Benefits of planning

All of these new clients undertook an Initial Review: a collaborative approach to defining the ways in which they wished to benefit from their wealth, including soft attributes, such as confidence and control, as well as specific measurable results, such as a lifetime spending plan immune to the worst that the economic gods might throw at it.

Good financial planning delivers its own benefits. Some are immediate in the sense of the clarity that comes from giving money different tasks to perform or the confidence that comes from stress testing the household economy. Others emerge gradually, such as the ease of decision making that comes when there is a plan to refer to, or are only apparent if and when stress actually happens. But the real test, whether they are able to look back in later years and decide they did get satisfaction from their wealth and avoided regrets, is one they have to wait for.

In 80% of cases, clients undertaking planning went on to retain us to manage their assets, which suggests the planning delivered some immediate or expected benefits. In several cases the clients who did not go on did not retain another manager and preferred to be self-directed (including financial professionals who valued the planning but had access to good investment solutions).

In no case did we end up managing part of the assets in conjunction with or competition with other managers – possibly because we are flexible about retaining good products or privileged access to products but largely because clients value having a single ‘ringmaster’ when multiple investment solutions are being used.

Why did they talk to No Monkey Business?

Our analysis suggests that only 10% of new investment clients were actually ’selling’, in the sense that they were keen to talk to other firms because they were fed up with their existing advisers.  We find this surprising and it contrasts with the first two years of our existence when many prospects cited problems with banks and IFAs over particular types of product and their assessment of risk.

Of the 90% who we say were ‘buying’ rather than selling, 40% had a specific event-based need, such as stopping work, selling up or needing pension-specific guidance. (The proportion looking for pension advice is down dramatically from the peak around A-Day.) That leaves 50% who were willing to talk to us just because it sounded like we might have a better mousetrap.

What did they leave behind?

Where they came from reflects the focus of our marketing in this period on high-earning professionals, where the well-entrenched advisers include Ruffer, UBS, Towry Law, Andersen Charnley and Saunderson House.

With the exception of Ruffer, which manages money with a bias to a single risk tolerance consistent with its own investment philosophy, the other firms seek to meet varying client risk preferences by matching them to a small range of standardised ‘balanced’ asset allocations. They therefore conform to what we call ‘factory wealth management’ which emphasises economies of scale and production-line processes. These are features common to most asset-gathering business models, whether discretionary or advisory, whether in a bank, an IFA or a pure wealth management firm.

In the factory model, productivity is maximised by channeling the very wide diversity of individual needs and constraints and idiosyncratic risk preferences into a narrow range of standard portfolios. In practice, the asset classes used as building blocks are common to all and the main difference between them is the weighting in fixed-interest bonds – an asset we think is extravagantly wasteful of a limited risk budget.

Nowhere is this manufacturing model more inappropriate than in ‘drawdown’, by which we mean a financial goal which requires a stream of cash flows to be generated and sustained from capital resources. Drawdown goals have quantifiable outcomes as date-stamped amounts, usually in real terms, after inflation. The most common is funding retirement spending (whether consuming pension or non-pension capital). In our market, where defined benefit pensions are not so common, self-funded retirement spending is a key objective.

The second common attribute of their previous managers was an implied belief in the active management bet. I say ‘implied’ because many investment professionals do not believe they can sell anything else even if they realise that active management is a loser’s game, so conditioned is the investing public to playing the game.

What did we do differently?

For planning clients who retained us as manager, our fully-customised Defined Outcome portfolio approach replaced the standard variants of balanced management they were used to. That is a big change.

Apart from altering the approach itself, the effect was never to validate the same level of risk taking and we either increased or reduced the overall level of risk, making it consistent with planning-based preferences. What planning typically revealed was that people were not taking enough risk to achieve the benefits they most valued. We do not find this insight became a source of blame for the previous adviser. A common tendency was for people to have accumulated cash from high earnings due to a lack of investment relationships they had confidence in or to avoid having an asset-based fee attached to that money.

Changes in risk levels were implemented not by altering the mix of standard diversified asset classes but by a ‘new’ mix of risky assets and risk free assets (’dilution’ not ‘diversification’).  Until clients undertook an Initial Review, virtually none was at all familiar with the institutional approach of Liability Driven Investment that ‘matches’ assets to liabilities either by hedging (duration-matched risk free assets) or making risky bets with uncertain outcomes.

When all risk sources were separately identified, the main change in risk budgets was the avoidance of inflation bets, achieved by getting rid of conventional fixed income exposure and replacing risk free assets that do not have inflation indexation with those that do (index linked gilts and National Savings & Investments). 

Where clients have different goals, every asset (including property), held by different owners in different accounts or wrappers, is assigned to a specific goal. Each is managed differently. Other than sibling children, no two clients have the same portfolio. This was a telling difference from clients’ previous experience.

At our clients’ typical wealth levels, substantial non-investment property holdings in the UK or abroad form an important part of the consumption benefits conferred by wealth. However, a common factor is that for lifetime wealth benefits to be maximised, some of this capital will need to come back into the funding of other goals, including retirement spending. We were able to incorporate this into the matching of assets to goal requirements and into the quantification of goal outcomes that otherwise depends on modelling financial asset returns. Clients valued, but had not previously encountered, such a holistic approach to lifetime efficiency of economic capital.

In most cases, after an Initial Review new clients gave up on ‘alternatives’ like hedge funds and private equity, although we often have to nurse holdings until they can be worked out appropriately. In some cases we organised new complementary investments but these used third-party products more often than third-party relationships.

Across the board, we have also substituted active funds by index trackers, using both unit trusts and Exchange Traded Funds (ETFs).

