Topic 2: Life Cycle Investing Flashcards
Life Cycle Investing (5)
- Time relationship between human capital and financial capital:
–Different discount rates, different profiles
–Can increase through education - Human capital
–different for all of us - Home as hedge against housing needs
- Growing focus on longevity risk
- Current industry structure based on getting good returns, needs to focus on consumption smoothing
Life Cycle Investing
- considerations,
- human capital = what in asset allocation space?
- place of models?
- consumption smoothing
- Consider all clients assets, liabilities and goals
2 Reduce consumption now (i.e. save) to increase it later - Human capital as fixed income, offset with equities exposure
4 Must do qualitatively, no single model, albeit “creeping academisation”of PWM (?) - Very important to keep this “consumption smoothing”approach in mind
- Do not focus on return divorced from objectives –e.g. the rich do not need to take on huge risk to meet objectives. Capital preservation can be a good model. Great filter for product selection (e.g. how will punting on weird product help?)
Uncertainties (10)
- How much to save and how ability to save will change through time?
- What return will I get?
- Future living costs?
- How long will I live?
- Insurance needed to protect wealth & human capital along way
- Ability to adjust income along the way if trouble strikes
- Need for housing and ultimately long term care?
- How to model volatility of human capital?
- No useful models to capture all this yet exist –no equivalent to MVO
- Best practice is awareness of issues and exercise of judgement in adjusting “traditional”asset allocations and portfolios
Life cycle/“target date”funds
- Make sense as is a tendency for “cohort” characteristics to be good starting point
- Different allocations from different providers
- Can be dangerous if hit 60 and sell shares at bottom of market, probably OK as approach trigger dates and make active decisions
- My opinion: an interim step until annuity markets become more complete
Reverse mortgage and equity access products
- Draw up as need income, up to max LVR
–May be guarantee can live there to death
–May include selling off a portion of future gains
–Would assume currently less wealthy clients, but who knows how things turn out - Perhaps may be required to do this as part of access to age pension???
Age pension including supplements
- amount
- type of hedge
- size
- reliance
Amount
-$21.5k singles, $32.5k couples
•Govt provided longevity hedge
•Low level of income (but can be more with “bonuses”, pensioner card, etc..)
•But large percentage of retirees at least partially rely on (77% of those over 65 receive income support, according to Harmer Background paper)
Finance theory is based on what simple idea?
- People forego consumption today to save / invest, in order to consume more in the future
- Smoothing consumption over the life cycle
- Focused on what level of income an investor’s capital can consistently produce
- Human Capital
- value of principal residence as a hedge against future housing needs
- accessibility to government pension
- longevity risk
Smooth consumption over time - eg (2)
- Reduce consumption now so to save & invest; to be consumed in the future
- Borrow to consume now, with repayment of debt in the future (this also reduces current consumption by making interest payments)
Human Capital
- define
- how do you model HC
- Ageing
- volatility
- Two types of risks
Define:
- HC is a person’s skills, talents, training, knowledge & strengths which can be used to generate wealth and income (eg salary).
- not readily tradeable
Model:
- HC is modelled as the NPV of future income payments discounted at an appropriate discount rate
Ageing
- as one ages, the proportion of wealth represented by HC declines and amount represented by financial assets increases
Volatility
- unemployment, injury, death, pay rises/cuts
- varies between individuals
Human Capital
- Risks
- hedge risk / highly correlated with markets risk by…
Risks
1. correlated with financial markets (eg stockmarkets and working as a PWM adviser)
2. Uncorrelated with financial markets (sickness etc)
Hedge
- if highly correlated with market, reduce allocation to equities
- may be able to work harder / adjust labour supply, in which case can allocate more to risky assets
- HC is important to overall wealth, therefore insure it - Death & TPD, income protection
Demand for life insurance
- higher if one has more human capital
- diminishes with age (ie family will rely more on savings & investments)
- diminishes with wealth
Life Cycle Products
- Early in Life
- Upon Retirement
Early in Life
- need savings products to start to accumulate & grow financial capital
- need debt products to effectively monetise future human capital earnings
Upon Retirement
- savings products to continue to grow financial capital, but possibly a product that sacrifices growth to provide a guaranteed income to replace a lost wage (eg annuity)
- sell financial capital to generate cash to spend
- reverse mortgage
Life Cycle Fund (aka Target date fund)
Define
Issues
Define Life Cycle Fund
- off the shelf asset allocation that automatically changes AA as the investor ages (eg reducing exposure to equities over time)
Issues
- Different offerings by different firms
- funds may be too conservative in later life, giving up growth opps
Role of family home
Why choose to buy? (4)
Why buy?
- historically has provided steady capital returns.
- may attract tax concessions (cap gains tax & land tax exemption in Aus, deductible interest in US)
- emotional appeal
- If debt free, provided less financial stress when older. Typically concessional treatment for social security etc
Family home - options to generate income
- downsize to release equity to provide consumption
- reverse mortgage
- partially or fully rent out
