Marketing material for professional investors and advisers only In focus A practical framework for evaluating retirement income strategies August 2020

Considering the ageing population in Hong Kong, post-retirement investment solutions to provide additional income are in demand. However, solutions vary across many dimensions: time horizon, certainty of income, level of income, of outliving assets. This Kelvin Lee has created a vexing challenge for investors as they explore and Head of Institutional Business, compare different options. Hong Kong

Evaluating solutions is challenging because despite our industry’s The matching HKD Bond does represent the least risky innovations in capital growth solutions, post-retirement is way of achieving the outcome, this means we can consistently different, difficult and (potentially) dangerous. and fairly compare all post-retirement solutions based on how much additional investment return they seek to provide and It is different because delivering stable income during retirement how much they intend to take versus the matching HKD requires additional considerations. For example, time weighted Bond portfolio. portfolio returns and standard deviations used for accumulation will no longer suffice. By definition, the matching HKD Bond portfolio is aligned to the income target of the post-retirement solution. Therefore, two It is difficult because there is a long-time horizon with complex post-retirement solutions that have different income targets and often conflicting objectives. There is no silver bullet solution (e.g. targeting different time horizons), will each need different and therefore a wide range of divergent solutions need to be matching HKD Bond portfolios. However, the matching HKD Bond assessed. portfolio is used to calculate relative performance and therefore comparing the relative performance of different strategies versus It is potentially dangerous because solutions that are not their matching HKD Bond portfolio is consistent and fair. appropriately evaluated may appear less risky than they actually are - leading to poor choices, unexpected risks and unsatisfactory For example, the volatility of the difference in performance outcomes. between the target portfolio and matching HKD Bond portfolio provides a consistent risk measure to evaluate different To design a post-retirement solution, we developed a framework solutions. We call this risk measure “Income Relative Risk” and to overcome these problems and focus on what matters for a it is similar to the tracking error metric often used for actively robust solution. managed portfolios. The only difference is that rather than using a market benchmark to compare performance, we’re using the least How to consistently evaluate post-retirement solutions risk way of achieving the target outcome. The starting point for the framework is to consider the lowest risk way of delivering the desired outcome: a stream of risk-free Let’s be “objective”: solutions should also be assessed income payments in retirement. versus their specific objectives The matching HKD Bond portfolio enables us to consistently The theoretical least risk portfolio uses risk-free bonds with evaluate the potential risk and return of different post-retirement coupon and redemption amounts that match the target solutions. However, it is still one step removed from the ultimate income. After making the initial investment in this portfolio, the goal – providing an income in retirement. Therefore, to evaluate investor can simply wait to receive the coupon and redemption ongoing performance, we should also include measures that more payments from the bonds. There is no need to worry about what directly relate to the specific objectives of each post retirement happens to interest rates or investment returns over that period, solution. because the target income has been secured at the start. For example, consider a solution that withdraws a fixed amount In practical terms, this can be achieved with a portfolio of HKD of income each year regardless of market performance. In this Bonds (e.g. Hong Kong Government Bonds) for solutions that do case, evaluating the historical variability in the income it has not target cost of living adjustments. delivered would not be helpful (there is none!). However, a key However, given the low level of yields, investing all of a pension risk would be how long the solution can provide the income (often member’s assets in a matching HKD Bond portfolio is likely to be referred to as ). The reverse would be true for a solution undesirable for most participants. The large majority of members that targets a particular time horizon to deliver the income and will prefer taking some investment risk with the hope of being rewarded with higher income over time. adjusts the amount withdrawn each year depending on portfolio Case Study 2: Fixed Payout – target fixed payments for performance. Here, volatility of income would be relevant and in an uncertain amount of time particular the key risk is the income falling below a level that is required by the member to sustain their retirement. Description A fixed payout strategy provides the same income regardless The choice between different income payout profiles should of the underlying investment performance. This means that the be evaluated based on the profile of the individual members, length of time that the income is provided will vary depending on their other retirement benefits, personal savings and general the investment performance. risk preferences to the extent they are observable. However, which income payout structure one chooses says nothing about The projected income can be calculated using the portfolios’ the effectiveness of a given underlying investment strategy in expected returns. delivering the outcome with a high degree of certainty. What profile of members would this be suited to? To assess the underlying investment strategy we therefore need to monitor how it is performing versus the appropriate This solution will appeal to members who value the stability of metrics that directly relate to the specific objectives e.g. the income they will receive above the length of time they income volatility versus risk of ruin. may receive it. This might be because they prefer income stability for planning purposes, or for behavioural reasons (feels like a We can consider a number of different solution designs, how paycheck) and are comfortable with some risk of running out of the matching HKD Bond portfolio can be used for each and the money provided it is sufficiently low e.g. <5%. However, this could relevant additional metrics to monitor. These case studies differ seem an abstract concept for an individual member to assess i.e. based on whether the target income is fixed or variable, the time what is an acceptable probability of ruin? It also seems unlikely horizon that the income is provided and whether the level of that members wouldn’t want to adjust the approach (take less savings run to zero at the end of the time horizon or there is a income) if they are close to ruin. target amount of residual savings remaining. We offer a couple of examples: Target income and level of savings for $100 investment Income () Savings () Case Study 1: Income for Life – providing variable 8 income for the whole of a member’s lifetime Description The target income is set based on life expectancy of an individual 6 at age 65. ied inoe This means, for each year, we need to multiply the initial income by the probability of surviving to that age. As the probability of 4 living to older ages is lower, it results in a declining income profile (see opposite).

