis detailed above around path dependency, we have analysed whether
historically either of these is the “best” option for retirees. Charts 4 and 5 show that based on real returns from
a balanced strategy since 1922 more than 50% of the time a typical retirement drawdown strategy would have
run out of money before the end of 20 years. However, in some cases the retiree is left with more money after
20 years than they started with (returns exceed drawdown). Thes e periods typically relate to those who retired
in the mid 1920’s, late 1970s and throughout the1980s (when subsequent returns were very good). In any
case, 50% odds are not good enough when your retirement is at stake. Trustees could indeed question
whether they would “sell” some of this upside for some cohorts to deliver better outcomes overall to all cohorts.
Charts 4 and 5: The history of drawdown scenarios
15 and 20 Year Drawdown Scenarios from a Balanced Fund
(1923-2011)
15 and 20 Year Drawdown Scenarios from a
Conservative Fund (1923-2011)
60%
50%
45%
50%
20 years
40%
30%
20%
Percentage of Results
Percentage of Results
40%
15 years
15 years
35%
20 years
30%
25%
20%
15%
10%
10%
5%
0%
0%
<0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Value of account balance at end as a multiple of the start balance.
Drawdown = 8% of starting balance
<0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Value of account balance at end as a multiple of the start balance.
Drawdown = 6% of starting balance
Source: Schroders, Datastream, Return series from 1922 to 2010, Balanced Fund proxy taken as 35% Aus equity, 30% global equity, 20%
Aus bonds, 15% cash. Conservative Balanced Fund proxy taken as 12.5% Aus equity, 12.5% global equity, 45% Aus bonds, 30% ca sh.
Indices - All ords, MSCI World ex Aus, S&P500, UBS Composite, Aust govt bond 10 year rates, RBA Cash rates, UBS Bank Bill index, ABS
CPI.
Even for a conservative balanced strategy the odds are not significantly better. Based on a lower drawdown
amount of 6% (which would extend the duration of drawdowns), more than 45% of the tim e the retiree ran out of
funds within 20 years.
While this is not the place to explore in detail the reasons why outcomes have been so varied, it does serve to
highlight what we consider to be ongoing issues with the current methodology behind portfolio c onstruction. In
particular we would make the points that:
4
5
1. Valuations do matter in determining longer term returns (see Bogle (1991) , Campbell & Shiller (2001) etc)
4
Bogle, J., (1991a), “Investing in the 1990s: Remembrance of Things Past and Things Yet to Come”, Journal of Portfolio Management,
Spring. Bogle, J., (1991b), “Investing in the 1990s: Occam’s Razor Revisited”, Journal of Portfolio Management, Fall.
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2. Risk is not annualised standard deviation of returns, the pretence of the Markowitz model and the
underlying basis on which much academic work on portfolio construction has been written. See for
6
example Veld (2006)
This highlights the need to be mindful of medium term volatility of returns as the impact on individual investment
outcomes can be significant.
Consequently, it is very important to minimise downside volatility for the older demographic. While a simple
model is to reduce the exposure of this demographic to risky assets, the episodic nature of equity market
returns makes this problematic - with periods of high returns being followed by periods of low returns. If the
period of high equity market returns is at the end of an individual’s career, this model of reducing their exposure
to this asset class toward the end of their career has the potential to severely limit the individual’s ability to
accumulate a lump sum for retirement. We addressed this in detail in a recent paper “Life Cycle Funds - Just
7
Marketing Spin” .
Taking the view that some retirees may have already adopted a more conservative strategy, Chart 6 shows the
duration of drawdowns historically under a conservative balanced approach. While quite clearly the volatility of
outcomes is reduced (relative to a balanced strategy), they remain substantial with a historical range of 10 to
nearly 35 years. Interestingly, the minimum outcome isn’t particularly different from the more aggressive
balanced approach which has a minimum of 9 years drawdown.
Chart 6: How long will my drawdown last?
55
Duration of Drawdowns - Conservative Fund
1900-2012
Number of Years Drawdown Lasts
50
45
40
Drawdowns havent run out yet
35
30
25
20
15
10
1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990
Year Drawdown Commences
Source: Schroders, Global Financial Data. Assumes initial draw down of 6% of capital at end of year and indexed thereafter w it h inflation.
