I'm going to ask a very naïve question here... isn't there a fund someone has already come up with, which has an optimal mix of stocks/bonds/other investments, which would provide a similar smoothing effect, and avoid the need to re-write the rule book? (eg: Vanguard Global Balanced Fund)Hi @Nermal
An assumption on future returns plays a minor role in the smoothing process, particularly at the start, but it really is minor, and becomes more minor over time. The smoothed graph can be viewed as a line cutting through market values, reducing the magnitude of the humps and hollows of market value movements. I've tried to append the graph of smoothed and unsmoothed indices if contributions were invested in the UK index between 1990 and 2019 to show how it looks pictorially. I hope my stupidity in all things technical hasn't stymied my efforts.
In case that hasn't worked, I attach the paper I submitted to the UK Institute and Faculties. That shows the same graph on the bottom of page 10. I suggest you also run through the numbers in Table 1 on page 9, calculating smoothed returns for the first six months of 2020, assuming a scheme start date of 1 Jan 2020 (just before Covid struck the stock markets). The calculations should answer your question. They show monthly unsmoothed returns spanning a 20% range (from -15.1% to +4.9%) while smoothed returns span a 0.2% range (0.13% to 0.33%).
I'm sorry if the answer to your question is a bit long-winded, but if it were child's play, it would have been done years ago. I think you'll get the hang of it quickly though if you just take 15 minutes or so to put the numbers of table 1 into a spreadsheet. It could actually be a bit of fun!
Yes, it's called "lifestyling" and involves giving up all or most of the Equity Risk Premium with a resultant major negative impact on long term pension savings. It is the default approach for many and was the basis of the original "strawman" proposal put forward by the Department of Social Protection which has not changed.I'm going to ask a very naïve question here... isn't there a fund someone has already come up with, which has an optimal mix of stocks/bonds/other investments, which would provide a similar smoothing effect, and avoid the need to re-write the rule book.
Lifestyling, at least for my pension provider, is a process which gradually moves my funds into less and less risky assets, as I get closer to retirement. Therefore I could miss out on all those (potentially juicy) returns close to my retirement age. Which isn't what I'm saying at all - but maybe I've misunderstood the lifestyling concept.Yes, it's called "lifestyling" and involves giving up all or most of the Equity Risk Premium with a resultant major negative impact on long term pension savings. It is the default approach for many and was the basis of the original "strawman" proposal put forward by the Department of Social Protection which has not changed.
Apologies. It is difficult to know how to pitch posts on AAM. Clearly you are quite clued in and yes you have described "lifestyling" accurately. The basic point though is that any mix involving bonds/low yielding assets/cash is expected (but not certain) to produce lower returns than 100% equities in the long term. I think Colm has described his own strategy as 100% equity but obviously without smoothing. Depending on your circumstances you may be comfortable with that and that does seem to be your approach - you seem to be ok with short term volatility. "Lifestyling" essentially recognises that many folk and especially those at whom AE is targeted would not be comfortable with that amount of volatility.Lifestyling, at least for my pension provider, is a process which gradually moves my funds into less and less risky assets, as I get closer to retirement. Therefore I could miss out on all those (potentially juicy) returns close to my retirement age. Which isn't what I'm saying at all - but maybe I've misunderstood the lifestyling concept.
In my case, I've opted out - and instead I'm invested in a passive equity fund, until I retire unless I make a further change. Ideally though, and taking inspiration from Colm's concept, I'd like to have the highs and lows smoothed out. both investing in, and withdrawing from the fund, along the way.
If I had access in my pension to invest in say Vanguard's Global Balanced Fund, would I get more or less the same benefit as Colm's approach? A smoothed return.
Ideally I would stay in this fund, with my current pension provider, after I retired, but even if I had to "cash out" and setup an ARF with the same fund at that point in time, the approach would stay the same (albeit with likely higher charges for the reasons other posters have already mentioned).
Is there a distinct advantage to Colm's approach vs investing in the long term in something like that Vanguard fund?
Apologies. It is difficult to know how to pitch posts on AAM. Clearly you are quite clued in and yes you have described "lifestyling" accurately. The basic point though is that any mix involving bonds/low yielding assets/cash is expected (but not certain) to produce lower returns than 100% equities in the long term. I think Colm has described his own strategy as 100% equity but obviously without smoothing. Depending on your circumstances you may be comfortable with that and that does seem to be your approach - you seem to be ok with short term volatility. "Lifestyling" essentially recognises that many folk and especially those at whom AE is targeted would not be comfortable with that amount of volatility.
Charges are another but also very significant aspect which Colm's proposal also addresses.
Agree, no need to critique it - there are many well diversified funds on the market. It's one I recalled offhand and I mentioned it purely as an example. Your assumptions are helpful though in terms of the evaluating the right fund to select and there will be tradeoffs of course.@nest egg It would take us a little off topic to critique the Vanguard Global Balanced Fund and I am not familiar with it. It's name suggests something like a 80/20 equity/bond split. Let's say in the long term equities outperform bonds by 4% p.a. (ERP) then long term this will expect to underperform a 100% equity fund by 20% x 4% = 0.8% p.a. Not disastrous for sure but still compared to the 0.5% cap on charges which was originally proposed it is significant.