In many cases we changed clients’ thinking about pensions. Sometimes this was just based on the maths: the quantification of present values of cash streams inside and outside pension wrappers. This takes into account not just tax breaks going into pensions but also the high taxation of pension income and the penal taxation of undrawn inherited benefits. Some new clients regret listening to pension salesmen as they realise the tax benefits are not what they thought and they now have to live with the inflexibility of their capital.

How have we altered their costs?

We have introduced total transparency of all costs and defined a cost budget with every new client. We have radically changed the way their costs are allocated. This brings into better balance:

• the amount of charges 
• their importance in terms of explaining outcomes or probability of obtaining value.

‘Implementation’ costs – for obtaining exposure to the market risks and returns sought – are typically cut from about 1.6% to 0.35% for equities and are virtually eliminated for the risk free assets that take over from ‘balanced’ diversification the job of risk control. This saving is mainly achieved by giving up active funds or active security selection as the means of implementing desired market exposure.

These savings free up cost capacity for what really counts:

• dynamic asset allocation 
• continuous risk management
• reporting focused on forward-looking outcome probabilities
• continuous planning in the light of actual goal progress.

In most cases, because of the size of the client’s assets, we managed to reduce total costs by several thousands each year and for the wealthiest, because our fees are much flatter than value-based fees, it is measured in tens of thousands. 

Providing insights into true cost levels and waste has sometimes affected how new clients feel about their previous managers! This suggests the industry is still a long way from being open and transparent but also that customers are not particularly discerning about value until something jogs them.

Service

Generally, clients spoke quite favourably of the service they were receiving from their previous advisers although when it goes wrong it is a killer for the relationship. This was rarely the reason prospects cited. Our competitors are not stupid and employ personable people and expect them to stick close to their clients.

I see no reason to expect us to perform the basic functions better. But we do expect to deliver more of value in the relationship, by making portfolio management a continuous process of financial planning. Defined Outcome portfolios generate a different form of reporting that is much more forward-looking than traditional reports.

I would also like to think, as some of the clients’ comments testify, that we can match any of our competitors when it comes to intelligent obervations about the financial world.

The challenge for private clients our title alludes to has two dimensions: giving them the right job and ensuring they do the right job well. The typical portfolio approaches for private clients focus on short-term constraints that are not consistent with maximum satisfaction with horizon-specific outcomes.

Using as an example No Monkey Business portfolio returns over the last two years of large falls and rises in markets, we illustrate how to set objectives and assess performance better. Because all our portfolios are different, for reasons that will be obvious from reading this Insight, we reference the same two portfolios as we did in an earlier Insight, Anatomy of a bear, one in ‘accumulation’ and one in ‘drawdown’.

Performance and confidence

Performance appears to be an important reason, perhaps the most important, for individual investors deciding to change their investment arrangements. This is not because they have a lot of information about their managers’ performance and are able to assess it rationally. In fact, they probably only get to see their own returns, compared with benchmarks, every three or possibly six months. Even then, without a lot more data history than their patience may tolerate, and without attribution (was it policy choices, market timing or selection choices?), there is limited information to be extracted from the reports.

If it is not continuous well-informed appraisal that leads clients to change manager, what aspects of performance do? It is usually because they are surprised by what has happened and in the absence of proper explanation they lose confidence that their adviser has understood the constraints or the objective or both. The surprise is all about expectations but the interpretation is all about confidence.

In other cases, however, investors will realise that the adviser or manager they appointed did a good job given the mandate but the mandate was wrong. It can be hard to leave a manager who has done a good job against the wrong mandate. In selecting us many clients have moved their money from managers with very good performance as well as from those with disappointing performance.

Wrong job, right job

We identify five common causes of disappointed expectations and mismatched mandates that are prevalent today:

1. The spread of a ‘factory’ approach to portfolio organisation that lacks close links to relevant personal objectives
2. The fact that equity returns over the past decade have not typically delivered the ‘risk premium’ professionals led clients to expect
3. The failure of diversification across the traditional asset classes to smooth portfolio volatility as portfolio theory apparently posited
4. The failure of ‘alternative’ asset classes to perform as expected, in terms of absolute returns, correlations and premiums for illiquidity
5. The ‘false prospectus’ that the fad of ‘absolute return investing’ turned out to be for many of its followers.

What all five have in common is that they are policy choices: high-level decisions about the general approach to how your money is to be managed. They belong to the client, who makes that policy choice. This is not to say the industry is blameless in adopting the easy sale in preference to a more exacting route to developing optimal investment solutions. The easy sale not so long ago was, after, all unitised with-profits.

We suggest that ‘outcomes driven’ investing, which Chris Drew and I developed ten years ago in parallel with the emergence of Liability Driven Investment in the institutional market, has avoided these problems and allowed for much clearer expectations and therefore more stability and consistency in following a planned and appropriate strategy.

The expectations effect works by being more explicit about what can happen, with more quantification of risks. But is also works via a feedback from greater confidence about outcomes to greater tolerance of short-term volatility. Consistency on the part of our clients means we are free to follow a model-driven discipline which is likely to increase wealth outcomes. Inconsistency means investors tend to raise their risk tolerance when times are good and lower it when markets and the economy are doing badly. This destroys wealth.

To illustrate how our clients can assess the job we are doing we reference our two actual portfolio examples. We do this in terms of three key questions we think all clients should want answers to:

• How is my portfolio structured to deliver what I want?
• How is risk being controlled?
• Are both evidenced by the activity in the period?

How is my portfolio structured to deliver what I want?

