While long-term expected returns are likely to be low and short-term risks remain high, developing retirement products is a tricky exercise, Troy Rieck, CIO of LGIAsuper, says.
When we think about retirement products, we often think about those who are closest to or just into retirement, say, 55 to 75 years of age. And those members are currently feeling the financial and psychological impacts of COVID-19 on their retirement income.
But when it comes to developing products with younger members in mind, a whole new series of difficulties is introduced, Troy Rieck, Chief Investment Officer of LGIAsuper, says in an interview with [i3] Insights.
“Everyone knows about the challenges that older members face in generating high enough returns in the retirement phase, but the investment challenge we have for younger members might be just as large. I’m talking about the low expected long-term returns from most asset classes that all members face,” Rieck says.
If share markets are to return mid-single-digit returns over the next 10 years, then younger members will build up significantly less wealth than those members who went through the system over the past 20 years, even if they contribute at the same rate as older members.
Everyone knows about the challenges that older members face in generating high enough returns in the retirement phase, but the investment challenge we have for younger members might be just as large. I’m talking about the low expected long-term returns from most asset classes that all members face
Rieck invokes the Rule of 72, which is a quick way to determine how long it takes to double your wealth at a certain rate of return. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how many years it will take for their initial investment to double.
“In the last 10 years, we have seen returns of around nine per cent per annum, so members have been doubling their wealth every eight years just through investment returns. But if future returns are going to be more like four to five per cent, then it is going to take 15 to 20 years for people to double their wealth,” Rieck says.
“For those who are just starting out, lower long-term expected return with no reduction in short-term risks will be a significant challenge for some time to come, just like the lack of income generation from cash and bonds are a huge challenge for retiring members who want to live off their income.
“We have to find a way to generate some extra return. We must find a way to manage the psychological as well as financial impacts of taking those risks. And we need to do that to a different extent for the young, middle-aged and increasingly those that are heading into and through the retirement phase. But if it were easy, then we all would have done it already.”
Alternatives and Unlisted Assets
One way to address the problem of low expected long-term returns is by increasing the allocation to unlisted and alternative assets to harvest the illiquidity and related risk premiums. Rieck acknowledges the issues with unlisted assets during the months of March and April when funds scrambled to revalue their holdings, but he believes they have a role to play in the portfolio.
“We are a big fan of unlisted assets and alternatives. We think there is an illiquidity premium there. It may not be as large as it used to be, but we think it still exists,” he says.
“The question is: Where do you find the biggest illiquidity premium now? It may not be in traditional real estate, where the ‘Amazon Effect’ is playing out in a nasty way for retail (property) funds.”
Hedge funds are another interesting strategy, he says, but it is one that comes with more than one price to pay. “We increasingly like alternative strategies, but there is a challenge with that. One is fees and two is that for several popular liquid alternative strategies, they just have not worked as well as expected in the last five to 10 years,” he says.
“The most challenging thing for us all as investors is the difference between the last 10 years and the next 10 years. The best thing a fund might have done 10 years ago was to hand over their money to a 100 per cent passive equity manager and walk away. But I think that is most likely the wrong decision to do for the next 10 years.
“And we have to do that in an environment where APRA’s (Australian Prudential Regulation Authority) heatmap encourages us to buy liquid assets and do that in a passive way because everybody cares about the little word that starts with an ‘f’.”
The most challenging thing for us all as investors is the difference between the last 10 years and the next 10 years. The best thing a fund might have done 10 years ago was to hand over their money to a 100 per cent passive equity manager and walk away. But I think that is most likely the wrong decision to do for the next 10 years.
He illustrates his point at the hand of the value factor, a factor that is embraced by some of the most famous and historically successful investors in the world, but which has struggled in the past decade to produce any decent returns.
“Value has systematically underperformed growth for the last 10 years. One theory is that value companies have been caught up in a huge secular trend: the Internet of Everything and technology companies eating the world. The secular and cyclical trends have interacted here and value has been terrible for much of the last decade,” he says.
