Asset Allocation Research for UK Advisers

• Understanding Target Date Funds
• Why a cohort-based approach makes sense
• The performance experience this year by cohort

 What are Target Date Funds?
Target Date Funds are multi-asset funds whose risk profile changes over time, becoming less risky on approach to, and after the target date in the fund’s name.
Investors, or their advisers, can use target date funds as an investment strategy that is purpose-built for retirement.  By selecting a fund whose target date matches a planned retirement year, investors get access to an accumulation-oriented investment strategy prior to the target date, and a decumulation-oriented strategy after the target date.  This makes target date funds a convenient “all-in one” fund which explains why they are often used as default funds within pension schemes, including NEST.
Why a cohort-based approach makes sense
It’s common sense that the risk capacity for an investor’s exposure to market risk is different at different stages of life and wealth levels.
For younger investors, where wealth levels are typically lower and time horizons are longer, there is a higher capacity for loss, hence a higher exposure to higher risk-return assets makes sense.
For older investors, where wealth levels are typically higher and time horizons are shorter, there is a lower capacity for loss, hence a lower exposure to higher risk-return assets makes sense.
If customers can be segmented by cohorts, it makes sense that investment strategy can be too.
What is the performance experience for different cohorts this year (time-weighted)?
The 2015-20 Target Date Fund from Architas experienced a moderate maximum monthly drawdown of -4.71% in March 2020.  By comparison, the 2020 Target Date Fund from Vanguard experienced a -6.66% drawdown.  This contrasts with -9.37% for the Elston 60/40 GBP Index, -10.94% for MSCI World, and -13.81% for the FTSE 100, all in GBP terms.
In this respect, investors who were in default decumulation strategies, with lower capacity for loss, saw better mitigation of downside risk relative to a traditional 60/40 “balanced” mandate.
Fig.1. YTD performance of UK Target Date Funds (GBP terms) for those retiring 2015-20.

 Source: Elston research, Bloomberg data
How Target Date Funds could fit in with policy evolution
Ensuring there is some form of in-built lifestyling is a longstanding feature of consumer protections for pensions investment since Stakeholder times.  Using behavioural finance in proposition design can provide a degree of consumer protection from poor outcomes for less confident, less engaged investors.  That’s why a growing number of regulatory interventions incorporate some form of built-in lifestyling.  Whilst this is complex to achieve from an administrative perspective, the fact that Target Date Funds deliver lifestyling within the multi-asset fund structure makes them a useful product type for default investment strategies.
Fig.3. Key behavioural aspects and price anchors of policy interventions