In addition, each year there will be an adjustment to the income 2 2 paid depending on market performance to target income for life.

What profile of members would this be suited to? Given the shape of the income profile, this type of solution would likely appeal to members who don’t want to run out of money, but are comfortable with some variability in income. As the 6 8 8 9 9 income declines quite significantly in later ages, this solution nnown horion might be best paired with an annuity once the member reaches an age where any future declines in income are unacceptable. Income arget Savings This means that the solution is also likely to be most appropriate Source: Schroders. For illustration only. for those who are happy replacing the solution with an annuity at some point in the future if they survive.

Target income and level of savings over time for $100 investment

Income () Savings () 8

rie inoe

6

4

2 2

6 8 8 9 9 Age arget Savings alue 2 Source: Schroders. For illustration only. Conclusion Perhaps the most fundamental insight we are trying to We have outlined a framework that may help overcome share is that conventional metrics, such as simple portfolio some of the challenges. A portfolio of HKD Bonds aligned to returns and of those returns, are not the target outcome should be used as a sensible and realistic fit for purpose in the decumulation phase. If these metrics benchmark to assess the risk and reward of different post- are used to evaluate, compare and monitor post-retirement retirement solutions. We also propose that this be combined vehicles, it may lead to wrong conclusions and increased with specific performance metrics that directly relate to the fiduciary risk. objectives of each solution.

Important Information Any security(s) mentioned above is for illustrative purpose only, not a of the overseas investments to rise or fall. For risks associated with recommendation to invest or divest. investment in securities in emerging and less developed markets, please refer to the relevant offering document. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The views The information contained in this document is provided for and opinions contained herein are those of the author(s), and do not information purpose only and does not constitute any solicitation and necessarily represent views expressed or reflected in other Schroders offering of investment products. Potential investors should be aware communications, strategies or funds. The material is not intended that such investments involve and should be regarded as to provide, and should not be relied on for investment advice or long-term investments. recommendation. Opinions stated are matters of judgment, which may change. Information herein is believed to be reliable, but Schroder Derivatives carry a high degree of risk and should only be considered (Hong Kong) Limited does not warrant its by sophisticated investors. completeness or accuracy. This material including the website has not been reviewed by the SFC. Investment involves risks. Past performance and any forecasts are Issued by Schroder Investment Management (Hong Kong) Limited. not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up 462998 and is not guaranteed. Exchange rate changes may cause the value