Key Post "Should the elderly be less conservative investors?"

Brendan Burgess

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I think that this is a very important issue and needs to be discussed.

It is important to distinguish between the financially correct strategy and the emotionally correct strategy. For example, it may be correct for a retired person to invest in equities but their personal disposition may scare them off equities. However, the advisor should still give the financially correct advice and then offer alternatives which are less volatile.

A 70 year old will typically say "I don't want to take any risk at all". The problem is that there is no risk-free investment available. Cash is very risky as it is very likely to be significantly reduced in real value by inflation. The 70 year old probably has an investment horizon of 20 years, over which period, they are much more likely to get a real return on equities.

I have seen elderly people leaving €2m on deposit as they don't want to take any risk. Even if they have only 5 years left to live, their investment horizon should be based on the investment horizon of the beneficiaries in their will. Say they have two children, one of whom has no mortgage and has plenty of assets, while the other has a mortgage of €500k. It's likely that the richer child would want to invest in stockmarkets, while the one with the mortgage would want cash. (The correct strategy in this case may be to gift any excess to the children now and let them invest according to their own investment strategy)

The gradual switch of pensions funds to cash prior to retirement
It is often recommended that a pension fund should gradually switch to cash or bonds over the last ten years before retirement. I think that cases may have been brought to the Ombudsman where the pension company did not do this.

I don't agree with this strategy. It might be right if the pension fund has to use the entire proceeds to buy an annuity. But in most cases they will be getting around 25% tax-free in cash, and it's probably best to have this in the stockmarket. In many cases, the proceeds will simply move to an ARF and so there is no need to or benefit from a switch to cash.
 

Marc

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Brendan

This is an extremely important point.

We have run thousands of simulations on ARF investment strategies and conclude that any investment strategy that is more conservative than a 70% equity allocation will most likely erode the value of the ARF in real terms given the requirement to take imputed distributions of 5%.

This means that the financial security of the ARF investor is seriously at risk in those instances where the ARF is the main source of retirement income security and the investment strategy is too conservative. They have no protection against longevity or the risk of outliving their capital and they have no protection against inflation. These are two of the greatest risks facing an ARF investor who to some extent has to rely on their ARF capital. Under these conditions the financially prudent course of action for a conservative investor should be to consider the purchase of an annuity for at least part of their pension or risk seeing a protracted decline in their standard of living through their retirement.

For those investors fortunate not to have to rely on their ARF capital many use their ARF as a form of estate planning and this was the reason for the introduction of imputed distributions in the first place.

Under these specific conditions where the ARF is primarily being used for estate planning for heirs then again an investment strategy over multiple generations would seem to favour a long term perspective and logically therefore an equity bias makes sense.

Many ARF investors will therefore find out after the fact that they actually should have purchased an annuity because their investment strategy was too conservative and they ended up living much longer than they had imagined.

A conservative investment strategy might suit the emotional requirements of the ARF investor but from a financial perspective in many instances such a strategy is a poor financial decision leading the Sandler report in the UK in the early 1990s to call this "reckless conservatism"

A similar logic applies equally to pre-retirement investors as a recent article in the Wall Street Journal highlights

http://online.wsj.com/article/SB10001424052702304453304576391734231318102.html?mod=WSJ_newsreel_personalFinance
 

Setanta12

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I'm appalled !!!

Let people invest where they want. In an example posited below, the 'needs' of an inhertor are taken ahead of the need to create said inheritance etc., etc.

Let the creators of wealth decide how to preserve it (and pass it on).
 

Brendan Burgess

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A good article in today's Financial Times

Dumping equities in later life does "not suit everyone"



the idea that investors should migrate away from equities and buy bonds before they hit the final stretch leading up to their retirement party is bogus, claim David Blake and Douglas Wright in Optimal Funding and Investment Strategies in Defined Contribution Pension Plans . Such an approach – which is the blueprint for the creation of target date funds in the US and lifestyle default funds in Europe’s defined contribution schemes – fails to factor in the investment performance of people’s pension pots, their feelings about risk-taking, or any projected increase to salaries. “You can’t just use a specific age . . . as a mechanical trigger to determine when to shift out of pension assets into an annuity,” says Prof Blake.
 

Duke of Marmalade

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Interesting debate. I know that PRSA Actuaries are required to define the "default strategy" especially for Standard PRSAs. It would be a brave PRSA Actuary who did not use lifestyling in this definition.

My own view is that this is not rocket science. A financial advisor can lay before the client the "personalities" of the various asset choices and let the client make up their own mind. If I were a FA I would never advise on this asset strategy or that one.

I regard myself as having enough familiarity with the subject not to need the help of a financial advisor and I have to say that despite the undoubted truth of Brendan's and Marc's assertions about the long term potential for equities I am almost entirely in cash type instruments. It's a utility thing. I can handle the stealthy erosion of inflation but I can't handle a sudden 15% fall in my net worth and I certainly can't handle being wiped out - think of the poor sods who invested in bank shares.
 

Marc

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When you say handle do you mean emotionally or financially?

We have met several clients recently who had the capacity to take investment risk but lacked the willingness.

The FSA in the UK looked at this question earlier this year and concluded that clients should be advised on the basis of being willing and able to take risk.