‘Delivering what I want’ translates, in investment theory, to ‘maximising the benefits I want to get from my money in the form I specify’. In this context, ‘benefits’ translate into ‘utility’ or (as sometimes expressed in the theory) as ‘welfare’. Utility is specific to a goal not general to an ‘investment personality’, assuming such a thing even exists.

In practice, utility is mainly about the consequences of uncertainty and how individuals express preferences in response to those consequences. In the factory model, the presumption has to be that these are common to everyone, not idiosyncratic. In reality, we make value judgements that are highly specific, such as:

• preferring to push possible bad outcomes further into the future, where we think we can better bear the consequences, or nearer where we can deal with them through adjustments to behaviour (such as a household budget change)
• setting explicit constraints on the consequences, such as a minimum spending level in retirement which no incremental potential spending chance should put at risk
• preferences that are dependent on progress in funding an objective that calls for a particular pot of money, which (whether the progress is good or bad) could invite taking either more risk or less risk.

You will know personal utility was never addressed if you did not start with planning conversations that identified these preferences and described a portfolio solution that matched them.

You will also know it if the conversations about ‘risk tolerance’ did not address whether your utility was best expressed in terms of path risk, or the short-term volatility in the path of the portfolio in money terms (as measured by those performance reports) or outcome risk, as in the form in which you ultimately derive the benefits from your wealth, such a future level of real spending (after inflation) say 20 years out. The first is not a substitute for the second.

We find that in practice most investors, when encouraged to plan in terms of specific goals for their money, can see clearly when (and why) path risk or real outcome risk dominates. The investment solution will be radically different depending on which dominates.

For the client who owns our drawdown example, the goal is meeting a schedule of annual draw in real terms from capital (part in pension, part not) subject to the constraints of i) not running out of capital before age 95 and ii) sustaining the spending plan without being forced to cut it, except to the extent of a planned schedule of tapering minimum spending at different stages of retirement. In this plan, risk taking is constrained by the agreed range of tolerable outcomes, as ‘real’ money available in a cash account to meet the next three years spending, in a schedule of three-year time slices from 50 to 95. With known resources, risk is solved for by reference to the range of probable outcomes (which come from our model) and the consequences (which must come from the client).

The key element of our quarterly performance reporting is therefore where the client now stands in relation to the goal outcomes: is the ‘new’ portfolio value sufficient, with ‘new’ expected returns, to meet the agreed drawdown targets with the same confidence?

Because there is a degree of volatility in the ‘funding status’ (though as the return-generating element of the model is designed, this is much less than the volatility of ‘the market’), we report (as a monetary amount and as a percentage of the ‘fully-funded’ position) the ‘interim projected shortfall or surplus’. What the client wants to know is:

• Has the portfolio done so badly that I may now breach the plan constraints and therefore need (in this example) to cut spending, contrary to the objective of sustaining it a planned real rate?
• Have I done so well that I can change the targets or risk level or assign surplus assets to a different goal?
• Is the change just ‘noise’ I should not attach any significance to?

We provide this guidance in every report, every quarter, drawing on stochastic simulations of a long-term plan and its changing interim funding status. Usually we will be suggesting that no action is called for by the client, particularly in the first 6-10 years of a plan.

A secondary aspect of the portfolio progress report is that, because the target outcomes were planned in real terms, we need to adjust them each quarter by the actual inflation in the quarter before calculating the new funding position. We report that change too.

How is risk being controlled?

In the typical investment solutions that dominate the IFA, banking and wealth management business models, risk is managed by diversification. This is not a control. It was never put forward by theorists as a risk control. Its origin was in the separation of:

• diversifiable risks that provide no reward and therefore should be eliminated from a portfolio and
• systematic risks, common to any exposure to particular asset classes or markets however you select within them.

Relying on diversification between asset classes and markets reduces risk to the extent the returns from each are less than perfectly correlated and so for a given level of resulting risk there is a set of possible portfolios that will yield the highest expected return. These portfolios are ‘more efficient’ in using risk than portfolios that have lower returns per unit of risk. That is all it means.

To serve as a risk control, there would need to be sufficient of these asset classes and markets with both i) low or negative correlations (or co-movement) and ii) stable and predictable correlations to reduce portfolio risk reliably to acceptable proportions. As investors worshiping at the new altars of ‘absolute returns’ and ‘multi-asset classes’ discovered, correlations do not have these highly desired characteristics. And they converge when you most depend on them, such as when liquidity tightens up and asset prices are falling. Hence the disappointment.

In a liability-driven approach, risk is controlled by combining risky exposures and hedges. Hedges are assets that perfectly match a liability, or goal outcome. If the outcome is a target level of money in real terms 10 years out, for instance, that exact amount can be produced, on time, with certainty, by buying an index linked gilt with the same duration.

When investors have preferences for outcomes that involve trading off possible higher wealth against some minimum wealth, there has to be a range of probable outcomes, with risk taking, that is acceptable and efficient. The size of that range is controlled not by diversification, although that is part of an efficient solution, but by the mix of risky assets and hedges, or risk free assets.

What is the evidence?

So when we report our transaction activity for a client in the quarter, it should be seen to be consistent, at a high level, with the process of risk control as market values alter. It becomes the visible proof of a risk management discipline. It will be particularly seen as a discipline if the actual activity appears (at the time) counter-intuitive.

In Fig 1 we show the market returns from the start of 2008, just after the bear market began, up to the end of 2009. This describes the environment for each of cash returns, index linked gilts (the FTSE over 5-year index whose duration most closely corresponds to the time slice outcomes we hedge) and the four equity markets and regions (in sterling terms) we use as building blocks for the risky asset portfolio.

