Retirement income: replacing what is no longer there

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With the ‘replacement rate’ in most European countries expected to decline, the need to make up for the resulting shortfall in income can be expected to be a major driver of savings in the decades ahead. Lump sums or regular savings – what matters is starting to save on time. Important questions concern how to allocate savings to maximise returns as your risk profile changes over time and whether to make the decisions yourself or delegate this to a manager. Should you look for a fixed guarantee? If so, at what level? Or is a ‘glide path’ preferable and how do you find a balance between adequate protection and enough flexibility to adjust the portfolio to opportunities and changing circumstances?

The expected drop in the replacement rate – i.e. the percentage of your income that you stand to receive in the form of pensions – is already affecting consumer behaviour. Workers have dismissed the idea that the welfare state will meet all their retirement needs. Many of them are concerned about setting aside enough to supplement the entitlement due to them from the various retirement schemes.

Less room for welfare

State pension reforms since the early 1990s have sought to stabilise the share of GDP devoted to pensions. Demographic studies have found that in France, growth in the working population will level off, while the number of retirees will almost double between 1990 and 2050. Obviously, to maintain living standards, future retirees will need additional sources of income. The main levers for keeping retirement funds and their costs at the same share of GDP have been to extend the length of the period during which contributions are made and reduce the total benefits. Benefit reforms have eaten into the replacement rate more than extending the period over which contributions are paid in.

This has resulted in inflows into savings accounts. In France, this can be seen in the mandatory employee or voluntary (Pilier III) savings plans. As an example, in the first six months of 2014, a little more than EUR 1.2 billion was deposited in French PERCO accounts, an 11%-plus increase over the same period in 2013, while PERCO assets under management expanded by more than 26% year-on-year (source: French Financial Management Association (AFG), 4 November 2014). The French are also increasingly using other retirement savings plans.

This marks a shift in the trend. Until recently, the baby-boom generation did not have to worry much about additional sources of retirement income as pensions rose during the post-war boom, driven by robust economic activity, strong demographics and a shrinking of the retirement-age population due to the two world wars. Pay-as-you-go did the rest.

Slow and steady wins the race

To cope with this new challenge of shrinking retirement income, workers will have to set aside long-term savings. What is the best approach?

Letting EUR 1 000 in savings simply ‘pile up’ in a bank account each year could earn you EUR 20 000.

If you do this in the first 10 years of your working life and then try to address a pension shortfall by investing EUR 2 000 annually in financial products over the next 10 years, you could earn EUR 25 000.

If you opt to invest your disposable savings at a steady pace of EUR 1 000 every year, the total could reach EUR 30 000. In order words, when it comes to long-term savings, slow and steady wins the race.

Of course, all this is easier said than done. To allow for surprises, savers should be able to access their capital at the pace they wish or under certain conditions. As professional careers follow a bumpier path and as the retirement age becomes more uncertain, it is important to let investors change priorities or investment horizons. Even so, it must be noted that one stands to earn higher remunerations over longer investment periods, so it is important to begin saving as soon as possible.

Best not to be passive

The golden rule of not putting all your eggs in one basket is, of course, paramount. Investors should seek to maximise returns while maintaining a minimum level of diversification, flexibility with regard to the investment horizon and taking into account a risk profile that will likely evolve over time, meaning that as you age, your appetite for risk and the need to safeguard your capital will change.

Accordingly, your asset allocation should be adjusted regularly.

This can be time-consuming and requires some financial know-how. That’s why many savers have decided to delegate this task to investment professionals. Their target-date investments are actively managed and adjusted to a declining risk appetite.

The rollercoaster ride on financial markets in recent decades has increased investors’ risk aversion markedly. This has been especially so since the 2007-2009 crisis and demand for risk transparency continues to expand. For many, the question now is: should we be as concerned about capital protection as we are about returns?

Protected management offers answers

Evolving from the concept of guaranteed capital, protected management, or risk budget management, works with risk envelopes which quantify the maximum risk assumed by the investor and give the manager guidelines to achieve his investment objectives.

Some protected management strategies are especially well suited to target-date funds. They combine capital protection and an exposure to high-yield financial assets that will tend to decline as the funds near maturity. One could wonder whether adding a guarantee comes at the expense of the potential yield. This depends on the level of the guarantee and how it can evolve.

With interest rates currently at historic lows in the eurozone, 100% guarantees can seriously dent the upside potential. Such guarantees typically involve buying bonds issued by the guarantor. When interest rates are near zero, this can leave little room for investments in other assets and hence there is little chance that the investor will receive anything beyond the guarantee.

Flexible allocations and flexible guarantees

A less capital-intensive guarantee could result in more long-term upside potential. Being able to adjust the guaranteed amounts during the life of the strategy and aligning guarantees with market interest rates could help you grow your savings while playing it safe. This is what is offered by the THEAM range of target-date strategies, with investment horizons ranging from five to 30 years and guarantees that can be adjusted to various interest-rate environments.

So to make up for a shortfall in retirement income, it could pay to start investing as early as possible; diversify your investments, but be sure to incorporate (some) risky assets; include various investment horizons; and opt for products that can adjust to shifts in market conditions.

Retirement is one of the nine themes which we think reflect investors’ key priorities this year. Linked to those themes we have chosen funds which we believe represent the most relevant solutions to the challenges of the current market environment as well as the evolving needs of our clients.

For more on the topic of retirement and related investment solutions, click here.

Charles Alberti

Investment specialist at THEAM

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