Making the moves toward clear outcomes at retirement

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Demand is increasing for investment solutions with a clear view of the outcome at retirement. Here we draw from a fuller paper to touch on solutions designed to meet three types of desired outcome at retirement: accruing capital for a project, buying an annuity and ensuring a decent income stream.

Accruing capital for a retirement project

To accrue as much capital as possible by retirement while protecting a minimum capital level in any market environment – ‘formal protection’ – involves dynamically managing exposures to both risky and safe assets to be sure the protection at maturity will be achieved. The safe asset is usually a fixed-income investment with the return objective of a zero-coupon bond maturing at the retirement date; the risky asset usually consists of equities.

Protection + ratchet = upside + risk trade-off

The main parameters of this approach are the initial level of protection and the ratchet applied to it to secure potential gains. These parameters strongly impact the trade-off between upside and risk: increasing the initial protection and/or the ratchet increases certainties at maturity but at the cost of lower upside potential. Initial protection is usually set to match the invested capital and then increased to follow the highest NAV. The motivation here is simple: securing the initial capital and the gains realised afterwards.

Following the lifecycle principle

BNPP IP’s research shows that protection should be set below 100% of the invested capital in low interest rate conditions and that the ratio of protection (protection/NAV) should be changed as a function of interest rates. Retirement solutions should follow the lifecycle principle: the ratio of protection should rise when getting closer to the retirement date so that the investment in risky assets will be higher when young and lower when old.

Graph: Example of state-dependent allocation to risky asset to protect the nominal contributions invested and part of the gains achieved

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Source: BNPP IP; simulation of the state-dependent allocation and corresponding NAV based on a specific scenario

Buying an annuity at retirement

For investors seeking to buy an annuity upon retirement, a similar solution would protect a notional annuity rather than the invested capital. Such solutions are referred to as Liability Driven Investment or LDI solutions for individuals. The notional annuity is modelled as an income stream weighted by survival probabilities. The safe asset used to hedge these liabilities is thus still a fixed-income investment but rather than being a zero coupon maturing at the retirement date, it is a set of zero coupons with maturities after the retirement date and with nominals proportional to the survival probabilities. The aim is to have the largest upside potential while protecting the notional annuity one could have bought at the time of investment.

Securing an income stream during retirement

Some investors may rather continue investing in risky assets during retirement. A sensible objective would then be to ensure income flows will be available after retirement. For this, similar solutions as those described earlier can be designed and offered, although the exposure to the risky asset remains to some extent in the decumulation phase. As such we benefit on average from the risk premium of the equity market which, on average, will increase the potential outcome.

BNPP IP’s ‘outcome oriented’ solutions for target date investing, when focused on retirement solutions, can offer effective ‘glide paths’ for different objectives such accruing the capital to finance a project upon retirement, securing an annuity or ensuring a steady income stream.

 This is an abridged version of a longer article – to obtain a full length version of the article please send an email to publicationcentre@bnpparibas-ip.com

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Thomas Heckel

Head of Financial Engineering at BNP Paribas Investment Partners

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