Flexibility: key to successful capital protection

IFA Cover Story

By Victoria Papandrea and Wouter Klijn
Mon, 15 Mar 2010

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Capital protection has become a hot topic after many Australians had their savings savaged by the GFC. Capital-protected product providers tell IFA's capital protection roundtable that flexibility is the key to making these investment vehicles work. Victoria Papandrea and Wouter Klijn report.

Industry participants at the roundtable: Axa North business development manager Peter Mermelas (PM), Macquarie Funds Group head of longevity solutions Andrew Robertson (AR), Milliman practice leader financial risk management Wade Matterson (WM), ING Australia retirement and investment solutions general manager David Kan (DK), Challenger Life chief executive Richard Howes (RH) and JP Morgan equity derivatives executive director David Jones-Prichard (DJP).

 

VP: As the markets recover and continue to climb, is there still a need for capital-protected products?

DJP: Any capital-protected product that any of us design really it should be about the solution. Rather than a product flog it's really about designing something that meets an investor's dilemma or solves a problem that they have and, therefore, I think capital-protected products, there's certainly a space for them still. I think we've seen a change in the style of investments over the past couple of years. In the lead-up to 2007, much of the market was driven by investors' ability to borrow 100 per cent to invest in a capital-protected product and it was really about investing in a rising market and investors were sort of hoping that those conditions would continue for some time. That sort of paradigm has changed and with that the style of products change as well. But there are certainly very valid reasons for investors to be investing in capital-protected products. It just depends on an investor's requirements and then those requirements need to turn into the choice of the very vast selection of products that are out there.

RH: I think that there is always going to be a place particularly in retirement portfolios for guaranteed, simple products that deliver certainty. If the global financial crisis (GFC) has taught us anything, it's that Australia has been the champion of equity exposure, and those with more exposure to equity in retirement have paid dearly for that, and I think the focus particularly on retirees will be on what they need to do to have certainty in their portfolios. Too many of our superannuants were forced to unload their equity exposure to pay for ongoing consumption at a time when it was least optimal to do so, more than I think that's a function of the excess of equity exposures that we've become accustomed to in this country. I think that the reality is that as a result of that too many retirees haven't been able to participate in the recovery at all and if anything that reinforces the need for defensive, simple guaranteed product.

 

WK: Have you seen the shift around moving from a geared strategy to a more conservative strategy?

DK: I think it depends on the individual's objectives, risk profiles and their individual circumstances and this is where the role of a financial planner is really important. I think an adviser will look at a client's holistic circumstances including their risk tolerance and gearing may play a part in their solution.

RH: I think that's one of the problems with these sort of panacea, silver bullet-style solutions. To a large extent they marginalise the role of the financial planner. Portfolio construction is one of the oldest and most trusted tools in protecting downside. I think in Australia we've become too reliant on excessive equity market exposure, but that's not to say that the basic principles of an appropriate combination of defensive and growth assets given one's personal circumstances is not the answer. I think the problem with these products, which promise a lot but at the end of the day, over a long period of time, end up charging a lot, is that it's basically fighting against the reality that you can't have upside without downside, and you can't remove downside without cost. These products rely on sufficient market outperformance to pay for what at the end of the day are very high fees and costs associated with these products.

DK: One can look at long-term expected returns in the market, they can look at average returns in the market and typically financial planning software will take such an approach . I think what protected products or guaranteed products provide is really that a certain minimum will be achieved while having the potential to obtain the upside. I think it's also important to not discount that guaranteed element. That's what an investor is certainly paying a price for that peace of mind.

AR: There is no silver bullet in this market so even a cash guarantee exposes certain types of annuities to interest rate risk and inflation risk. So to say that many of these products that they're taking away the role of the planner, I fundamentally don't believe that. I think it's a complex issue, but no matter what product you bring to the table there is a role for the planner to play in helping the retiree actually get an outcome that makes sense to them . what we think the new role for structured products is in the retirement incomes market is helping retirees find a middle ground, finding an all-weather-style strategy that actually performs well when markets boom, but also provides them some level of minimum security in underlying, underpinning when things can go really badly, and it is possible that things can go really bad . there is a level of uncertainty that we believe you cannot manage using plain vanilla investment portfolio-style thinking of the accumulation phase.   