Fig 1 Index total returns in £ for portfolio building blocks

Two aspects are important to our model:

• The expected return on equities rises as markets fall in price, because we accept the evidence that equities generate a trend of positive real return over long horizons (capitalism requires it) and ’revert to the mean’
• The attraction of any expected equity return depends on the competition it faces from hedging assets, at their own ‘certain’ real return.

In Fig 2. we show how we moved money between the hedge portfolio and the risky portfolio over the course of the market cycle, responding to both effects. The bars show the net addition to (positive) or sale (negative) of equities in each quarter of the two-year period.

Fig 2 Net flow from risk free to risky assets as % risky

At the start of the bear market, equities fell but so did the risk free rate, so we added to the equity position. As this was followed by a reversal of the fall in risk free rates and slightly higher equity prices, we took some bets off the table and added to index linked gilts. As the bear market turned nasty, and the crisis in the banking sector spilled over into expectations of a global recession or new depression, additions to equities were mainly driven by falling price, rising expected returns, rather than by changes in risk free rates. More recently we have started taking bets off the table as both equities and index linked gilt prices have been very strong. Though mean expected equity real returns are still above average, the incentive to take risk is greater because index linked gilt yields are at record lows. However, the incentive has been lessening simply because of the scale of the recovery.

We suggest that few managers have shown such consistency in their risk taking approach during this market cycle. Looking at their activity will probably tell a clearer story than the performance they reported or the comparisons they showed. Over the long term, there is clear evidence that adopting a consistent attitude to risk, which is not at all the same as the same level of risk, produces higher returns because it avoids selling low and buying high.

Backward looking performance

Even on a pure accounting basis, we need to report what actually happened to our clients’ portfolios in each quarter and we do that too, in a fairly conventional way.

• We calculate the money weighted returns in each month (so adjusting for cash flows into or out of the portfolio during the month according to roughly when they arose) and multiplying them through to produce what is then very close to a time-weighted or internal rate of return for that quarter
• We show the returns for the assets we use a building blocks in the same period, so that the actual return can be viewed broadly in the context of the environment in which we were operating
• And from now on we plan to show something we have resisted hitherto: a measure of what clients might have earned with a more conventional approach, for which purpose there is nothing ‘better’ than the benchmarks developed to match the different version of the factory model by the Association of Private Client Investment Managers and Stockbrokers.

In a liability driven approach, the changing market values of the hedging assets are meaningless in terms of outcomes, as the two are perfectly matched: a rise in price will reduce the expected real return symmetrically leaving outcomes unchanged. So realistically it is only the risky portfolio whose volatility is meaningful, but in our view its meaning is in the impact on funding adequacy, and so requires a forward-looking measure. As a backward-facing measure of industry returns, the closest APCIMs benchmark for the risky portfolio is the Growth index although it is not still not representative of equity returns alone, as it includes cash, bonds, property and hedge funds (to the extent in full of 22.5%).

In Fig 3 we show the returns of two portfolios, one in drawdown (and so combining hedges and risky assets, the latter averaging about 55% over the period) and one in accumulation (with long enough horizons to have been fully invested in risky assets throughout the two-year period).

Fig 3 Quarterly portfolio and benchmark returns (indexed)

We can note, in terms of attribution, that we were helped by the extent of our diversification geograhically, as we tend to more equal weightings than conventional managers and have less of a bias to the UK as home market. This helped particularly in the bear market because of currency gains, although this was partially offset in the following year.  The returns to these structural characteristics, or policy features, in any particular period contain relatively little information except that diversification does not necessarily require lots of different assets. As the APCIMs benchmark shows, conventional diversification, even with the addition of 7.5% in hedge funds, did not produce either better performance or less volatility than our risky portfolio.

Though you can make comparisons with your own performance, we suggest the guidance in this Insight as to how to interpret what your manager is doing is probably much more important than a crude comparison of the numbers in a short period. As my book suggested, investment is best viewed as a journey not a race. You are not picking the winner so much as the best planner, navigator and driver, all rolled into one.

Lifetime Allowance
The Lifetime Allowance (LTA) will increase from £1.75m to £1.8m at the turn of the tax year. It will then be fixed at £1.8m until at least 2016 (unless reviewed by an incoming government).

As planned, individuals aged 50 that have opted for primary protection will have the allowable growth within their pension funds effectively capped for a period of 5 years.

By vesting the pension in full, the pension will not be subject to the LTA at a later date. The pension fund is not therefore restricted to any particular growth rate.

If further income is not required immediately, the income can be set at zero. And because the crystallisation of the pension triggered an ‘entitlement’ to pension benefits, the option for an income stream to commence before age 55 is retained.

What to do with the PCLS
On pension crystallisation, an individual can take a portion of their pension as a pension commencement lump sum (PCLS) or, as more commonly known, ’ tax free cash’. If there is not an immediate need for the capital, it can be reinvested outside the pension environment. If held in a taxable form, growth will be subject to capital gains tax (currently set at 18%) after the personal annual allowance of £10,100 has been used. This is a lower ‘effective tax rate’ on growth than experienced in a pension, 75% of which will effectively be subject to income tax at 40% or 50% for higher earners when extracted.

This presumes that the individual buys assets that attract capital gains. If on the other hand, index linked gilts (ILGs) were purchased the arrangement becomes even more tax efficient. ILGs are subject to minimal taxation when held directly (outside a tax wrapper). Most of the inflation compensation element of the return is in the form of tax-free capital uplift rather than taxed coupon uplift. This contrasts with nominal interest rates, where most of the rate paid is compensation for inflation and is then taxed as income, and with equity returns, where the inflation compensation is partly via income and partly gain, with both subject to taxation.

