This is Part 3 in our coverage of the 2012 DC Plan Summit, held in Mont Tremblant, Que.
Read Part 2: Current trends in DC plan governance
More important today than ever before is having a retirement savings portfolio that’s balanced between capital preservation and capital accumulation. To help members achieve this, plan sponsors need to consider target date funds (TDFs), a relatively under-appreciated asset class.
TDFs are a popular choice for members who don’t feel able to achieve an adequate balance in their own portfolios. But at the 2012 DC Plan Summit, Tom Nelson, portfolio manager, director, strategic asset allocation research, with Franklin Templeton Multi-Asset Strategies in New York, said building an appropriate portfolio mix for the retirement years is just as important as pre-retirement investing—yet it’s often neglected.
He explained a five-step modelling process than can identify the appropriate asset mix in these funds and ensure that plan members have enough money to last throughout retirement.
The first step is to review the overall objective of the fund’s strategy.
“The objective is to provide a portfolio that lasts throughout an investor’s retirement years, given an assumed withdrawal rate, while maintaining an appropriate level of portfolio risk,” he said.
Next, create an efficient asset allocation portfolio to use as a base case in the modelling.
Third, outline a scorecard based on the objectives. “So the objective is to maximize the probability of positive assets throughout the retirement years and minimize the worst-case scenario analysis while taking into account overall portfolio risk,” said Nelson.
The fourth step is to run this portfolio through simulations to see a number of potential outcomes, given market conditions and asset depletion rates. Nelson says it’s important to run the simulations out to 30 years of retirement since Canadian life expectancy is rising. When looking at the simulations, “take into account both expected outcomes as well as the worst-case scenarios in scoring the portfolio options and really strike a good balance between these two opposing forces.”
The final step is to select the portfolio asset mix that most closely reaches the objective in Step 1.
“[Plan sponsors] should use this process when thinking about retirement income solutions. The important thing is that the inputs should all be fully customized to any set of underlying investor preferences or circumstances. The modelling should incorporate robust analysis and produce important insights as to what potentially could happen,” he recommended.
Watch: Tom Nelson discusses the advantages of TDFs
Whether as part of a TDF or as part of a larger investment lineup, plan sponsors should consider including the global small cap asset class, said Nick Hamilton, head of international products with Invesco Perpetual in Henley, England.
“Small caps are a huge market opportunity. The evidence is very strong that it should be a percentage or a proportion of all equity portfolios.” (For the purpose of this discussion, small caps are defined as having under US$5 billion in market capitalization.)
It’s the long-term performance of these small cap companies that Hamilton argues should prompt pension plans to strongly consider them. Looking at data from between 1926 and 2008, small cap returns are the highest of all asset classes and, despite the perceived weakness in equities this last decade in many markets, are in line with long-term averages.
“Returns have been about 9% over the last decade. So the credentials of the asset class have been proven,” he said.
To further illustrate the opportunity in this asset class, Hamilton looked at the government bond market. “Bonds, historically, over 10-year periods, have a far higher chance of experiencing substantially negative results.”
What’s key to note with small caps is that the longer a plan holds the asset, the more the volatility declines.
“The absolute volatility of small caps is exactly the same as large caps,” said Hamilton. “So with a higher expected return and the same volatility, you get a very strong risk/return relationship.”
Hamilton said there are two reasons why small caps are such a great investment opportunity right now. The first is structurally higher earnings growth. The second and more influential reason has to do with management ownership.
“The management teams of small cap companies are either founders in that company, or a very substantial proportion of their personal wealth is involved in the company,” he explained. So the management is personally invested in the success of the company, which positively influences the likelihood of success—and, in turn, returns for the company.
“This is really one of the most exciting investment opportunities of our lifetime,” Hamilton concluded.
Leigh Doyle is a freelance writer based in Toronto. leigh.doyle@gmail.com
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