Goals-Based Investing

How goals-based investing took ‘liability matching’ to the retail market

By Darren Beesley
Sydney, Australia

One of the feats of goals-based investing is its transformation of ‘asset liability matching’ into a tool that advisers and investors can use to deliver better outcomes, particularly for retirees.

Big institutional investors and insurers use asset liability matching to deliver future cash streams that fund liabilities. Asset liability matching places the goal – meeting liabilities – as the top priority when implementing investment strategies.

But how does goals-based investing deliver the powerful benefits of the asset liability matching approach to the retail investor?

To understand that, Darren Beesley, Senior Portfolio Manager, delves into the recent evolution of investing and client needs.


How big instos and insurers really invest

I started as a graduate in asset consulting at Watson Wyatt, now Willis Towers Watson. Some of our clients back then were insurance companies and big defined benefit (DB) schemes.

We spent weeks, if not months, working on the projected cash flows of the Defined Benefits (DB) scheme or insurance pay-out. A DB scheme obviously has a future stream of pensions to pay; an insurer has a future stream of insurance claims to pay.

Our goal was to value the liability of the scheme or insurance book. We needed to understand the factors that drove movements in liabilities, interest rate risks, inflation risks and member longevity.

Only when that liability was understood and valued, would an investment strategy be implemented.

The benefits of this liability matching are obvious: it clearly linked the investment strategy to a goal – funding a liability. Risk, based on this approach, is the mismatch – or funding gap – between assets and liabilities.


The retail ‘return’ approach

But, as you know, the traditional retail approach to investment has been very different.

It’s all about returns: how is the fund performing relative to competitors on the league tables. Or investments compete against benchmarks, such as the Australian equities index or a global equities index. Or investments are grouped into risk buckets, such as the growth and defensive asset split.

Have we beaten that index? That is the proxy for risk.

When an individual sets up a strategy, whether based on advice or by going straight into a balanced fund, there is very little reference to their personal liability set, such as an income stream in retirement.

There is a vast difference between institutional investors who use liability matching to set investment strategies based on a clear goal, and the retail approach with the primacy of returns and benchmarks.
When the retail approach does and doesn’t makes sense

Now, during accumulation, it should all be about total return. An investor’s or client’s goal – retirement cash flows – is a very long time away.

All we know, for now, is we have some sort of personal tolerance of risk. We want to maximise returns, go for alpha. It’s a total return framework and we really don’t need to think about the asset liability world.

That all changes during decumulation. Clients and investors are closer to their goals. We can see them and map them out.

But those goals may be complex and layered. We need to trade off how much income we spend during different stages of retirement, how much we leave kids, tax, and whether government welfare is going to come into play.

In terms of terminology, on an individual level, a goal – I want to go to Europe in 2025, or essential income for groceries – is a liability, a future stream of cash flows you’re looking forward to.

How to implement liability matching?

If we begin to think about how our assets need to fund future cash flows, it becomes clear that we could manage our assets better.

Basically, we want to adopt the liability matching approach for each client and investor.

The problem is that’s extremely difficult.

You could take every single asset the retiree has, factor in future changes to welfare rules and a range of returns. On the liability side, you could map out how much they needed for utilities and groceries. And map out what they want to do with excess savings, whether it’s that European trip or a legacy for kids. You then model this altogether and factor in every different combination.

It would become way too complex and costly on an individual level.

Institutions do this -- though it’s not even as complex – and it takes months and it’s expensive.
Yes, people talk about this happening through a very advanced form of robo advice called ‘dynamic programming’ where you put in all the different preferences of life, and there is a utility function that basically spits out your optimal strategy based on very permutation and that could happen in your life.

But it’s fantasy land at least for the next ten years. So, it’s not going to happen at an individual level.

The solution: the goals-based approach

This is where goals-based advice comes into play, delivering the liability matching approach to retail clients and investors.

Imagine a retiree walking into a room. On the wall are 29 cards representing major goals. They could pick a holiday, or to pay for grandkids’ schooling, or a bequest to a charity.

They select a list of goals. But rather than manage an investment strategy that’s specific for each goal, we bucket the goals by hierarchy.

In one bucket are essential needs goals – a regular income the retiree wants to be able to count on that won’t be too volatile and that has clear visibility around cash flow. Another bucket contains lifestyle wants – such as an aspirational holiday. Those funds can be invested a little more aggressively. And a legacy bucket – endowments and inheritances – can be funded using a longer-term growth-style investment.

As you can see, this is basically the institutional approach -- asset liability management -- for the individual. It focuses on goals and then implements strategies to deliver that goal.

That’s a very powerful outcome from goals-based investing, and a powerful tool for investors and advisers.
 

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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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