Investment return based on stylised conservative balanced fund with fixed strategic asset allocation of 12.5% global equity, 12.5%
Australian equity, 45% Australian bonds and 30% cash. Draw downs commence in year stated and go until 1 January 2012 or w hen
balance reaches $0.
More generally the fact that asset class risks are not stable through time makes any approach to reducing risk
that is premised on a fixed relationship between asset class exposures flawed. Rather, the emphasis should be
on reducing the incidence of downside volatility not necessarily a particular pre-determined asset allocation that
bears no relationship to forward looking returns. This is particularly the case today when we consider the
collapse in bond yields over the last 30 years or so. Allocating significant assets to bonds may not turn out to be
as “conservative” as hoped.
5
Campbell, J., and R. Shiller, (2001), “Valuation Ratios and the Long-Run Stock Market Outlook: An Update”, Cow les Foundation
Discussion Paper No.1295, March.
6
C. Veld, “The Risk Preferences of Individual Investors”, Department of Accounting and Finance, Univers ity of Stirling, October 2006.
7
“Life Cycle Funds - Just Marketing Spin”, Greg Cooper, Schroder Investment Management Australia Limited, September 2011
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Chart 7: Long term bond yields
Australian 10 Year Bond Yields
% p.a. yield
18
16
14
12
10
8
6
4
2
0
1979
1983
1987
1991
1995
1999
2003
2007
2011
Source: Schroders, Global Financial Data
This would suggest that for plans dominated by an ageing demographic structure, downside risk management is
very important. However, it could be argued that this should be the status quo no matter what the demographic
breakdown of a plan. Given members of all demographics will generally be present, tilting the fixed asset
allocation to suit the dominant demographic will raise intergenerational transfer issues.
Managing to a return objective and not to a fixed asset allocation will help to minimise the impact of the episodic
nature of returns from equity markets and therefore the fixed asset allocation model. Importantly, this would
reduce the impact the lucky year of birth has had on historical results.
What is the optimal approach?
The above ideas highlight some substantial shortcomings in the way portfolio construction has been
approached for at least the last 3 decades, particularly for those approaching and in the drawdown phase. In
our view, an alternative approach should be considered to overcome these constraints and deliver to investors
the sorts of outcomes they genuinely require, and fit with the criteria described by Merton in the opening:




Be robust through time and market conditions, scalable and low cost;
Manage the risks of not achieving that goal by providing greater outcome certainty (in real terms);
Be an effective solution for different cohorts (and so better in dealing with disengaged members);
Be part of a broader range of possible solutions that is consistent and easy to explain.
Analysis of alternatives
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In prior papers we have discussed the very long term outcomes of a typical investment approach . From the
perspective of an investor requiring some form of drawdown over time, we would suggest that outcomes of
between CPI +1%-2% (being cash-like and in line with the RBA’s target) and CPI+5% (as a growth balanced
strategy) are the likely lower and upper bounds of any long term investment strategy. Presenting alternatives to
retirees that are framed in terms of real outcomes is also likely to be easier to explain and understand.
We have compared three alternative diversified investment strategies from the perspective of an individual
entering the drawdown phase, being the balanced and conservative balanced strategies alongside a theoretical
strategy that delivers CPI + 3.5% p.a. consistently. In particular we have examined the distribution of outcomes
for the length of the drawdown period, where drawdowns commence anytime 1930 through to 1990 for the more
conservative balanced strategy versus the CPI+3.5% portfolio in the Chart 8.
8
See Appendix for a complete list
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Chart 8: Comparison of drawdown periods for a conservative strategy
Distribution of Drawdown Outcomes
(Drawdowns commence 1930-1990. Calcuation through until 1 Jan 2012)
20
18
16
Conservative Balanced Portfolio
CPI+3.5%
Frequency
14
12
10
8
6
4
2
0
14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Number of Years Drawdown Lasted
Source: Global Financial Data, Schroders. Assumes initial draw down of 6% of lump sum and indexed w ith CPI thereafter. Draw downs run
until 1 January 2012 or w hen balance reaches $0.
Contrasting the above more conservative approaches with a typical balanced fund, Table 1 shows the
comparison of drawdown outcomes.