PM: Our analysis and feedback from advisers is that solutions around protection and structured product need to provide flexibility; they need to be dynamic products, they need to work in tandem with the advice industry. We've always had asset allocation there to be able to shelter people from risks. All we're saying now is that we've got another piece to work with and that other piece is the protection piece. So you can repair people's superannuation funds right now, they've suffered through the GFC, can we up the risk profile on some of these investors by adding a guarantee and help to give them additional exposure in the marketplace to repair a strategy.

Flexibility: key to successful capital protection

IFA Cover Story

By Victoria Papandrea and Wouter Klijn

Page 2 of 5

RH: But the problem is that the cost of that guarantee together with the inherent fees in these products means that the market upside scenario, which is sufficient to deliver such that you could conclude that the product has delivered value over and above say 10-year bond returns, is an unlikely market scenario. They rely on an overly optimistic view of market outperformance to pay for the fees.

WM: I think we get hung up a lot of the time on the size of the fees embedded in some of these products and if you look through the universe of protection-style products, there's actually a wide universe of methods to deliver protection strategies in one form or another. Now clearly if you're going to provide a guarantee, then someone had to stand behind that guarantee and then hold capital for it, so that's the cost inherent in that.

PM: Regardless of the way that these mechanisms work, whether we start analysing the bond and call structure versus the CPPI (constant proportion portfolio insurance) or a dynamic hedging, at the end of the day clients during falls in the marketplace will sell out of their portfolios and revert to cash.

RH: But only if they've got too much in equities to begin with. The problem is how much equity exposure are retirees taking into retirement.

PM: But even if they don't, and speaking to advisers in the industry no matter how hard advisers try to educate their clients to hold onto their portfolios, they sell out. Every wrap provider in this country can tell you that people sell out at exactly the wrong moment, so if these protected products can assist advisers to overcome that educational piece, then I think we've collectively done a whole lot for the industry.

RH: Well it's a very expensive piece of education, that's the problem.

WM: It is a portfolio construction problem and I think we all agree on that. The method of how you compose that portfolio is up for debate, but we've seen any number of funds that are out there that promise to manage risk in some way . ultimately it's about saying look, an investor needs to have an allocation to growth assets, they need some allocation to defensive assets, but they also need an allocation to hedge assets in some way that insulates them against those market downturns. Now whether that's through a guaranteed product, a CPPI mechanism or you give them direct access through an SMA (separately managed account) to a hedging strategy that's built into that, it doesn't really matter.

AR: We're about to enter a phase where a huge proportion of the population is going to transition from the accumulation phase into the retirement income phase, and while they may have always been exposed to this type of risk, it's going to be particularly visible to them over the course of the next five to 10 years. But what a lot of retirees are, and really should be, most worried about is actually the ability of  the portfolio to provide for an income . but what we think retirees in particular will respond to is something that actually takes away the worry that they could outlay their savings. So the ability to provide a no-questions-asked guaranteed income for life, now that is both security and a comfort to retirees to take, but it's also an economically efficient mechanism.

 

VP: Macquarie has actually set up a new division that specialises in longevity risk. Can you discuss why you've done that? Do investors have an increasing appetite for longevity risk?

AR: There are a couple of drivers here. One is that we're realising that where our market is going to go is going to be increasingly into a retirement income provision-style market. Now as soon as you get into retirement income provision, the core need and desire that people have is for an income for life. Now the natural product offering is to provide a guarantee around an income for life. So one arm of what we're doing is looking to provide products that help retirees meet that need. But just as importantly, as we start to issue those guarantees, we also become exposed to what's called systematic longevity risk. Currently in the Australian market, and in fact even around the world, there are a relative paucity of solutions and structures to help insurers deal with that type of risk. So we're also particularly interested in participating in creating the structures to actually transfer those risks into capital markets and then also helping investors access that risk, because there are a large number of investors in the capital markets, many of whom are not insurers, who don't have exposure to this risk and they are a natural party to be paid to help insurers manage their capital . it is a multi-faceted problem that needs to be addressed from multiple directions.

Flexibility: key to successful capital protection

IFA Cover Story

By Victoria Papandrea and Wouter Klijn

Page 3 of 5

DK: I think that's a key point that that's what we're in the business of doing, which is actually providing a mechanism for providing retail investors to access mitigation of market risk which contributes to longevity risk, and then directly by pooling the longevity risk that's really what these solutions are about because for the vast majority of individual investors they wouldn't be able to put these types of solutions together themselves.

