Robo-Retirement (Dynamic Retirement Planning): what Robo-Advisors and traditional WM should do.

Personalised and transparent investment experience is mantra for added value Wealth Management, challenged by tighter market regulation (ban of retrocessions) and the rise of Robo-Advisors. Yet, both incumbent institutions and FinTechs are still falling short to address the needs of taxable investors when it comes to make life-changing investment choices, such as pre- and post-retirement goals.

The economic slowdown post GFC has weakened public finances and made government sponsored pension plans dramatically inadequate to support an individual's income during a longer than ever retirement life. This is happening right at the time when the first wave of baby boomers is reaching retirement age. Individuals and their financial advisors might not be ready to tackle the challenges of investing in the long-term with a clear understanding of the impact of their decisions on the chances to achieve a balanced income stream for the golden days: most of the industry is still locked into myopic portfolio management techniques (MPT), which appeal more to internal compliance than investors' needs.

Probabilistic Scenario Optimisation (PSO) emerges as an adequate Goal Based Investing (GBI) framework to advise individuals on Dynamic Retirement Planning (DRP). The approach allows to discuss the probability of reaching an investment target (investment worth or income stream) by leveraging on stochastic scenario analysis (eg, IBM Algorithmics' Mark to Future) and facilitates the convergence into a single graphical analysis of Financial Planning (cash flow expectations) and Financial Advisory (long term dynamics of investments).

As noted by Nobel Prize Robert C. Merton in “The Crisis in Retirement Planning “(HBR, 2014):

“The only feedback [the investor] needs from her plan provider is her probability of achieving her income goals.”

Many providers of retirement solutions seem to fall short of a healthy implementation of Dynamic Retirement Planning, because they are more concerned with the evolution of Asset Values than the understanding of the retirement-time chances for financial wealth to be sufficient to provide the right amount of secured income (eg, buy the right annuity contract) given prevailing economic conditions, (near to zero interest rates), or to switch from the saving retirement plan (eg, US Defined Contribution Pension Plans or 401(k), Australian Superannuation or Super, Canadian Registered Retirement Saving Plan or RRSP) into the most appropriate pension/income plan (eg, Australian Account Based Pension or ABP, Canadian Registered Retirement Income Fund or RRIF), or invest part of the only into a discretionary portfolio (which could be a valuable option when partial tax free withdrawal is allowed at retirement date) to grant oneself extra time to strengthen personal finances.

Australia can be a school case, as the Superannuation program accounts for a sheer portion of AUM of taxable investors. There would differences in the functioning of these plans in other constituencies (as in US, UK or Canada), but the Australian example here showcased would hold without loss of generality meaning. Superannuation refers to the government-supported and encouraged arrangements that people make to accrue funds and replace their income in retirement. Employers are required to pay a proportion on top of an employee's salaries into a superannuation fund. The minimum obligation is set to increase gradually from 9% to 12%, starting 2013.

Wealth managers are asked to advise their clients on the need of attaining enough wealth to afford a sufficient income stream after retirement, which fits their desired standard of living.

Yet, might not be easy for the average investors to understand the long-term risks of a potential misallocations of their money before retirement, during the Superannuation Retirement Plan (RP) and after retirement, having to chose among strategies like:

• buy an Annuity (AN);
• enter a Pension Plan (PP), known as Account Based Pension;
• withdraw a tax free lump sum to support consumption or reinvest tax-free money into a discretionary portfolio (DM);
• top-up the Retirement Plan (RP) before retirement date vs. entering a mortgage;
• identify the most feasible ambitions for retirement income;
• work a longer time;
• switch from Super to Super (RP) before retirement;
• rebalance the Pension Plan (PP) port retirement.

We can use the Australian case and visualise how the PSO framework can support Dynamic Retirement Planning.

Example

Assume we still have 10 years to work before retirement, our pre-retirement Retirement Plan (RP) is worth 300k, we are adding to the fund 20k a year till retirement and have set for ourself a goal to afford a net post-retirement income of 50k yearly (with marginal tax rate 20%). Let's see what happens to our goal in 4 different cases:

1. At retirement, we use all available wealth to buy an Annuity.
2. At retirement, we remain fully invested in the RP.
3. We have a much higher investment goal (100k per annum).
4. We might have to work 20 more years (not only 10).

Clearly, compared to a classical Financial Planning case we need to carefully consider the potential risks and returns of the various investments over time, because the amount of money that will be available at retirement date and after retirement date is not certain but linked to the market dynamics (RP, PP and DM). Also the Annuity amount is not certain today, as we do not know how much money will be accrued till retirement date to afford the unknown prevailing annuity premium and rate. In our exercise, we issue a virtual Annuity contract at a future date using full-revaluation techniques.

This uncertainty can be represented by plotting the Mark-to-Future space of the potential evolution of our wealth pre- and post-retirement, and shading the target cash flows bar by their corresponding probability of occurrence (eg, light blue for a 100%-80% probability of securing such a payment, ...).

1. Secure post-retirement income with an Annuity

There is less than 20% probability to reach our income goal at retirement time.

The simulation show that there might be economic scenarios into the future which grant a chance to afford an Annuity for the required rate (the graph shows that some money might also left for a de-cumulation into a PP). But these scenarios might not be enough to secure (with high certainty) the required post-retirement income.

2. All money goes into a de-cumulation Pension Plan (PP)

There seems a much higher probability to achieve our personal income goal, although the funds amortise over time.

The clear risk we are facing is that markets drop and we survive our post-retirement money.

3. Income stream goal is higher: 100k per annum

Our goal is too ambitious given selected strategies, initial wealth and market conditions.

Our de-cumualtion funds amortise very fast.

4. Working 20 more years

Should we have more time to grow our pre-retirement funds (RP), we would have a better chance to reach our desired post-retirement income goal.

Can we afford to work longer?

Only a probabilistic framework like PSO, based on scenario analysis over time, allows to enter the full total return space of financial investments and design an adequate income stream strategy that can optimise investment goals pre-, at- and post-retirement.

I owe to Thomas Martin and Andres Hernandez for this analysis.

by Paolo Sironi, Though Leader Wealth Management Solutions at IBM Risk Analytics. Author of goal-based investing book "Modern Portfolio Management: from Markowitz to Probabilistic Scenario Optimisation" (Amazon or RiskBooks).