But it is not just value that has struggled, he says, many other factors have also failed to repeat the level of performance seen before the Global Financial Crisis.
“If you look at a typical momentum strategy, one of the most wildly successful strategies in history, it has produced significantly lower but positive returns in the last 10 years compared to the previous 30 years,” he says.
“One theory is markets have changed post the Global Financial Crisis, with central banks dampening market volatility through their intervention activities. There is more price-insensitive market activity and intervention might be one of the reasons why systematic strategies haven’t performed as well as people expected.”
Risk and Retirement
This environment of low yields and low long-term expected returns does not make it any easier for funds to develop a robust retirement product that is suitable for many members. Rieck believes it means members have little choice but to take more risk in their investments and funds will provide further assistance to members on helping to better manage those risks.
“Members want really liquid products that generate a high return and little to no risk. But what members often end up with is lower-returning, higher-risk, more illiquid products than funds used to offer because it is the least-worst alternative to traditional solutions,” he says.
“Funds will need to be willing to consider new, innovative and unconventional return sources and different ways to assemble those portfolios.”
It is not simply a matter of adding more equities to the mix, since the outlook for this asset is lower returns at high levels of short-term risk, including the risk of a prolonged bear market at some point. Rieck says the solution will ultimately be some sort of compromise.
“I’m personally a fan of moving up the capital structure [from equities into various forms of debt securities] and looking at different ways to put together the building blocks, including the use of leverage, shorting and derivatives,” he says.
I’m personally a fan of moving up the capital structure [from equities into various forms of debt securities] and looking at different ways to put together the building blocks, including the use of leverage, shorting and derivatives.
“And, of course, you’ve got to diversify across a whole range of sources. We’ve got infrastructure debt, we’ve got real estate debt, we’ve got private credit, bank loans, high yield, emerging market debt, but we are also generating income from other sources.
“We generate income from our real estate portfolios from rental income, for example. You want a diversified stream of income that is sustainable in the long term and preferably growing at a rate that exceeds inflation.
“But you do not want to focus just on income because we know those strategies carry with them large tail risks. You only have to think of the pain of owning too many Australian banks in the last five years because of the high dividend yields and franking credits that they generate.
“We need to think differently about how we construct portfolios, including considering the prudent use of derivatives, leverage and tail-risk protection strategies to create a better risk-return trade-off for retirees, who value capital protection more than younger members.
“Whilst these ideas may be uncomfortable for some to consider, if they improve the likely outcomes for members, then nothing should be ruled out.”
Annuities and Tail Risk
One element that has been much discussed in the development of retirement products is finding ways to protect retirement portfolios against large shocks and create a reliable income stream. The two suggestions most often mentioned to achieve this are deferred annuities and tail-risk strategies.
Rieck is more in favour of tail-risk strategies than deferred annuities, partly because of people’s reluctance to buy the latter currently.
“This is one part of the cycle where tail-risk hedging strategies make sense, but not for all members. They might not make sense for a 25-year-old, but maybe they make sense for a 65-year-old retiree. They probably do not make sense for an average MySuper option, but they make sense for an overfunded, defined benefit fund that is in run-off phase,” he says.
Deferred annuities have their place as well, but the challenge here is that there are clear behavioural aspects that need to be considered. The experience in the United Kingdom, where annuities were compulsory for a long time, shows people are not keen on these instruments.
“I find deferred annuities to be an interesting, potentially quite useful product. There are a couple of challenges and again they are both psychological as well as financial. A deferred annuity is really a trust agreement over the next 20 to 50 years. That can be a very challenging idea for members,” Rieck says.
“The onus upon the fund and the regulator to ensure that annuity providers will be around is absolutely huge.”
The other problem with annuities is they still need to be funded by underlying investments and in a world where investment returns are low, the likely payout of any annuity will be low as well.