In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for discretionary managers and financial advisers.
Aligning investment strategy with objectives
Investing can be defined as putting capital at risk of gain or loss to earn a return in excess of what can be received from a risk-free asset such as cash or a government bond over the medium-to long-term.
There can be any number of motives for investing: it could be to fund a future retirement via a SIPP, or to fund future university fees via a JISA.
Online tools and calculators can help estimate how much is required to invest today to fund goals in the future.
Investors can target a particular return, but learn to understand that the higher the required return, the higher the required level of portfolio risk.  Risk and return are the “ying and yang” of investment.  You can’t get one without the other.
Total return can be broken down into income yield (dividends from equities and interest from bonds) and capital growth.  In the UK, income and gains are taxed at different rates.  If investing within a tax-efficient account, like a SIPP or an ISA, then income and gains are tax-free.  If investing outside a tax-efficient account, investors must also then consider in their objectives how they want to receive total return – with a bias towards income or with a bias towards growth.
Given the majority of DIY investors are able to make use of tax-efficient accounts, there is less need to consider income or growth, with many investors opting to focus on Total Returns and to use funds that offer “Accumulating” units that reinvest income, and reflect a fund’s total return.
How then to build a portfolio to deliver an appropriate level of risk-return?
What matters most when investing?
For the purposes of these articles, I assume that readers need no reminder of the basic checklist of investing: to start early, to maximise allowances, keep topping up regularly, and to keep costs down.  Then comes the key decision – what to invest in.
The main driver of portfolio risk and return is not which stocks or equity funds are within a portfolio, but what the proportion is between higher risk-return assets such as equities, and lower risk-return assets such as shorter duration bonds.
Put simply, whether to invest 20%, 60% or 100% of a portfolio in equities, will have a greater impact on overall portfolio returns, than the selection of shares or funds within that equity allocation.
For example, when making spaghetti Bolognese, the ratio between spaghetti and Bolognese impacts the “outcome” of the overall meal, more than how finely chopped the onions are within the Bolognese recipe.
While this may seem obvious, it gets lost in all the noise and news that focuses on hot stocks, star managers and performance rankings.
For those that want to back up common sense with academic theory, the academic articles most referenced that explore this topic are Brinson Hood & Beebower (1986), Ibboton & Kaplan (2000), and Ibbotson, Xiong, Idzorek & Cheng (2010), all referenced and summarised in my book.
Building a multi-asset portfolio to an optimised asset allocation to align to a particular risk-return objectives sounds like hard work and it is.  That’s why multi-asset funds exist.
The rise of multi-asset funds
As investing becomes more accessible to more people, there is less interest in the detail of how investments work and more interest in portfolios that get people from A to B, for a given level of risk-return.  After all, there are fewer people who are interested in the detail of how engines work than there are who are interested in how a car looks, how it drives and what they need it for.
There is nothing new about multi-asset funds, indeed one could argue that the earliest investment trust Foreign & Colonial Investment Trust, founded in 1868, invested in both equities and bonds "to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks”.  In the unit trust world, managed balanced funds have been around for decades.  I would define a multi-asset fund as a strategy that invests across a diversified range of asset classes to achieve a particular asset allocation and/or risk-return objective.
They offer a ready-made “portfolio within a fund” thereby enabling a managed portfolio service for the investor from a minimum regular investment of £25 per month.  .  In this respect, multi-asset funds help democratise investing, and make the hardest part of the investor’s checklist – how to construct and manage a diversified portfolio.  The different types of multi-asset fund available is a topic in itself.
The ability for investors to select a multi-asset fund for a given level or risk-return characteristics for a given time frame is one of the most straightforward ways to implement a strategy once that has been aligned to a given set of objectives.
Multi-Asset Fund or ETF Portfolio?
The main advantage of a ready-made multi-asset fund is convenience.  Asset allocation, and portfolio construction decisions are made by the fund provider.
The main advantages of an ETF Portfolio are timeliness, cost and flexible.  ETF Portfolios are timely.  You can adjust positions the same day without 4-5 day dealing cycles associated with funds – an important feature in volatile times.  ETF portfolios are good value.  You can construct a multi-asset ETF portfolio for a lower cost than even the cheapest multi-asset fund.  ETF Portfolio are flexible – you can tilt a core strategy to reflect your views on a particular region (e.g. US or Emerging Markets), sector (e.g. healthcare or technology), theme (e.g. sustainability or demographics), or factor (e.g. momentum or value), to reflect your views based on your research.
Conclusion
Setting the right objectives to meet a target financial outcome, such as funding future retirement, university fees, or creating a rainy day fund is the primary consideration when making an investment plan.
Getting the asset allocation right – choosing a risk profile – in a way best suited to deliver that plan is the second most important decision.
Finding a straight forward to deliver that risk-return profile, by building your own ETF portfolio or using a ready-made multi-asset index fund, is the final most important step.
All the while, it makes sense to stick to the investing checklist: to start early, keep topping up, and keep costs down.

Source: FTSE Russell

Evaluating DC pension scheme performance should be done on a cohort-by-cohort basis.

The standard FTSE UK DC Benchmark Indices provide a helpful reference index for a simple equity/bond allocation.

​But DC schemes could consider creating an independently calculated custom benchmark to match their "glidepath". 
 
FTSE UK DC Benchmark Index Performance 1q18 performance:
+0.1% 2015 Retirees, -1.5% 2025 Retirees, -3.8% 2035 Retirees, -4.4% 2045 Retirees.
Annualised 3 year performance to end March 2018:
+7.7% 2015 Retirees, +8.8% 2025 Retirees, +10.6% 2035 Retirees, +10.9% 2045 Retirees

View Factsheet
Learn about FTSE UK DC Indices
Visit 1UKDC025 Index <Go> on the Bloomberg Terminal

The new pension freedoms means that advisers have a key role to play in helping their clients get the retirement they expected.  In most cases, that’s unlikely to be a simple choice between cash, drawdown or annuity but more of a combination of each to match a client’s needs, requirements and aspirations.
When researching the solutions that could help advisers navigate the new retirement freedoms, we looked to the US where annuities have long ceased being the mainstay of retirement income to understand the innovations that can help create more durable retirement portfolios.

From “to” to “through”
Lifestyling pensions are managed to a retirement date typically targeting annuity conversion.  Target date funds can be managed through retirement targeting sustainable withdrawals from a balance of stability and growth.
​
The target date is not an end date but a start date for the drawdown phase.  It is the turning point where investors move from making regular contributions, to making regular withdrawals.  The investment objectives gradually pivot from making a pot grow before retirement, to making it last in retirement, sustaining a durable income.