Capital Extraction / Income Drawdown
Extracting the full ‘economic value’ in a personal pension fund is extremely difficult and in many cases impossible. Therefore, once a decision has been made to extract the tax free cash, a plan to extract the maximum amount of pension capital is likely to follow.

Throughout ‘decumulation’, the period of time during which individuals enjoy the accumulated capital, pensions are overly restrictive. Once the tax free lump sum has been drawn, the annual income that can be drawn from the pension is restricted to rigid government actuarial department (GAD) tables, influenced by the yield on 15 year Gilts, and taxed at marginal rates of income tax.

The after-tax benefits of savings in or out of a pension wrapper can be measured by comparing net present values (the total present value of a time series of cash flows minus the initial investment) of the two cash streams after their different tax treatment. We find many people who have previously focused on the tax advantages of accumulation are shocked to discover how small the net present value gain from their pension is. However, even this calculation ignores the uncertainty about the amount of capital that can be enjoyed either as lifetime spending or as a bequest. This is a serious oversight as there is in practice a large degree of inefficiency in the extraction of value from a pension account under current tax rules, aggravated by the penal taxation of residual funds after the deaths of both member and spouse. The rules are also designed to ensure that there is likely to be a residue if the second death occurs after age 75. The intention of these rules may have been to make the option of drawing down after age 75 unappealing.

The risk of not extracting all of the value from the pension fund can be avoided by buying, at some stage, an annuity. The potential loss of early death is offset by an equivalent gain from outliving one’s actuarial expectancy. However, this calculation is not a satisfactory explanation of the benefit of capital in or out of pensions where there are children and a significant value is placed on a bequest motive. Such an approach to the economic value of pensions is clearly dependent on individual levels of wealth relative to spending.

A critical source of loss of economic value in pensions is inflexibility. Pension rules generally do not allow an individual to access pension capital should it be needed. This is highly relevant when a large proportion of the assets assigned to retirement spending takes the form of pension capital, in which case it may be impossible to meet unexpected exceptional expenditures.

Pension Winners
When considering the whole duration of a pension, from commencement of contributions to the pensioners demise, the tax benefits are very difficult to calculate. The only group that can be confident that they benefited from the pension tax structure, ahead of other alternatives, are individuals that made contributions to pensions as higher rate tax payers, and then drew down income as a basic rate (or lower) tax payer.

Pension Losers
High earners who were able to make very large contributions to personal pension arrangements and based their actions on the tax benefits going in are those most likely, depending on later circumstances, to have destroyed value.

Their number will be significantly increased if, as many now fear, the pension commencement lump sum of, typically 25%, is axed by a future government desperate for tax revenues. We believe this fear is exaggerated because it would render savings in a pension fund economically irrational even for the majority of savers. But this concern has been described to us by one of our clients as a ‘monster under the bed’ which, once it had entered his mind, could not be ignored, and could only be assuaged by crystallising his pension to be certain of not losing out.

Potential for conflict?
You may now be wondering, why you have not been advised to consume capital or crystallise pensions early by other advisers?

It could be that that they have placed too great a value on the benefit of income tax deferral and gross roll up (less the 10% tax credit), ignoring the real (after inflation) value that can actually be extracted from the pension fund.

It could be that they enjoy the dependency that is created by using the complicated legislation and tax structure of pensions?

Or it could be that the majority of advisers are remunerated by the value of assets within the pension fund.
In practice these may play a part, but the most significant reason is that most advisers do not have the necessary investment expertise to manage what is, an extremely difficult investment challenge. On this basis they will be reluctant to advise, and will almost certainly refrain from drawing on your pension early, regardless of the level of assets an individual holds elsewhere. They may also advise clients to draw more conservatively from the pension than is sustainable so to avoid depletion of the fund.

Planning from a holistic perspective
Putting aside the previous considerations, the decision to crystallise pension benefits should really be made within the context of establishing a sustainable level of lifetime spending that a total portfolio can support. Most pensioners are likely to value higher spending when fit and active, with income tapering down later in life. They are also likely to prefer passing surplus wealth to beneficiaries by the method of regular gifting from income. Not only is it efficient with regards to inheritance tax but the client also values the gifting with ‘warm hands’.

This type of spending plan is likely to be funded not just by pension funds but various financial assets both in and out of tax wrappers, as well (perhaps) as real property or contingent assets such as inheritance. Only by considering the balance sheet as a whole and the existing arrangements for holding assets can one make a fully-informed decision.

In a context of holistic resource planning , retirement spending funded by non-pension sources may run up against a cultural attitude that differentiates between income and capital, as in ‘not consuming the seed corn’. In a pension fund, of course, this distinction clearly does not need to mean anything significant. The ‘income’ drawn in retirement or taken as an annuity is actually a conversion of accumulated ‘capital’ to a stream of cash flows. The ‘capital’ accumulated is itself the product of savings out of earned ‘income’. It is just money.

The important output of planning is how money is consumed. Freeing up attitudes about where the money should come from will also allow greater tax efficiency, as the tax code penalises income relative to capital. Consuming capital is a way of reducing one’s overall effective tax rate but this is only likely to be acted upon if there is confidence in the solution managing the sustainable level of income.

The underlying economic principle of a holistic approach is total capital efficiency, where after-tax outcomes are measured against the particular way in which clients expect to derive benefits from their wealth. This is the essence of outcomes-based investment, organised to deliver both client- and goal-specific planned outcomes.

The chances are you or your adviser will be following the money already flowing into China and the wider Asian area. Data collected by the Investment Management Association shows that through 2009 retail investors in the UK moved increasingly large sums into funds investing in emerging markets and Asia (ex Japan), to the extent of about one quarter of their net purchases of equities. For both sectors, these are record flows. The vast majority of the flows have been handled by intermediary firms, not self-directed investors. US retail investors have similarly shown record interest in China, India and smaller Asian markets.

