Remember the rules of thumb that advise shrinking your equity allocation as you age in retirement? Well, a radical paper from two US retirement research experts, Wade Pfau and Michael Kitces, threatens to turn that advice on its head.

Their research suggests that investors may actually be better off increasing equity exposure during retirement.

In the world of retirement planning that’s like walking into the medieval Vatican and claiming that the Earth is not flat, that it does indeed revolve around the sun and, by the way Popey, women would make very good priests.

Sequence of returns risk

The conventional approach of decreasing your equity allocation in retirement is meant to protect you from big bear markets. The idea is to cut the risk of your portfolio evaporating when you have fewer years left and can’t wait for a market recovery.

But the biggest threat to a successful retirement is a long run of bad returns in the early years, otherwise known as sequence of returns risk.

A combination of a lost decade and having to sell equities at low prices in order to live can diminish your portfolio – to the point where it won’t recover even when the salad days return.

U-turn if you want to

The contrary approach being advocated by Pfau and Kitces builds in sequence of return risk protection, according to their results.

In this analysis, your equity allocation is trimmed in the run up to retirement as normal. But then, instead of continuing to cut shares out of your life like so many Mars Bars, you gradually increase your intake – post-retirement – for so long as ye shall last.

The authors call this a rising equity glide path and envisage a lifetime allocation to equities that resembles a U shape.

The range of outcomes once retired for the rising glide path boil down to two main eventualities:

Scenario #1: A poor stock market followed by an upturn

Part one: Bad stock market returns early on: The majority of your portfolio is in fixed income assets i.e. bonds, cash and/or annuities. You don’t permanently damage your portfolio because your living expenses are mostly paid from the fixed income, so you don’t have to sell equities at low prices.

Part two: Stock market returns recover later: Equities should eventually bounce back due to mean reversion. Because your equity allocation is increasing, you benefit from pound-cost averaging – buying low and selling higher. These gains carry you to safety, making up for the ground lost in the early years. (By contrast, a strategy that requires you to sell equities at this time chokes off the upside, increasing the chances of you running out of money.)

Scenario #2: A good stock market followed by a bad one

Part one: Good stock market returns early on: Your portfolio grows well beyond the amount you need for a happy retirement. At this point you could decide to protect your winnings and move into less risky assets, knowing your retirement is secure (unless you marry a Kardashian).

Part two: Poor returns later: In most scenarios the portfolio swelled so much in the golden years that it’s still able to sustain your life style as your clock runs down, even if (/when) the market eventually turns lower.

Of course, other things could happen, too.

• The market could be great for decades: If the market smiles upon your entire retirement then who cares how rich you are when you die? (My postal address is available on request, and I currently accept bequests…)

• The market could be bad and stay bad: If your fate is nothing but lost decades then we’re all in trouble. At least your early (and traditional) heavy fixed income allocation starts you off on the right foot.

So what should I do?

You can find out how all the scenarios play out in detail by reading the research paper and Kitces’ excellent précis.

To give you a flavour, they researchers find that the chances of not running out of money at a 4% withdrawal rate are optimised when:

• Equity allocation at the start of retirement is 20 – 40%.

• Equity allocation at the end of 30 years is 60 – 80%.

The percentages change according to each scenario’s assumptions based on differing withdrawal rates, returns, retirement lengths and objectives. The historical returns scenario favours an initial equity allocation of 30% and a final figure of 70%.

The authors suggest that the rising equity glidepath can be managed using a rule like rebalancing 1% of your portfolio per year from fixed income to equity.

The more downbeat the return assumptions1, the less difference a rising equity glidepath makes in comparison to conventional strategies.

In certain low-return scenarios, the results require investors to think about what they fear most – missing their target income goal, or missing it by miles.

If you’re dead set on reaching an ideal income goal then you need a high equity start and end point. Essentially you’re gambling that equity returns turn out favourably, but you could suffer if they don’t.

If you choose a low equity start and end, then you limit the chances of a big shortfall but increase the probability that you will run out of money before the end of your retirement. (In other words, you’re not heavily exposed to a major fail scenario for equities that means you burn through your capital very quickly, but by the same token you’re not exposed to a major success scenario either).

Tricky.

Why can’t it be simple?

It seems the debate on the best retirement strategy is far from over.