DJP: You know an insurance company really can't do this on its own and an investment bank can't do it on their own either. An investment bank can perfectly provide market exposure, whereas an insurance company can perfectly provide the longevity risk and also I guess the longevity insurance . we need to be able to give investors the option of having something where if they die they have something to pass down to their family.

AR: That's absolutely critical and we've looked at products around the world where the issue of actually making longevity risk attractive has been cracked. So there's a lot of discussion through the Henry review work, for instance, that identifies that in the Australian market individuals have got access to longevity insurance; they can buy lifetime annuities but they choose not to. There have been some commentators that suggest that the solution to that is that they need to be forced to buy that in some sort of alternative fashion. The other way to look at it is to say in fact we could actually set the bar higher for the financial services industry to say let's go and create products that people want to buy and the things that make longevity risk something that people want to buy is diversifying the cost for it over time, so they're actually paying their premiums in a drip-fee sort of a basis, so that if their circumstances change they can simply stop paying those premiums. That flexibility is incredibly powerful, so if you're a retiree who retires at about 65 you might pay premiums for the first 10 years of your retirement and you may enjoy the great roaring equity market boom and you may be well ahead by the time you're 75. At that point you may no longer need longevity insurance, so you stop paying each premium. Alternatively, by the end of those 10 years a retiree may have very little left in their account. In that case obviously you have made a wise decision to purchase longevity insurance because it is actually going to pay out for you a lot more than you pay into it over the rest of the course of your life, and it's that flexibility and it's the ability to manage risks on an ongoing basis that will tip these types of products into the mainstream and will make them attractive to clients, and by being attractive to clients they'll be solutions that advisers will use.

DK: I agree that loss of capital in a lifetime annuity is a real significant issue and as you pointed out before, the sales of those are very minimal but really that's because they don't combine the best elements of flexibility, that is, access to capital with the certainty of income for life.

RH: I agree that the current offering out there in terms of lifetime annuities is inadequate. It sort of reflects the lack of competition in that market and, to some degree, the adverse selection problem, which I'm sure we'd all be familiar with as life insurers. We believe absolutely that there is a need for longevity solutions that Australia, with its ageing population, needs to deal with both from a public policy perspective and from an individual's return perspective. The problem with highly complex black box products though, which are, I agree, a marketing elixir, it's very easy to sell the idea that you've got a guarantee and you still get exposure to the upside. The problem is that that upside, given the extent of the fees, is in reality quite unlikely; it requires a very bullish market or an ability to time the market and I think it's pretty well documented how successful even professional managers are in doing that to generate a benefit from all of that flexibility. What we believe in is simple, low-cost products which do pull together longevity risk absolutely and provide people certainty of income for life which will actually deliver on that, rather than deliver a return which is so far beneath what they could have achieved without any risk to begin with.

AR: What we really should be shooting for as an industry in this group is actually just a diverse range of solutions where there's a template of products and solutions that retirees can draw from . one of the dangers in this market at the moment is that some of the discussion that's coming out in public policy debate could be read to actually take away some of that diversity. There have been discussions around the government for instance getting into the provision of these types of products on a mandatory basis. It doesn't take a lot of reading between the lines of that type of solution to actually get to the view that that would actually be taking this choice away from retirees.

RH: We agree that would be dangerous and reckless public policy ... from a competitive market standpoint, it would be akin to the government nationalising the life insurance industry. From a public finance viewpoint, we have the former head of Standard & Poor's in this country do some analysis around what happened to the country's credit rating if they would step in and be the provider of lifetime annuities. Let's just say it is not a terribly rosy outlook.

WM: If you go that way, the government would jump to the end game before considering the other options on the table. I think there is quite a lot the government can do to help facilitate the market. We have seen innovation occur, so it's not that the industry can't do it or doesn't want to, but there are barriers there and the government can do a lot to help facilitate that market to help it develop and prosper.

 

WK: One of the topics you've touched on is complexity. Some advisers find it hard to explain exact structures to their clients. How would you address that and can you reduce the complexity in those products?