“I find them interesting from a retirement point of view, but then there is also problem number two: Where are those companies offering annuities getting their returns from? We are talking often about the longevity risk of members, but many still have an adequacy risk that is going to dominate. They do not have enough to retire on in the first place. And then we throw in low expected returns as a third leg on a chair and that makes it a very hard place to sit,” Rieck says.
“I like the idea of deferred annuities, but I hesitate to say that they are a solution for every member, but for some members out there, sure they are going to be useful tools. I just don’t think they are going to be as widely useful as we all hope.”
But ultimately it is not a matter of whether one strategy is better than another, it is about which strategy suits a given set of circumstances best.
“People talk about whether strategies make sense or not for the fund, but I think that is the wrong question. The right question is: For which cohort of members is this the right strategy? And what does make sense really mean? We are talking here about the whole solution we provide to members being more valuable than the sum of individual parts,” Rieck says.
LGIAsuper’s Default Pension
Rieck joined LGIAsuper as CIO in September 2019 from Equipsuper and he is not only responsible for investments, but also for product. Apart from a retirement strategy, he is looking to review the range of investment options for members, while also putting the right tools in the hands of the fund’s financial advisers.
“It is a simple approach: if you want us to build a strategy for you, then we will build it for you. If you want to build it yourself, then we will give you the tools to do it. The trick, as always, is to put the right tools in the hands of the right people and provide them with the right information to make decisions,” he says.
“We are one of the very few funds that have a default strategy in pension. It is the exact parallel of our pre-retirement strategy. Until age 75 we put people into a diversified growth portfolio, then at age 75 we put them into a fund which has a more balanced approach to growth and defensive assets. That strategy was originally designed by John Smith, who is now the chair, but he was the actuary for the fund.”
He says he is likely to make some changes to the fund’s retirement product as part of the overhaul.
I’m a fan of the non-investment cash account. I have seen people building income strategies [particularly in listed equities] and then the product design leads to the income being reinvested straight back into the market because they put the cash into an investment account. In a pension product, you know that the account will be drawn down upon on a regular basis, so do not reinvest into the market – instead, have it ready to distribute to members.
“There are a whole bunch of things that funds can do. What we are most interested in here is what makes the biggest difference for the most members at the lowest impact. Sometimes it is a simple thing. The three-bucket strategy that we built at Equip is a really good tool for communication and engagement with retiring members and it is a wonderful conversation starter for people who come in for advice,” he says.
“It addresses people’s mental accounting biases and helps them to better deal with the psychological aspects of risk. And then as the investment person you try to deal with risk in a very financial way. This is where you need to consider the whole member.
“I’m a fan of the non-investment cash account. I have seen people building income strategies [particularly in listed equities] and then the product design leads to the income being reinvested straight back into the market because they put the cash into an investment account. In a pension product, you know that the account will be drawn down upon on a regular basis, so do not reinvest into the market – instead, have it ready to distribute to members.
“The test, of course, is: Can you do it cost-effectively? Can you make the changes sufficiently powerful so it makes a difference to members’ outcomes and can you do it while the regulatory environment keeps changing?”
Restructuring of the Portfolio
When we speak with Rieck, he is in the middle of a portfolio restructuring to create a more efficient portfolio and build up liquidity. “The focus here is simple: refining the allocations to better align them with member needs. We have been systematically rebuilding the fund asset class by asset class. We’ve got some strategic changes coming up in October, looking at the cost base and rebuilding the alternatives and real assets portfolios,” he says.
“When I walked in the door here the fund held about $250 million in cash in the diversified options, but we are currently holding about $1.25 billion worth of cash in a $13 billion fund. That liquidity provides a small war chest to reinvest into new strategies that better suit the future investment, regulatory and competitive environment.
“We need to deal with greater regulatory scrutiny such as the APRA heatmap, as well being more efficient with our fee budgets and our risk budgets. It’s a huge long-term challenge, but one we embrace with enthusiasm – making a difference in members’ lives is a huge motivation for me.”
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.