When I first started investing, I clung on to rules of thumb as beacons of certainty that I could navigate by. But it’s obvious now that there is no single rule of thumb that everyone can abide by and expect to live happily after.

Certainly simpler strategies exist, and rules of thumb can help us manoeuvre into the right areas, but it is in our nature to want to optimise our approach.

Rising lifespans throw another Zimmer frame into the traditional machinery of pension planning, too.

Pfau and Kitces acknowledge there is plenty more work to be done refining their analysis. Other researchers may well counter or improve upon their findings.

But what makes this research so exciting is its potential to cave in the calcified assumptions of old while helping us achieve better results just when we need them – in the future.

Take it steady,

The Accumulator

1. The study uses historical returns as well as a more conservative set designed to mimic the possibility of the ‘new normal.’ [↩]

Good reads from around the Web.

I spent Friday at the London Investor Show. It was far busier – and very slightly more diverse – than a few years ago.

Sure, there was the usual preponderance of 50-something men with rucksacks and 20-something salesmen in suits. It’s always good fun watching the latter trying to decide if the former – invariably scruffy – are millionaires next door, or simply chancers who’ve come along to score free pens and biscuits.

But I did notice some guys in their 30s. And while there were literally as many young women in tight-fitting clothing giving out promos as women watching the presentations, there were at least some women watching the presentations.

I’ve been to events like this where it seemed women weren’t allowed in the building unless accompanied by a promotional stand and a bar code scanner. Surely feminism hasn’t truly won until women feel as entitled as men to lose their life savings on spivvy mining stocks?

Of course, women – superior investors, according some studies – could well be doing something more productive than listening to AIM companies explaining how wonderful they are. Something like passive investing on auto-pilot, say, while they spend their days earning an income or taking walks in the country.

Whatever, it’s clear that ‘hobbyist’ active investing remains the preserve of older men with, I imagine, as much money to lose as to gain.

I do wonder what draws these fellows to active investing. Have they not saved enough for retirement, and so see potential big wins as their only salvation? Or are they wealthier types who, like me, enjoy the pursuit as much as any pay-off?

Or do they just not know any better? Do they think picking individual shares is the only ‘proper’ way to invest?

I’ve read some articles suggesting that it’s the younger demographic who are more inclined to invest in trackers and ETFs.

Roll up, roll up!

All that to one side, the busyness of the show suggests to me that we’re closer to the middle or the end of this long bull market than the beginning.

I don’t intend to do anything radical based on my impressions – and I’m certainly not suggesting you do. Your time horizon and your risk tolerance should determine your asset allocation, not how many investors show up at some promotional jamboree in London. Any more radical changes in your exposure to shares are best saved for apparent extremes of over- or under-valuation, and I’m not saying things look super-frothy.

But I do think equity investing is more attractive to the mass market than it has been for many years. Bull markets attract people, whereas of course it’s bear markets that should logically draw them in.

I’ve long wondered what the audience for Monevator would be like if investing in shares ever became really popular again.

[continue reading…]

The following is a guest post from an industry expert who prefers to remain anonymous in sharing these insider tips with us. While I’m still not exactly crying tears for big name fund managers, it does shed extra light on the hurdles faced by small, innovative entrants who want to bring us new funds.

After exhaustive research you have finally decided that none of the funds available to you as a private investor do exactly what you want. Moreover, you are sure that your concept is a blinder, and that other people will throw money at you to invest in your new concept.

Clearly, you need to start your own fund.

The financial press is full of stories about how much money fund management companies make. If it has such high margins surely it must be a great business to get into, right?

Sure, there will be fees – whether it is active, strategic, dynamic, low risk, income or even, horror of horrors, passive. The basic legal and regulatory framework applies to all investment vehicles. On top of that the normal business issues of promotion and marketing are still relevant, and have associated costs, whatever the product.

So how do you establish a retail investment fund from scratch?

Assembling your team

Your first step is to find someone qualified to run it. Ideally that will be you but if you have not got the requisite experience and qualifications you will need to employ someone to fill what is known by the Financial Conduct Authority (FCA) as the CF 30 role. This is someone who it judges has sufficient experience and knowledge, either from having passed exams or spent enough time in the market, to have the necessary skills.

