In recent years, we have witnessed a combination of poor savings habits and weak investment results that has depleted the left-hand side of the equation. As a result, left-hand side components are not pulling the weight they once did. Meanwhile, the demographic phenomenon of increasing longevity has only exacerbated the equation’s imbalance. In a study by Statistics Canada, for instance, it is estimated that we could see a 200% increase in the population age 65 and older over the next 50 years.
Addressing the Retirement Conundrum
For the investment industry, the real focus and challenge is how we can tackle the portion of the equation that is within our control—namely, the left-hand side—through innovative solutions that reflect changing realities.
We are faced with a number of headwinds in achieving our objective. One such challenge is that savings levels are far lower than they have been historically. For example, in 1990, the Canadian savings rate was 13%. By the end of 2005, that level had decreased substantially to an alarming -0.04%!
Weak performance is another material headwind. Behavioural finance indicates that investors make many common cognitive errors when it comes to investing, allowing emotion to drive investment decisions. One of the most costly errors of these behavioral pitfalls is poor market timing.
The desire for more active retirement lifestyles is also a significant barrier to achieving sufficient retirement assets. More active retirement lifestyles are accompanied by the need for greater retirement assets. However, people are not necessarily choosing to work longer. They want to retire at the same age (or even younger, if possible) leaving more “golden years” that need to be funded by retirement savings.
Thus we encounter a situation in which people are living longer, but substantial asset erosion is occurring in the period leading up to retirement and during retirement itself. Something has got to give.
The Investment Industry’s Challenge
The investment industry has an obvious priority to recalibrate the retirement equation by bolstering the savings and returns component. This is not achieved in isolation, of course, but with the help of other investment managers, plan sponsors, service providers and consultants to ensure plan members are better equipped to meet their retirement goals through ongoing education addressing, for example, the need for responsible savings regimens.
Currently, the solutions available to defined contribution (DC) pension plans include GICs, mutual funds and other traditional portfolio solutions. Lifecycle portfolios—one of the fastest-growing portfolio-based solutions among DC plans—are an example of a solution that is well-suited to meet investors’ needs in retirement and can combat the reality of longevity risk, as well as the pitfalls of behavioural finance.
Indeed, one of the primary ways that lifecycle solutions can help is by managing investor emotions—in effect, protecting investors from themselves. With the benefit of built-in asset mix management, lifecycle solutions offer sound and disciplined portfolio construction that can keep an investor’s goals in focus, preventing deviation from the path.
Not All Lifecycle Solutions are Created Alike
There are essentially two approaches to lifecycle investing: target date solutions and target risk solutions. Of course, each approach has its pros and cons.
Target risk solutions acknowledge that risk tolerance varies, even for investors with the same time horizon. By contrast, pure target date solutions don’t recognize different risk tolerances. Meanwhile, target date solutions typically operate with a dynamic asset mix that changes as plan members’ time horizons change, a feature that isn’t shared by target risk solutions.
The Best of Both Worlds
A hybrid of the target date and target risk approaches can in fact enhance the benefits of target risk solutions while displacing the failings of target date solutions, and vice versa. By combining the benefits of the two strategies and alleviating some of their weaknesses, a potential win-win solution is generated for plan members and sponsors.
Let’s take this concept one step further, and introduce the concept of “active management,” another important feature of professional management. Up until now, few lifecycle solutions have boasted this innovation.
Target date portfolios have traditionally relied on strategic asset allocation. That is, identifying an asset mix roll-down strategy and adhering within those guidelines, regardless of market conditions. By contrast, an active management approach acknowledges the benefit of strategic asset allocation, but does not believe in following this path blindly. Instead, an active management approach responds proactively to market developments, with the flexibility of taking advantage of opportunities to ensure that long-term risk-adjusted returns are held in priority.
In the coming years, the investment industry will likely seek to recalibrate the retirement equation even further as variables continue to change and evolve. The evolution of lifecycle investing has greatly increased the overall effectiveness of plans, and we believe that solutions that combine target date, target risk and active management are well poised to lead the way for DC pension plans.
They are the industry’s response to the eroding retirement equation by providing a one-stop solution that can be implemented—and grasped—with ease. This is an effective hedge against paralysis on the part of the plan member, especially during today’s turbulent times.
Stephen Lingard is a vice-president/portfolio manager with Franklin Templeton Investments.
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