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© Copyright 2000 Rogers Media. The following article first appeared in the January 2001 edition of
BENEFITS CANADA magazine.
Balancing act
Employees have to weigh the risk of insufficient retirement income against market volatility when
devising an investment strategy for their DC plan. Plan sponsors can help them understand the value of
equities as a long-term investment vehicle.
By Peter Gorham
"What's the most risky type of investment you can make for your retirement?" the telephone pollster asked.
"That's easy. Guaranteed investment certificates (GICs)," I replied. The pollster was taken aback. My
investment philosophy may sound radical but it's actually simple. When we talk about retirement savings,
the ultimate risk is whether there will be enough income in retirement to support the lifestyle the retiree
is seeking.
With their generally low returns relative to other investments, GICs virtually guarantee a lower retirement
income or force investors to divert additional cash into savings. Equities are the most appropriate
long-term investment for employees who are serious about maximizing investment income. My personal plan is
to be 100% invested in equities until I am at least 70. This seemingly crackpot idea is actually the least
risky way to save for the long term.
As plan members approach retirement, they start reassessing their retirement savings and focus on downside
risk. They ignore the upside potential, such as "what if I invest in GICs for safety and there is a big
run-up in equities and my friends all retire with oodles more money that me?" We employ the traditional
lifestyle approach to investing and teach employees to concentrate on securing capital. GICs and money
market funds remain popular as a result.
There's also the question of diversification. The investment gurus preach greater diversification and lower
return expectations in pursuit of the ultimate goal--lower risk. But the ultimate risk is whether there
will be enough income to retire with a desired lifestyle. Fluctuating investment returns are not a risk,
they are merely bumps on the road to a smooth retirement.
Many financial consultants tout the wisdom of reducing risk by switching into a bond fund as retirement
approaches. Bonds react to the economy in the same fashion as annuity purchase rates. When interest rates
go up, bonds drop in value and annuity purchase prices also drop. The amount of retirement income employees
can buy with their now depleted assets is not supposed to change too much, since they can buy the same
monthly annuity with less cash.
That's fine, but many investors shun annuities in favour of registered retirement income funds. Financial
consultants suggest moving to a more conservative strategy, reducing equities and increasing cash and
bonds. Conventional wisdom says that equities are too volatile while bonds and cash are much less prone to
fluctuations. This reasoning is flawed. Statistics show Canadian bonds can have greater volatility than
Canadian equities. Cash, meanwhile, has lower volatility than both equities and bonds.
Two British researchers, Philip Booth, a senior lecturer in actuarial science at City University in London,
England, and Yakoub Yakoubov, a senior investment analyst with Aon Consulting, also in London, recently
wrote a paper that demonstrates the flaws in traditional investing principles. When applied to investment
returns, volatility is a statistical measure (called standard deviation) of how much and how often returns
differ from the average. This means that positive differences, or greater than expected returns, produce
the same volatility as negative differences.
Booth and Yakoubov determined that using a statistical measure called semi-variance to measure risk would
focus on the savings goal rather than positive and negative returns. The concept is to develop a goal for
the desired level of retirement savings based on current account balances and future planned contributions.
We then look at what happens over the 10 years prior to retirement based on different investment
portfolios.
The test is whether the goal was reached or not. We start with three principles: an investment fund equal
to three times earnings; an annual contribution of 12% of earnings; and a goal of retiring in 10 years with
an accumulated investment fund of five times final year's earnings.
For many plan members, a 12% contribution seems like an unattainable target. But once the mortgage is paid
off and the kids are through school, many people find they can put aside enough money that, when added to
their employer's contributions, can achieve this goal.
Five investment strategies are considered in the British report. They are:
1. Equity.A fund comprised of 70% equities, 20% government bonds and 10% cash. The fund assumes no change
in investments during the run-up period to retirement and it is assumed to be the starting investment mix
for the other strategies.
2. Bonds. In each year, 10% of the equities and cash were switched into government bonds so that the entire
fund is invested in bonds in the last year.
3. Cash. In each year, 10% of the equities and bonds were switched into cash (money market) so that for the
last year the entire fund is invested in cash.
4. Equity/Bond. The equity portfolio is maintained for seven years. It is then switched completely into
bonds for the last three years.
5. Equity/Cash. The equity portfolio is maintained for seven years, then it is switched completely into
cash for the remaining three years.
Investment performance is simulated using investment returns for all years since the Second World War based
on U.K. investment returns. Earnings growth is based on U.K. average wages. The results show that using the
traditional measure of risk (standard deviation), the equity fund is most risky and the cash fund least
risky.