Remember that this is not like a driving licence, where you have to pass a specific test. After all, Fred Goodwin was allowed to run a bank even though he had no banking qualifications.

Fine, you have your CF 30 function. But you or employee will want holidays or may fall ill so you need another one to act as back-up. Alternatively, you can ask a suitably qualified mate to act as a locum to fill when you are on your yacht. So that is two staff already.

You will also need a Compliance and/or Money Laundering Officer, a CF10 function.

This usually falls to the person who was most inebriated in the pub when it was discussed, as he or she won’t really know what they are committing to. But he or she will of course be the person to blame if it all goes pear shaped and the FCA comes knocking on the door.

You will also need a Compliance Officer. This usually falls to the person who was most inebriated when it was discussed.

Fortunately there are lots of people who don’t quite understand all the ramifications of filling in a seemingly endless stream of forms, so these positions are quite easy to place.

Set up your fund management company

Next step is to form a company via Companies House in the normal way. This is probably the easiest part of the process.

In addition you need an office, a computer, oh and a BCP (business contingency plan) in case the office blows up. You will probably also require some data feeds for news and price information on whatever securities you will be investing in. And you need a broker who will need to do some DD (due diligence) on you to make sure you are legit and not some Trashcanistan money laundering scheme.

You might think banks would be keen to open a new account for you, but don’t bet on it. Lawyers, accountants, and book keepers are also on the shopping list of service providers.

What is a problem is writing a business plan to explain to the FCA how the business will work. Lots of spreadsheets, writing and business speak. This then has to be endorsed by a qualified accountant (more fees) before being submitted to the FCA by a lawyer (yet more fees).

All being well the FCA will grant permission and give you a designation such as BIPRU50K. This is not your password but your classification for regulatory purposes. It also means your company has to have 50,000 euros of Tier 1 Capital. That means about forty grand of shareholders equity that you can never ever use. It might be more if the FCA judge that the company’s running costs for 13 weeks will exceed that.

You see it wants to ensure that if it all goes badly wrong the company can survive for a quarter of a year while you return funds to investors.

Prepare the company coffers

Your little company now needs working capital to get going on top of the regulatory capital that you can’t use. And of course it can’t be debt because that would affect the Tier 1 capital.

So dig into you pockets, again.

Now, here is where it starts to get more complex. To run a fund you need to take money in from the public, keep it in a separate account, keep track of the investments you make, any dividends received, deduct your costs and any others, and write to the investors on a regular basis to keep them updated.

To ensure that is done properly the FCA insist that you appoint a depositary. A depositary actually consists of two roles: a trustee and a custodian.

A trustee doesn’t actually do any of this stuff, they just make sure it is done, and properly. So, yes you guessed it, more fees.

A custodian actually holds the cash and securities on your behalf. And guess what? The banks that do this are not charities and will want to paid for their services.

The banks are not charities and will want to be paid for their services.

All this assumes that your little company will keep track of the beans. If you do, the FCA will say that increases the risk and will increase your Tier 1 capital requirements.

An alternative is to find another company to provide the services of an Authorised Corporate Director (ACD). It will essentially do all the back office stuff, for a fee.

How to reach Other People’s Money

Everything is now in place and all you need to do is get the public to give you money. How hard can that be, when we read how many boiler room scams there are easily fleecing the public of hard earned cash?

Actually it is not easy at all because, rightly, the public is very suspicious of people asking for your money.

Recent events with Northern Rock, RBS, HBOS, Bradford & Bingley, and even the Co-Op have only served to increase public apprehension about trusting even the most long established organisations. So asking someone to invest money in something established last week is a whole lot harder than it used to be.

There is one other hurdle to overcome. As a manager of a financial product you are not allowed to approach the public to solicit business. Normally, fund managers do not have FCA approval to give financial advice, simply because they are not familiar with all the other products on the market or, more importantly, the financial circumstances of the individual.

To sell your financial product you therefore have to enlist the services of an intermediary, either an IFA or a platform. Not surprisingly, neither of these two types of businesses do anything for free.

Time was when the fee structure of funds allowed IFAs to take trail commission to encourage them to recommend funds. The more recent trend to fee based advisers, encouraged by RDR, has made it more difficult to provide financial incentives to IFAs to promote certain funds.