Global sounds good. A well diversified global equity approach is what I think Colm is proposing.
What about volatility? Well let's say we would not be at all happy if our retirement fund fell by 20% in a year. Let's say the 100% equity fund fell by 20%, then other things equal the 80/20 fund would fall 16%. Is that much different?
Talk of an "optimal mix" sounds a bit like hubris to me, though I have seen analysis which suggests 60/40 is "optimal".. "Optimal" will be relative to a personal risk/reward appetite.
You must have read my submission to the AE consultationAgree, no need to critique it - there are many well diversified funds on the market. It's one I recalled offhand and I mentioned it purely as an example. Your assumptions are helpful though in terms of the evaluating the right fund to select and there will be tradeoffs of course.
My counter proposal is a "hybrid" of Colm's, where everyone benefits from the following by default:
Options can exist for the small minority who may want to do something else.
- No cliff-edge at retirement, you stay in the fund forever (leveraging its economies of scale and simplicity)
- No lifestyling (not necessary due to the default fund)
- A level of smoothing still achieved, using a well diversified passive fund (this should also keep charges low)
While very likely inferior to Colm's full approach, crucially it is better than what's being proposed by the Govt. From my standpoint, it also has the distinct advantage that it doesn't require any politician / civil servant to take a "brave" decision (in the Yes Minister sense of the word!) on something new.
You've cheered me up Duke! The big question is, do you have anyone's ear?? I hope so.You must have read my submission to the AE consultationIt was headed "one fund for life".
I was aware of Colm's approach and said it required serious consideration, which is all Colm is asking for.
I recently had a relative retiring with a pension target of €40k p.a. His fund was c. €1m which was about right for his target. 1% charges are €10k p.a. or 25% of target pensionThe “lifestyle “ approach was a reaction to two separate issues:
- those who wanted to reduce volatility as they approach ”drawdown” at retirement in order to ensure their retirement lump sum
- the balance of the fund being used to buy an Annuity (the price of which is determined - to a significant extent- on bond/interest rates)
But with the introduction of ARFs very few retirees from D.C. schemes have bought Annuities, probably because in a decade or more of low interest rates, Annuity rates have looked poor value. Most retirees have gone the ARF route and reinvested the residual fund (typically 75%). But in doing so, many (but not all) have tended to adopt a relatively conservative investment strategy (“I am reluctant to take much investment risk”, “ I am not sure I can live with Equity volatility for the entire ARF fund”). In my experience, very few have adopted Colm’s strategy of 100% Equities (unless they we not reliant on the ARF drawdown for income in retirement).
So for the typical retiree, they require advice on whether ARF or Annuity (and Annuity rates are now looking better as interest rates are on the rise), and if going the ARF route they require advice on what ARF, what investment strategy, what level of drawdown etc. So invariably all of this comes at a cost. Even if all of this was set at a charge of say 1% pa, it means the fund has to earn 1% pa before the client gets any return.
So apart from Colm’s “smoothing proposal”, the idea of leaving the residual 75% in the AE fund and drawing income from that fund, is likely to result in an expense saving for the client.
As someone once said “I works fine in practice, but does it work in theory”.
There still will be some fund charge even if the retiree can remain in fund post retirement. But the AE proposal suggests a max annual fund charge of c0.5% . And if no advice is required, then that results in a potential further saving.I recently had a relative retiring with a pension target of €40k p.a. His fund was c. €1m which was about right for his target. 1% charges are €10k p.a. or 25% of target pensionThis is the sort of drag on income that young folk face in their mortgage. That ain't right.
I don't know what you mean by "emergency measures". I never mentioned anything of that nature in anything I ever wrote.
You seem to think that AE is a quasi State supplementary pension and therefore open season for the State to raid irrespective of whether it is using smoothing or otherwise. It is no more vulnerable than any other private sector arrangement (which we have seen of course have been raided) or indeed the UK NEST funds.
Of course, that's how smoothing formulae are designed to work! But these formulae are totally dependent on parameters estimated from long-term performance. These parameters are updated over time and if they are not regularly then something is wrong!The smoothing formula is constantly pulling smoothed value towards market value (not vice versa, as some people claim that I'm saying)
Boss that is an unwarranted swipe at Colm IMHO. He could have covered his proposal with one chapter. Instead he produced a 60 page paper for the Society of Actuaries, mostly devoted to implicitly or explicitly addressing the twin (valid) concerns arising if and when smoothed values exceed market values - (1) the fair sustainability of future contributions and (2) the possibility of an implicit State guarantee.These are certainly concerns. Colm needs to face up to them , deal with them and show how they will not come to pass. and not just dismiss them as invalid criticisms. He will not be able to get people on board by attacking them.
Brendan
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