DK: The understanding of the financial planners who are taking this out to the clients is critical. We have done a number of things to facilitate that. We have developed a calculator ... to show how MoneyForLife would fit in with, for example, the age pension, guaranteeing a certain income stream for the retiree and then potentially other assets could be invested into higher growth assets to combat the effect of inflation.

Flexibility: key to successful capital protection

IFA Cover Story

By Victoria Papandrea and Wouter Klijn

Page 4 of 5

RH: I think that there is a risk that the product complexity gets too much for clients and even for the lion share of planners. The reality is that some of these products are promising capital guarantee, market upside, longevity protection, the ability to take your money out early, the ability to put it back in, the ability to leave some for your kids, the ability to protect against inflation, if you want to, or if you feel like it.

The issue is that the complexity involved means you need to have an A3 fold-out wall chart to explain the product. The reality is that that is beyond the grasp of many of the financial planners and certainly their clients.

DK: I don't think we should underestimate the ability of financial planners to understand the structure of guaranteed products and for investors to understand the value and flexibility that comes with innovation.

AR: We live in a competitive market and if these products are too complex for the financial planners and too complex for mum and dad investors, then I think they just won't succeed. The commercial success of these will actually depend on the ability for these things to be simple.

PM: I do think financial planners have the capability to understand as long as we don't over-complicate the products and we try to have dynamic products that are flexible.

RH: But what about the fees? The problem is that it is very difficult, even for trained financial professionals, to understand the interplay between some of the costs of these products and the likelihood of the market scenarios coming to pass. The problem is that the fees on these black box, panacea-style solutions are so great that it is highly unlikely that they will outperform a simple, guaranteed, good returning defensive product.

DK: It is very dangerous to take a deterministic approach to an expected outcome. All we can be very sure [about] is that there is a fairly average outcome for an individual investor in some of these products. What an investor needs to manage, or with a financial adviser, is a range of potential outcomes.

AR: What we have done is picking the best economists around the world to come up with the four most likely outcome scenarios. They are cast in a modern time frame within the modern economic constrains that we have. When you project those sorts of solutions forward then you see exactly the point that David is making, which is: we are standing here and the best brains in the world can't agree whether the account-based pension is going up through the roof or down through the floor.

RH: The reality is that between 1980 and 2010 the equity markets outperformed the 10-year government bonds by less than 2 per cent. In that scenario you can't afford to be paying 4 per cent here and 4 per cent there for various protection fees, underlying management fees and for a whole bunch of complexity, which over the long term you don't need.

Flexibility: key to successful capital protection

IFA Cover Story

By Victoria Papandrea and Wouter Klijn

Page 5 of 5

DJP: I was waiting for you to finally mention the number on the fees. You know there are products out there that have daily liquidity, are protected and have fees of 1 per cent. It is very dangerous to knock capital-protected products across the board with a high fee manner. Going back a decade ago that may have been a relevant point, but over the last decade, and the last five years in particular, we have seen costs coming down dramatically.

 

VP: You have mentioned calculators. What other tools can you offer advisers to help them educate their clients?

PM: After we've had the experience of the last couple of years, we certainly work with technical people to be able to provide as much smarts as we can to the financial adviser. Making the financial adviser's job as easy as possible is part of this journey.

I've seen some very poor calculators and I have seen fantastic calculators ... as well. The fantastic ones are the ones where you come up with a client strategy in pension phase, and then you can remodel that. What if you had retired in 1989? You can look at the difference of those pictures simply in terms of where you started, and those sorts of pieces can be added to a statement of advice to give the client a more thorough understanding of the possibilities.

 

VP: Fast forward 10 years in time. Where would you like to see the market in regards to products available as well as regulation in place?

DK: I think it is a fully competitive market, facilitated by the government removing any barriers to the private sector providing those solutions. I think it comes down to education, so that investors are fully aware of the risks and that financial planners have the right set of tools to manage those risks.

RH: I like to see the system maturing with appropriate allocations in retirement in Australia; less unique in its reliance on equities, and less dependent on unfulfilled promises of growth asset outperformance.

PM: I like to see the legislators matching what we are doing in the industry, to listen to the industry on increasing contribution levels inside superannuation, where there is a greater understanding between the industry that creates products and outcomes for clients and the legislators who sometimes provide barriers rather than encouragement.