Though the flows are enormous for the sectors, the stock of holdings is still relatively small. But that is the point about China and the other large economies playing catchup: India and Russia. They generate a sense of anxiety that personal portfolios ought to look more like the global size and importance of different economies. As if that was not enough, the idea of participating in much faster growth is even more compelling when investors see Western economies being held back in the growth stakes by the lasting loss of productive potential inflicted by the credit crisis.  It is a good story but it is also a trap.

The growth trap

The growth trap is one that through history has caught out professional investors as well as retail investors. This suggests it is not as simple as professionals: smart, amateurs: dumb. It has to do with something that divides professional investors too: understanding the nitty gritty of business planning with financing costs allowed for. You can be smart by understanding how to analyse growth dynamics, whether for single companies or country equity markets as a whole. Or you can be smart by understanding the mistakes that others are making and exploiting them. In competitive fund management, good analysts often have to go with the flow, or momentum of markets, and hold positions much longer than fundamental value warrants, because of the need to keep up. Mistakes can be made even by smart investors, either in the analysis itself or in the gaming of other investors’ activity. Self-directed investors also get the analysis wrong but then usually compound that error by arriving late enough at the party to provide the sucker money that lets the smartest game players get out near the top.

In terms of its analytical roots, the growth trap is all about the difference between ‘top-line’ growth, say GDP for an economy or sales for a company, and ‘bottom-line’ growth, as in the cash flows and accounting profit underpinning each share owned by an investor. This difference between top and bottom line growth is largely explained by the irritant of having to finance growth. This is an irritant because there is almost always a gap between the opportunities for physical expansion (superior) and return on capital (average). This is because return on capital is determined by competition and scarcity which are largely independent of growth opportunities. Indeed, if anything, the more obvious the growth opportunities, the more likely competition will displace scarcity and push return on capital below the level required to finance growth without dilution.

Dilution is the effect on existing shareholders of issuing new shares to plug the gap between profit generation and capital investment. Dilution can be avoided by plugging the gap with debt, but only up to a point. And in any case the investor’s actual achieved return should then reflect the additional risk they are asked to bear.

High growth economies

The dilution issue for companies scales up to whole economies. There is overwhelming evidence from achieved real returns from different markets that the return-generating process is essentially the same but neither return differences nor risk differences within this system are explained statistically by top-line growth differences. The world of investor returns is much flatter than naive observers would assume but that is consistent with profitability internationally being much flatter.

The evidence is in deflated equity indices for some 20 markets for much or all of the 20th century. In my book I also showed a chart of the fitted return trend for a Wilshire index of US shares from 1820 to 1999 and there was esentially no difference in the returns earned in the early period, when America was a fast-developing but already large economy, and the later period as a mature economy and stockmarket.

These general observations apply to the BRIC story even though the story appears to have particular explanations that are not typical in past data histories. The growth opportunity is seen as being a function of the gap between

• the actual and projected size of the economy and its importance in a global context and
• the total size of the stockmarket, being the value of the listed companies in the fast-growing economy.

For China, India and Russia the gap is seen as unusual in origin because long periods of more or less socialist systems, for up 80 years, destroyed productive capacity. Errors in economic management and perverse incentives continued only as long as they did because these countries could feed themselves, up to a point. That takes large populations and land mass including, to survive the worst or longest mismanagement, indigenous industrial raw materials.

Though Brazil is also put together with these to form ‘the BRICs’, its growth story is more to do with riding a commodity wave than having an obviously less well-developed and poorly capitalised group of publicly-traded companies. Though it is not the same sort of ‘corporate gap’ story, Brazil does share with India a long history of disappointment in realising its productive capacity, even with less state control of production than China and Russia.

The change in economic system that has the potential to realise the catchup possibility does not need to take the same form, as all modern systems are politically constrained rather than free markets. Indeed, though emerging capitalism is very different in China from the West, it is not dissimilar to the Japanese system, yet the equity return process in Japan throughout its peacetime history appears to be the same as in the West.

Our argument is not with the catchup story but with the implications for realised future investment returns. The naive assumption is that the gap will be filled by higher higher returns for the owners of the existing companies. This could not be more wrong. The gap will inevitably mostly be filled by new capital, whether for existing or as yet unformed businesses. It is in this respect no different from the growth trap in any growth economy. The financing problem does not go away just because these are large economies held back by bad government.

Valuation

If the return process is the same, it is the valuation at points of entry and exit that will mainly explain holding-period returns, not the sustainable return trend itself. But if typical investor assumptions about future returns are based on a mistake, it follows that there is a risk that valuations will be too high.  This presents itself as an opportunity to game other investors over the short term but also as a risk of misallocation of personal capital over long holding periods.

We show below the real total return of the MSCI Emerging Market Index as an index (base 100 in December 1987), firstly as published in US dollar terms (orange) and secondly in real terms, deflated by US CPI (green). The second series is intended to correspond as closely as possible to our real return measures for developed markets. These follow the logic of a global model of real total returns in which the trend matters because of ‘mean reversion’ but the deviations from trend explain more of holding-period returns. If there were no net trend of either currency appreciation or depreciation over the period, differences in local-currency valuation would translate into future real returns to investors from other countries. In fact, holding-period real returns for international investors are also explained by differences between the actual exchange rate movements and changes in the ‘real exchange rate’, as derived from any gap between the two countries’ domestic inflation in the same period. Using US deflated returns for emerging markets is realistic from a global valuation perspective because the dollar is the key nominal and real exchange rate for emerging economies.