But it hasn’t ended.

Fancy a ticket to that international match? How about a track day at Silverstone? The range of promotional events provided by the big fund managers is mind-boggling. For the new kid on the block, offering a glass of wine and some sandwiches at the nearest Harvester is simply not going to cut it, not when the intermediaries are used to being taken on a three day cruise to the Channel Islands.

The range of promotional events provided by the big fund managers is mind-boggling. Offering a glass of wine and some sandwiches at the nearest Harvester is not going to cut it.

It is true that some managers have offered off-site ‘educational’ seminars to introduce so called new-fangled concepts like behavioural finance, the efficient market hypothesis (EMH) and modern portfolio theory (MPT). (Though to be fair some of these ideas are now 50 years old and you can also get a Nobel prize for saying they don’t work.)

However, the golden rule still applies. The intermediaries don’t pay for anything. That is the privileged role of the product provider.

Then there are the platforms. If you consumers think they are complex for you, they are even worse for fund managers. This is another mouth that needs to be fed from the annual management charge (AMC).

There are a few exceptions but in general the platforms want several features before they will host your fund. These include a minimum size, a track record of at least three years, expressions of interest from a number of IFAs, a guaranteed level of flow in the first year, oh, and sometimes an upfront fee. How expensive can it be to enter SEDOL codes into a spreadsheet?

All this can be regarded as the “plumbing” of the distribution network. This is just getting the infrastructure in place to enable investors and intermediaries to actually invest in the fund.

Of course there is no guarantee that a platform will actually host the fund. Just like any shop they do not have to offer every single fund that is available. They will only offer what they think they can sell. If they do not want to put your fund on their shelf there is nothing you can do.

The problem of self-promotion

Buyers of your fund will either be intermediaries investing on behalf of their clients or investors acting on their own behalf.

Remember that because of FCA rules, fund managers are not allowed to promote their funds directly to the public. Providing advice can only be done by someone qualified to do so who has assessed the risk profile of the client and who has a full appreciation of his or hers financial situation.

Because of this, all that product providers can do is create ads showing mountains, happy people, and other such generic images.

They cannot run ads that say this fund has a TER of X%, a beta of Y, an alpha of X, or any other specific data such as you might find in an ad for a car or a mobile phone that might be as advice. In other words you can’t do a lot of specific advertising to create demand for your new fund, even if you want to spend the cash.

IFAs might be a more fertile ground. First though they want a three-year track record. Not much use to a business start-up. Even if that is not a pre-condition they usually insist on a minimum size – say £10m or even £100m if they want to be awkward.

The reason they usually quote for this is that they have so many clients, they are worried they would put so much money in that they would end up owning too much of it. Their rules prevent them from holding more than 10 or 20% of any investment.

They may also insist that the fund is rated by one of the agencies. How do you qualify to get rated? See the beginning of this paragraph and repeat.

Even if those hurdles can be overcome they then hit you with the killer challenge. No one in their IFA firm will be allowed to invest unless it is on the recommended list. How do you get on their recommended list? Go back to the top of the previous paragraph and repeat.

Running your own fund

Amongst all this administration and marketing activity you still actually have to run the fund. And it has to perform otherwise no one will buy it.

Here the logic can get tricky. No one wants to buy a fund that is bottom of the heap relative to others. Equally, few investors are keen to invest in something that has recently gone up more than its competitors.

Amongst all this administration and marketing activity you still actually have to run the fund…

Either way, performance is usually measured against one of the main established indices we see and hear quoted everywhere. But that data is proprietary to the company that owns and calculates it, so if you start reproducing its data and quoting it in your marketing material it will expect some financial recognition for its intellectual property.

That means – yes, you guessed it – more fees.

These days fund managers are also expected to exercise corporate governance. That doesn’t just mean voting for directors. It also means understanding pay packages and deciding if they are appropriate or not. And, to be honest, most public disclosure on these is so obtuse as to make the exercise virtually meaningless.

Nevertheless, politicians and the press want you to vote. That is fine, except that in these days of nominee holdings you need to do that through a third party. And guess what, they charge each time you do.

In reality running a fund is not really much about picking securities. Just as with Tesco Lasagne or any other consumer product, as long as it is true to its label, then it is far more about distribution and keeping on the right side of the legislation.