Flexible, not fixed
In contrast to old-fashioned lifestyle strategies which follow a fixed investment plan, target date funds enable flexible asset allocation to adjust for the market and economic environment.  This is the difference between being asleep or awake at the wheel: the journey looks similar, but it’s who’s driving that counts.  This flexibility enables active risk management for a smoother ride for clients.

Partial annuitisation
Annuities’ key feature is to provide guaranteed income in old age until death.  That was generous in 1928 when the pension age was 65 and the average age of death was 67, now it’s a stretch as, happily, we are all living longer.

Partial annuitisation may have a role to play to top up other guaranteed incomes, like DB benefits and the state pension, to help cover a client’s essential spending in retirement. So while most retirees in the UK took 25% cash/75% annuity, about 19% of retirees in the US take some form of annuity with optimal allocation considered to be 25% annuity/75% drawdown on average.

Deferred annuities
Traditional annuities and enhanced annuities would both be termed in the US as “immediate” annuities as they start paying out at point of purchase.  What we don’t have yet in the toolkit are “deferred” annuities, which start in the future to do what annuities were originally meant to do: to form a perfect hedge to longevity risk.

By combining target date funds with a progressive purchase of deferred annuities, there is scope to get the best of both worlds: a managed portfolio to drawdown over time, and a longevity hedge for later life, when longevity risk is an insurance worth having.  We encourage UK insurers to offer deferred annuities to broaden the retirement toolkit.

A “bucket” approach
One framework in the US for retirement portfolio construction is the “bucket approach”. Each bucket includes a cash component for short-term needs, a medium risk bucket for medium-term needs, and a higher risk bucket for longer-term growth.  The allocation to each bucket changes as time goes on, as risk capacity changes with time.  With target date funds, allocations to these different “buckets” is managed within the fund, for convenience, efficiency and value, and enables advisers to focus on more holistic planning decisions.

Bringing it together
Instead of considering a portfolio’s potential for risk and return, advisers are now having to consider retirement outcomes – income replacement and adequacy rates, sustainable withdrawal rates, life expectancy and legacy decisions.

Our accredited CPD series for advisers around retirement investing examines the ‘lifecycle’ framework for combining future income, current portfolio, life insurance and annuity choices to optimise asset allocation over time to consider not only investment risk, but mortality risk and longevity risk too.

Old problems, new answers
While none of these considerations are new to advisers, the responsibility for managing them is.  The innovation that target date funds provide for a managed drawdown portfolio forms part of the retirement planning toolkit alongside cash, guaranteed income, and insurance. It’s for advisers to combine these to create a plan that suits their client’s needs.  It’s time to rethinking retirement investing and we are here to help.

The new pension freedoms means that advisers have a key role to play in helping their clients get the retirement they expected. In most cases, that’s unlikely to be a simple choice between cash, drawdown or annuity, but more of a combination of each to match a client’s needs, requirements and aspirations.

​Read the full article in Employee Benefits

The new pensions freedoms that came into force this April allow much more flexibility on how to invest for and in retirement.
This flexibility is welcome and overdue. It also means that advisers have a more important role than ever in helping their customers navigate the multi-dimensional world of retirement investing: both from a financial planning perspective and from an investment perspective.
​
Read the full article in Money Marketing

Regulatory changes in pensions and advisory markets are prompting a fresh look at age-based multi-asset funds, known as lifecycle or Target date Funds (TDFs).  As part of a broader move towards packaged investment strategies, investment managers may need to reassess their product offering to become a wealth manager, a fund factory, or both.
​
"For packaged investment strategies, with an emphasis on strategic and tactical asset allocation, we expect passive constituent funds to be the most prevalent, to keep TERs to a minimum. Lower TERs reduces the bar for investors hoping to make real returns, net of fees, which is increasingly important in the current era of depressed real returns.
Indeed, a preference for passive constituent funds could drive a shift in the fund management industry itself. The industry could gradually polarise between asset allocating wealth managers or constituent fund factories: the former to provide investment strategy, portfolio construction and risk control, and the latter providing active and/or passive constituent funds.
If fund managers already have a comprehensive range of funds, then we expect them to defend their offering by enhancing their multi-asset product… If fund managers have only a niche range of fnuds, then they need to decide whether to remain a specialist fund manager, or start offering wealth management solutions in combination with third-party funds. In either case, there will be pressure on fund management houses to adapt their product offering, or risk commoditisation."

Henry Cobbe, CFA

Read the full article from CFA UK Professional Investor Magazine