The real growth trend (broken line) is 6% pa which is almost exactly what we would expect from a developed economy’s stock market (even though this basket of markets across several geographical regions has shown higher volatility than an individual developed market).

The latest ratio to trend is 120%. It is not exceptionally high relative to previous deviations from trend but it needs to be seen in the context of much lower grow expectations for developed markets. The equivalent ratio of trend returns is currently 96% for the UK which is the most fully-valued of them all. The European ratio is 80% and the US 75%. Only Japan is priced for very low expectations, for reasons most investors will be familiar with, with a ratio as low as 44%. These detrended measures of value deviation since 2000 (the last peak of overvaluation) are shown below.

Our own measure of value is confirmed by a conventional fundamental measure that is very relevant if an investor accepts that the investor return world is relatively flat because corporate returns are relatively flat: price divided by the carrying value of equity capital in the balance sheet. Differences in price to book value ratios can only be rationalised by profitability differences.

Price to book value multiples of around 3-5 times in Chinese stocks (the range being between those available or not to foreigners), albeit lower than 6-7 times two years ago, are on a par with Japan at its 1989 peak. Even the banks, whose return on equity is surely not many multiples of banks in other economies, trade on ratios between 2 and 5 times book value. The MSCI India index ratio is 4 times. The MSCI BRIC index ended the year on 3.8 times book.

China fragility

If we had to pick candidates for major capital allocation errors of 2009, they will almost certainly appear somewhere in China’s economy. Though our argument here is not with the top-line growth, the signs of capital misallocation are enough to make a China blow-up plausible.

Any Japan analyst will surely be struck by the similarities with the way Japanese banks and companies misallocated capital throughout the 1980s and 90s, driving down marginal returns on capital even as high levels of capital investment continued. For households, the trap lay in both stockmarket speculation and rampant house prices. These too are echoed in China.

Any serious concern about the banking system in China will spring the valuation trap much quicker than if left to the typical cycle of equity momentum. There is always some risk in trying to be smart by gaming other investors, as people found out when the bubble burst in housing and credit markets in 2007 when levels of equity valuation were far from extreme.

The banking crisis was an accident waiting to happen. Its root causes, though economic in nature, lie in the activities of the banks. But it certainly was not inevitable. It should have stopped in bank board rooms, well before it got out of hand. What should have stopped it was rational self-interest, as perceived by each of bank directors, their shareholders and regulators.

In this Insight, we explain in laymen’s terms how the way business is organised leads to certain predictable outcomes. Though the focus is on the business of banking and its regulation, the trails we explore echo to a recurring No Monkey Business theme: smart agents will always exploit weak principals. Monkeys do what monkeys do.

Follow the money

We see five trails in the banking crisis that lead back from bad outcomes to flawed incentives.

• Since the recession of the early 90s, government policies in the areas of money, credit and employment have all tended to encourage ‘moral hazard’, interfering with the symmetry of punishment and reward that systems depend on if they are to function normally.
• Changes in international rules for determining how much capital banks needed led directly to bankers shunting assets and liabilities off their balance sheet, without a care for their risk and return.
• Rising volumes of increasingly complex transactions led bankers to rely for simplicity on rating agencies to assess credit quality, even though these agencies were paid by the issuers of the paper they were assessing.
• Senior bankers wrote their own asymmetrical pay incentives so that they participated quickly and handsomely if they wrote high business volumes but did not participate in the losses if volumes came at the expense of lower quality and future defaults.
• Bank shareholders should have been the ones to hold bank management’s incentives in check but shareholders are today represented by institutional investment managers who have collectively and individually created similar perverse incentives for themselves. Independent advisers are too weak to counter these incentives and have even been tainted by them.

Moral hazard

Banking will always be tightly regulated, because banks have the power to create money, as deposits make for loans and loans create more deposits. This makes them an instrument of government (or central bank) monetary policy, not a ‘free market’. So in judging the incentives provided by regulation and supervision of banks, we have to leave behind many free market notions of competition.

Monetary policy in democratic, advanced economies has created a spoilt generation of voters, much as parents now seem to run scared of their children.

The first evidence of this emerged in the USA in the Greenspan-led Federal Reserve Bank as financial market actors started to behave as though any signs of either recession or weak asset prices would be met by monetary stimulus, to prevent a rerun of the recession of the early 90s.

In general, such thinking has been validated by subsequent events. Policy responses to the financial crisis in emerging markets and the collapse of Long Term Capital Management, though aimed at stability, in fact fed instability, in the form of the boom in technology and new media stocks. To ensure the subsequent bust did not feed back to real economic activity (a risk thought to have been increased by 9/11), the response was to hold interest rates at about 1% for several years. After that, not even rapidly accumulating financial imbalances between nation states, increasing leverage in personal and corporate balance sheets and an unprecedented bubble in real house prices were enough to put steel into central bankers’ spines. No wonder that in bank board rooms around the world decisions were made to hold (or trade) as many as possible of the assets being created by unchecked borrowing.

This narrative does not even need the added ingredient that agents behaved as if many banks were too big to be allowed to fail. More likely, this emerged only after the sub-prime lending bubble burst. Prior to that, the thought of failure probably did not even enter their heads.

The policy response of governments to the ensuing crisis has been more of the same. If the underlying financial imbalances are at some point to be corrected it will be in spite of governments, not because of them, and then only thanks to the rational self-interest of households (who are also voters) when guided by fear and mistrust.