However, when we focus only on risk of poor performance (semi-variance), bonds emerge as the most risky
and--surprise--equities are far less risky than either bonds or cash (see "Redefining risk," left).
Interestingly, the all-time worst strategy from the study was the equity/cash fund for retirement at the
end of 1977. U.K. equity markets, like those in Canada, tanked in 1973 and 1974, yet the strategy called
for a switch to cash at that point. Given these poor returns, many people would likely have fled equities.
For the next three years, the U.K. had good cash returns totaling 35%, averaging 10.5% per year. There was
only one problem--huge inflation and large wage increases meant investors lost ground. U.K. wages went up
almost 60% over these three years. Thanks to wage and price controls in Canada, domestic wages only
increased by 37%.
During the years of stratospheric inflation (1974 to 1982), the bond strategy produced an accumulated fund
at retirement of less than three times final earnings in seven of the nine years. Investors actually lost
ground relative to earnings, since they began with a fund equal to three times earnings.
Focusing on annual income rather than on the accumulated fund value, the analysis was repeated but the
target was changed to a goal of purchasing an annuity to pay 50% of final earnings. The overall results
were close to those based on the fund accumulations.
The high correlation between bonds and annuity prices forms the basis for encouraging plan members to shift
into bonds as they get closer to retirement. The results from this study, however, suggest that there is
also a good correlation between equities and annuity prices, but that equities also deliver a greater
chance of capital appreciation than bonds.
Booth and Yakoubov offer some cautions about the target levels used. The measure of semi-variance is driven
from the target point of five times earnings for a fund accumulation or 50% of earnings for retirement
income for the two analyses performed. If the target had been set lower, at say 40% of earnings, fewer of
the bond and cash outcomes would have been classified as bad, and risk would have been lower. Of course,
the equity fund would also have been less risky.
The target for income level used in this study is reasonable for Canada. Ignoring government benefits from
the Canada Pension Plan, Quebec Pension Plan and Old Age Security, a target income of 50% from employer
plans plus personal savings is a good rule of thumb--if the goal is to maintain lifestyle.
The target is also attainable. With a fund equal to three times earnings, and contributing 12% annually,
investors only need to earn 2% more per year than their increase in earnings to end up with a fund equal to
five times their earnings. You'd think that would be simple.
The equity fund produces a final amount equal to or greater than five times earnings, 77% of the time (see
"Multiplying member assets," page 48). In comparison, the bond strategy beat the five-times target only 39%
of the time. That's less than half the time for bonds and cash. The only strategies that beat the target at
least half the time were the three comprising the equity portfolio for the first seven years.
For all earnings multiples, the equity strategy is the best at providing a fund greater than the target.
Bonds produced the worst results, except in fund values above seven times earnings where they were almost
the best.
This does not mean that the bond fund was best overall though. It was the worst performer of all five
strategies when targets were set lower. You could bet on bonds because of the chance for a really good
result, but that would be like betting on a long shot, with a big chance of losing (sort of like putting
your money on the Argos to win the Grey Cup).
There were five years where the bond strategy produced a better income than equities. But there were 39
years where equities beat bonds. With results like this, why would you even consider a bond or cash
strategy? If a plan member knows that there is a better than 50% chance they'll miss their goal, wouldn't
it make sense for them to try something else?
The negative consequences of using the equity strategy are stress and sleepless nights when the markets are
not doing well. But this is a byproduct of our traditional view of risk as being volatility and something
to avoid.
If employees accept that risk is based on the pension they can get, one consequence is the danger of
redefining the target after a good period of investment performance. If an annual review of savings shows
that an investor is 10% ahead of where he needs to be, how likely is the individual to think that he has a
10% cushion in case of poor performance?
Most people would establish a new target or strategy, such as a lower savings rate, earlier retirement or
higher standard of living. With the cushion, the fund could absorb a 10% drop before the results are
considered to be poor. But once we redefine the target, there is no downside room before results are
considered to be bad.
The majority of plan members will recognize that equities produce the best returns, but they come with a
high risk. But when they are taught to think of volatility in terms of meeting their retirement income
goals, equities may be viewed as actually having a relatively small risk.
These findings are radically different from conventional investment wisdom, which isn't surprising
considering that much of employee communication on investing has been provided by investment managers.
However, before betting the farm on equities, we need to examine other investment strategies, consider
alternative definitions of risk and develop clear methods of measuring risk that do not confuse retirement
risk with investment volatility.
Peter Gorham is a partner at Morneau Sobeco in Toronto. pgorham@morneausobeco.com.
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