Improving pensions with ETFs

Accumulating enough money to retire with a 60% replacement income is great — unless you were planning to retire with 70%. Keeping the client on track for a 70% income is where an advisor can add value.

Personal Alpha(TM) means achieving a goal beyond a target, like saving money and earning extra years of retirement income.

Accountants and financial planners, particularly fee-only planners who consider their client’s interests unbiased by product trailers and incentives, have been doing this successfully for some time. But new products like ETFs and services like discount and online brokerages have ushered in a new reality.

As consumers become more knowledgeable, financial advisors will have to develop and expand their value proposition beyond trading and research.

ETFs allow investors access to instant diversification and relatively inexpensive exposure to a large and rapidly growing list of asset classes, regions, countries, styles, capitalizations, sectors, and industries.

As retail investors discover the flexibility that ETFs offer, their expectations from other financial products will change. One consequence of an informed public is the growing acceptance of the principles of passive or index investing as the efficient way to access market or beta exposure.

The debate over active or passive will rage on as investment professionals protect the turf that pays their bills. But most active managers concede a role for passive investing, particularly in a multi-fund, multi-manager environment when overlap yields market returns at full fees.

At the very least, more investors understand that adding returns above the market is not easy and that few can do it consistently. Advisors may find building a core business around this kind of activity to be frustrating at best.

Managing risk

An investment professional’s definition of risk — volatility — is different than most retail clients who fear absolute losses. An alternative definition, based on the reality of clients’ lives, is the risk of not achieving a goal.

Let’s use retirement investing as an example. Defined-benefit (DB) pension plans, given to Members of Parliament and civil servants, are tenaciously guarded by unions and some large corporations. They are professionally managed and, in retirement, pay a percentage of final year’s salary depending upon each plan. DB plans are administered by expert committees and employers are obliged to pay or, in the example above, the taxpayers are.

While both employer and employee contribute, investment decisions are left to the committee. Mandatory valuations every three years assess how the fund measured up to the theoretical liability to pay all those folks their pensions currently, if retired, or in the future, if still working. Any shortfall or funding deficit must be made up over time by the employer or taxpayers.

DC plans like registered plans

In contrast, defined-contribution (DC) plans are like registered retirement plans. The employee makes contributions, usually with employer matches, but the responsibility for investment decisions is the employee’s.

Importantly, there is no target income in retirement and no triennial valuations assuring that the program is tracking towards success or failure. In fact, no targeted percentage of income like a DB plan is required. Over several decades, many DB plans have switched to DC or stopped admitting new members in an attempt to control corporate liabilities.

Financial advisors have a great opportunity here. By targeting a percentage of salary as retirement income, a DC or RRSP portfolio can be managed like a DB plan. Investors benefit by focusing on a stream of income in retirement rather than short-term performance, and improve the chance that they receive what they want from a retirement plan — a reliable income.

Here’s how to do it

If your client wants to replace 70% of her annual income through her retirement, the advisor calculates the capital required to fund an immediate annuity that would pay this amount in today’s dollars at retirement.

Using the investor’s contribution rate and assumptions for inflation and something reasonable for returns, the advisor establishes a capital accumulation path towards the target retirement capital.

Actual performance will be above or below this path as indicated by A, B and C in the chart. By matching the risk of a portfolio to the capital accumulation path, the advisor makes decisions based upon progress towards the goal.

The target may change modestly over time as interest rates change or dramatically as the investor’s circumstances change, such as a big promotion, more children than expected, family illness, inheritances or a lottery win.

This is an important function missing in DC and RRSP management today. Advisors can help investors work on a solution that is useful and valuable.

For more on this topic, see Mark’s whitepaper in the Rotman International Journal of Pension Management called “What DC plan members really want.”