. 2020. Lionel Martellini And Vincent Milhau. Cambridge University Press, Elements of the quantitative financial series.
This is a very important source of coherent retirement investment strategies based on the buildup and depletion of wealth and viewed as a continuum. The strategies are compared with those of traditional retirement investments equivalent to target-group funds, balanced mutual funds and annuities. It proposes the introduction of latest types of retirement investment solutions that higher serve the target of generating alternative income than existing retirement-labelled products.
Almost every working person faces the large challenge of saving enough for retirement. There are many variables to contemplate, from estimating the fee of retirement to estimating how long retirement savings can be needed. It can also be vital to acknowledge that public pension systems are inadequate to support the life-style that retirees want and wish.
Lionel Martellini, Professor of Finance, and Vincent Milhau, Head of Research, each on the EDHEC-Risk Institute in Nice, France, have created this accessible guide, which is characterised by a solid mathematical foundation. They define consistent investment strategies based on risk tolerance and a set time horizon, combining the phases of wealth accumulation and wealth reduction. Their strategy is different from the seek for the “retirement number” or the goal wealth. Rather, it relies on an investment strategy whose objective is to generate alternative income through targeted spending, following the principles of goal-oriented investing.
The authors begin their evaluation with a discussion of pension systems, specializing in the United States, the United Kingdom and France. They divide the systems into three pillars:
- The universal core of pension insurance that covers basic consumption needs in retirement (the social insurance system).
- Public or private occupational pension plans that require mandatory registration (profit plans).
- Voluntary arrangements, equivalent to defined contribution plans
Each pillar is related to various positive and negative elements that provide the authors with the premise for developing their strategies. They consider the strains that an aging population places on Social Security, the underfunding of defined profit pension plans, the opportunity of individuals going broke in retirement if their savings are insufficient. Finally, there’s also the opportunity of outliving one’s well-planned savings.
The authors acknowledge the abundance of traditional investment solutions for retirement savings (e.g. goal funds, mutual funds with quite a few investment objectives and stuck risk parameters, and annuities). However, they raise many questions when reviewing these instruments, equivalent to insufficient retirement income within the case of goal funds and mutual funds, and lack of flexibility within the structure and costs related to annuities. Retirement savings is further complicated by persistently low or non-positive rates of interest worldwide. Market volatility on the time of retirement represents one other challenge. Issuing only interest, a set percentage of the principal, or a mixture of interest and a set percentage of the principal proves to be a weak plan of motion based on different rates of interest and principal values. What is an investor to do?
A differentiator of Martellini and Milhau’s strategy is the introduction of the annuity bond. What is an annuity bond? It is a liquid asset that will be replicated using bonds and other interest products and provides money flows over the required annuity period. An easy approach to have a look at the annuity bond option is to view it when it comes to life stages – for instance, saving for retirement for 20 years and spending for 20 years during that point. The annuity bond is an important a part of a very long-term investment strategy – on this case 40 years – that features a performance-oriented portfolio. It is becoming a constructing block for brand spanking new types of balanced funds and target-date funds.
Unlike an everyday bond, interest payments on an annuity bond start later. There is not any principal payment at maturity since the interest payments and principal are spread over a time frame in order that the annuity stays constant. Alternatively, the bond will be adjusted for the fee of living to create a pattern of accelerating money flows through the investor’s retirement years.
How is a set income bond constructed and valued? The authors provide clear answers based on the development of a basket of zero-coupon bonds with staggered maturities in an arbitrage-free environment. In the course of this discussion, they admit that their strategy just isn’t unique (see page 25).
What could go mistaken with this strategy? The risk of short-term losses is all the time present. To protect against this risk, the investor should use an appropriate portfolio insurance strategy. Consider the instance of the impact on assets of the equity bear markets in 2000, 2002, 2008 and 2011, in addition to the less severe declines in 2015 and 2018. The authors discuss the positive impact on gap risk of frequent portfolio rebalancing, which is designed to stop the portfolio from falling “under the floor.” They also discuss the impact of a stop-gain decision, where an income stream will be secured at any point through the accumulation phase by transferring assets into the bond.
Why is it so vital to contemplate one of these strategy right away? U.S. employees born after 1970 (and employees in other countries, addressed within the book’s introduction) must depend on their very own savings for many of their retirement savings. The 2020 Annual Report on the Status of the U.S. Social Security and Medicare Programs states that each face long-term funding deficits with currently planned advantages and funding: “Both programs are expected to experience cost growth well above [of] GDP growth by the mid-2030s on account of rapid population aging.” In 2035, trust fund reserves can be depleted and current tax revenues can be sufficient to pay only 76% of planned advantages. In addition, these projections don’t reflect the potential impact of the COVID-19 pandemic on the U.S. Social Security and Medicare programs. The key message is that everybody should start saving for retirement as early and as much as possible and adjust their investment policies as essential, fully aware of the implications of their decisions.
There just isn’t much missing from this compact, comprehensive guide, although I’d have liked a more detailed discussion of income coverage in “later life,” defined because the period of life after life expectancy. Also, an index is clearly needed, particularly for references to classic portfolio theorists equivalent to Malkiel, Markowitz, Merton, and Modigliani (“the 4 Ms”). Nonetheless, the appendices and references provide excellent tools for further research. This is a book for all investment professionals and for anyone fascinated with developing approaches and products that enable clients to completely fund their future long before retirement.
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