Fighting over the rent

In banks, in addition to their role in monetary policy, the normal tension between shareholders and management has always been particularly acute. This is particularly so for the old ‘merchant banks’ and modern ‘investment banks’, where profit generation depends less on running a broadly diversified book of financial assets and liabilities and more on deal making and trading. These activities are less capable of being dehumanised as mere systems and processes.

Doing more of these activities shows up as both higher and more volatile operating profitability. It makes it more important to keep staff costs variable. Bonuses achieve this. But dependency on individuals rather than systems increases the risk that individuals will succeed in extracting too high a rent for their labour relative to the rent on the bank’s fixed and financial capital that they need to use.

Weak supervision

Checking this balance between shareholders and managers was never explicitly the role of bank supervisors. However, the earlier form of personal interaction between the Bank of England and senior bankers was possibly more attuned to spotting causes of risky behaviour than is the more data-dependent and process-driven FSA. It is also possible (as the Conservatives believe) that the separation of powers between the Treasury (although this normally does delegate its powers), the Bank of England and the FSA weakened the effectiveness of supervision. We may safely anticipate, therefore, that the regulatory lessons learned will include a return to closer board-level observation and dialogue.

Lord Turner, arriving late as the head of the FSA, has argued in public that regulators placed too much reliance on the ‘efficiency’ of financial markets. Presumably what he had in mind is not just market efficiency in the narrow, technical sense of information flows, and rational responses to information, but also the more widely-understood meaning, that open competitive markets tend to be self-correcting because of inbuilt incentives, in the form of commercial rewards and punishments.

The first interpretation of efficiency serves as an excuse for regulators to assume that regulation of products, and particularly innovative products, is not a critical focus for them. They could not be more wrong. There is a depressingly long history of product failures in both banking and investment markets that should keep regulators constantly focused on the technical integrity of products.

The second interpretation of efficiency refers to the theoretical function of equity owners, in a public stock market: rewarding good and sustainable business models and punishing bad or excessively risky ones. If the regulators relied on this theoretical function working well in the bank sector, they were again deluded.

Where were the shareholders?

The owners of the primary bank capital, equity, are the people with the powers to ensure management incentives are checked and to influence business models and strategy. They used these powers weakly.

This is not a new story, a British one or one peculiar to banks. Shareholders in the US as well as the UK have been mindful of the distortions created by pay incentives but the effect has been to shift more of the variable remuneration onto share incentives. Executive options have exploded as a form of deferred and only partially contingent pay, more so in the US than here. Institutional shareholders were extremely slow to realise that they were being taken for a ride.

The same lack of engagement by shareholders is signalled by the rising share of reported bank profits going to labour, unless they glibly assumed that the rise in operating profits was itself the result of needing less capital (and by implication) less need for return to capital relative to labour. We have yet to see the full cost of their error. Regulators are now bound to increase the capital banks are required to hold. It represents a second wave of dilution of shareholders’ permanent claim on banking profits, following emergency funding by governments.

The fund management agency problem

Shareholders are today predominantly represented by ‘professional’ or institutional money managers. Though their clients may wish they were fiduciaries, like trustees, the fact is they are commercial agents. As such, they respond to their own incentives. Unfortunately these too have become perverse.

Consider the particular effects of the banking practices that, with hindsight, caused the collapse of confidence and liquidity and turned booked profits into restated losses. We can see that stockmarkets had rewarded, with strong absolute and relative share price gains, both exceptionally high volume growth on banks’ balance sheets and capital-efficient ‘wholesaling’ activities that moved ‘structured’ forms of lending off the balance sheet, for an ‘origination’ fee. As you should expect, what was happening within banks was a microcosm of the increasing dependence of GDP growth on leverage, which stockmarkets also failed to see as increasing risk rather than value.

Professional or institutional shareholders, supported by competing research on banks by brokers, should have known better. Maybe they did, but it then required them to balance long-term risk (deteriorating quality means no value is being created) against short-term advantage (rising volumes support rising share prices). As many people have observed in recent years, professional investment managers have become increasingly reluctant to take the longer view or to back discernment of quality and sustainability rather than short-term momentum.

In doing so, however, they are acting rationally as the structure of the competition in professional fund management means that short-term performance is better rewarded than long-term performance. There are two sets of perverse incentives at work here.

As collective forms of retail investment have grown, the nature of firms’ competition for assets has been dominated by relatively recent achieved investment returns. Academic evidence demonstrates that strong short-term relative performance adds more assets and revenues than are subsequently lost when performance reverses. This ‘game’ effect is much more important for business management than the overwhelming evidence of the ubiquity of randomness in performance data. No surprise, then, if firms decide to use the public’s misconception rather than disabuse it.

The second set of perverse incentives is the link between achieved investment returns and the remuneration of the managers supposedly responsible for those returns, either through explicit linkages or through discretionary bonuses or pay awards. Performance awards now mirror the three to five year horizons that matter for asset gathering, which is perfectly rational. But that has nothing to do with skill. It might not even be long enough to capture more than a single decisive asset allocation move, such as a change in market trend.

What about the independent advisers?

Theoretically, the agency problem associated with short-term performance would be corrected by the involvement of smart and independent advisers, through their influence over investors’ asset allocation decisions, manager selection and fund trading.

Not a bit of it. They have made themselves complicit in the fund management agency problem by making their revenue model dependent on product providers, who then use them as distribution agents in the asset gathering game. The way that game works, even random shifts in relative return between competing funds provide scope for churning fund positions, to generate new commissions paid by the investment houses to advisers. It is totally irrational for their customers, except (of course) they have been led to believe it is a worthwhile endeavour.

If these agency incentives in investment markets are to change radically, the ultimate investors, as customers of the industry, need to want to know everything about its dirty little secrets.