Table 1: Comparison of drawdown outcomes (1926-1990)
Duration of drawdowns (yrs)
10%’ile
Lower Quartile
Average
Upper Quartile
90%’ile
Average Return, 1926-2012 (%p.a.)
Balanced
Conservative
CPI + 3.5%
16.6
20.0
28.7
33.0
47.0
9.6%
14.0
16.0
21.2
26.5
32.0
8.0%
23.0
25.0
25.7
27.0
29.0
8.1%
There are three observations we would make from the above analysis:
1. By reducing the volatility of returns relative to inflation, the outcomes from the CPI+3.5% option are
significantly better on average than the conservative option and the volatility of outcomes is massively
reduced as the sequencing risk is better managed. That is, it is more robust.
2. The CPI+3.5 (theoretical) portfolio delivers nearly the same upside as the conservative portfolio and an
average outcome close to the balanced portfolio, however the interquartile range (upper-lower quartile) is
only 2 years on the CPI+3.5% portfolio vs 10.5 years for the conservative portfolio and 13 years for the
balanced portfolio. That is, it provides significantly greater certainty.
3. The incidence of severely negative outcomes in the drawdown phase is removed through reduci ng the
sequencing risk. The minimum (10%’ile) of the CPI+3.5% portfolio is better than the lower quartile outcomes
for the other portfolios and better than the average outcome for the conservative portfolio.
Of course, managing to a CPI+ outcome requires a different investment approach to the fixed asset allocation
approach of a traditional balanced or conservative portfolio. In order to generate lower volatility inflation relative
outcomes, particular attention has to be paid to valuation and likely ris k-adjusted returns of the underlying
assets in the construction of the portfolio.
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Conclusion
After a period of accumulation, the process of decumulation and the investment strategy adopted will have a
large bearing on the duration of drawdowns, the size of those drawdowns and the consistency with which
different member cohorts will achieve similar outcomes. These outcomes can vary significantly even when the
chosen investment strategy is relatively stable.
For investors looking for a greater degree of certainty in their drawdown outcomes it is important to control
sequencing risk as well as achieving an absolute real return through time.
The decumulation process, and in particular the structure of the offerings available to those approaching and in
retirement, is a very important part of the overall superannuation process. Investors who are planning on
adopting a more conservative portfolio would do well to consider an objective based portfolio targeting 3.5%
over inflation relative to a more traditional conservative balanced strategy.
In particular a CPI+3.5% solution (combined with other outcome orientated solutions at different targets)
provides:
1. A better series of strategic choices for retirees that is easier to understand and i mplement in their
retirement planning process;
2. Can be applied simply to disengaged as well as engaged members and reduce the incidence of poor
aggregate outcomes.
3. Increases significantly the certainty of outcomes and so provides a much better opportunity to plan and in
particular decide on a more robust drawdown strategy.
Appendix
Bibliography of prior research pieces on Objective Based Investment Strategies (and related topics) from
Schroder Investment Management Australia Limited referred to in this paper. Copies available from Schroders
on request:
2007, 2008, 2009, “CPI+5 White Paper”;
January 2009, “It’s about risk, not return”;
April 2009, “What price complexity”;
August 2009, “Keeping it simple, back to the future for Asset Allocation”
February 2011, “Complexity Adding Value”
August 2011, “Post Retirement – Time to Focus on the Endgame”
September 2011, “Life Cycle Funds – Just Marketing Spin”
March 2012, “Why SAA is Flawed”
April 2012, “Asset Allocation - How flexible do we need to be?”
May 2012, “Understanding the Journey to Retirement”
October 2012, “Risk Parity – No Free Lunch”
November 2012, “Avoiding the valuation traps in Strategic Asset Allocation”
February 2013, “Searching for the Holy Grail in Asset Allocation”
May 2013, “It’s not all about Income”
Data sources used in this paper
Data sourced from Global Financial Data:
Australia Consumer Price Index
Australia Total Return Bills Index
Australia 10-year Government Bond Return Index
GFD World Return Index
Australia S&P/ASX 200 Accumulation Index
S&P 500 Total Return Index (w/GFD extension)
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Disclaimer
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article.
They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274,
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