This is the crux of the advisory question raised by Duke above.

As a client's Fiduciary I have to recommend the course of action most appropriate for a client. This can be a course of action that the client is unwilling to follow.

As for equity risk it is possible to diversify the risk of bank shares.

Even the most conservative investor should have some allocation to equities as part of an ARF strategy provided that they are well diversified otherwise they may find that an annuity was a better option.
 

Duke of Marmalade

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When you say handle do you mean emotionally or financially?
Wipe out - both financially and emotionally. 15% sudden loss - emotionally.

I sometimes lament the demise of With Profits, with its generation pooling and indeed with its opaqueness it was not so in your face whether you got the timing right or what its current market value is.

ARF versus Annuity raises a whole raft of utility style questions, like how do you rate a € when you're 90 versus a € when you're 60 versus a € to your kids. Of course, the fact that it is an ARF does not really set it apart from other investible assets that a retired person might have, except for taxation aspects which are somewhat peripheral to the investment decision.
 

Marc

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The late Paul Samuelson published a paper in 1969 showing that, under a specific set of assumptions, investors should keep a constant fraction of their wealth in risky assets. This contradicts the conventional wisdom, which says that investors should reduce the amount of risk in their portfolios as they approach retirement. This creates a dilemma for investors. Should they follow the conventional wisdom, which makes intuitive sense, or should they heed Samuelson's proof, which is mathematically indisputable? The answer lies in the assumptions. If Samuelson's assumptions are valid, then his conclusion is not subject to debate. Therefore, the remainder of this discussion will center on the assumptions Samuelson made in order to derive his now-famous result.

Assumption #1: CRRA Preferences

CRRA stands for constant relative risk aversion. Investors with this attitude toward risk say that a 20% loss of wealth hurts the same, whether their portfolio is worth $20,000 or $20 million. They also believe a 20% loss is just as painful at age 20 as at age 60.

Fortunately, there are some academic papers that can shed light on this issue. For example, the papers that study habit formation*recognize that people tend to become comfortable with a certain standard of living, and they are very averse to risks that might impair their ability to maintain that standard. Consequently, attitudes toward risk can change over time. Willingness to hold risky assets may change as standards of living change—a contradiction of the CRRA assumption. See Abel (1990) for an example of such a model.

I am very sympathetic to the notion that people become comfortable with a certain standard of living. I loved my years as a college student, but I have no interest in going back to that way of life. My portfolio choices are affected by a desire not to return to the good old days.

Assumption #2: IID Returns

IID stands for*independent, identically distributed. This means that past returns provide no new information about future returns. The fact that 2003 was a good year for equities tells us nothing about the outlook for 2004 if returns are IID. Since the distribution of returns remains constant under this assumption, investors have no reason to change their target portfolio weights in response to past market returns.

There is a lot of evidence that suggests returns are not IID. For example, there is strong evidence that the variance of returns changes over time. (See Bollerslev, Chou, and Kroner, 1992, for an in-depth discussion.) There is also some evidence that equity returns are subject to*mean reversion, a phenomenon whereby unusually low returns are followed by high returns. Based on the evidence of mean reversion, some authors have concluded that long-horizon returns are less risky than short-horizon returns. Others dispute this claim. To get a flavor for the two sides of this argument, see Siegel (1994), Bodie (1995), and Jorion (2003).

Tests of mean reversion require very long sample periods; and even with decades of data, the statistical tests can have low power. For this reason, I do not believe it is prudent to base one's asset allocation on an assumption of mean reversion. Nevertheless, for purposes of the present discussion, we can recognize that returns are probably not IID.

Assumption #3: One Source of Income

Samuelson assumed that the only source of income is investment income. This simplified his analysis—he could ignore the effect of wages on portfolio choices. As is the case with many simplifying assumptions, this one isn't very realistic for most investors. In addition to their existing assets, most investors have an expected stream of future wages. This uncertain income stream has a level of risk, just as an investment portfolio does. For example, the expected future wages of a tenured college professor are probably much less risky than the expected wages of a new hedge fund manager. Portfolio choices should reflect the riskiness of expected wages (i.e., human capital). If the professor and the hedge fund manager have the same tolerance for risk, the professor can take on more investment risk, since her human capital is less risky.1

Let's review:

Do investors have CRRA preferences? It's debatable.
Are returns IID? Probably not.
Are investments the only source of income? Not in my neighborhood.
Since Samuelson's assumptions are open to question, so is his conclusion.2*However, this does not mean that we can simply accept at face value the conventional wisdom of reducing equity exposure over time. A little more analysis is necessary. Note that each of Samuelson's assumptions rules out a reason for changing target portfolio weights. By considering some examples that relax these assumptions, we can see the possible resulting impact on asset allocation.

Consider the effect of wages on portfolio choice. A young professor who has just received tenure has two sources of wealth: assets-in-place and expected future wages. Since she hasn't been out of graduate school very long, her investment portfolio is small. Thus, expected future wages make up the bulk of her total wealth, since she expects to lecture and grade exams for many years to come. Most of her total wealth is represented by low-risk expected wages, so she can afford to take on a significant amount of investment risk. As the years go by, her investments become a larger share of her total wealth. Her investment portfolio grows, and her stream of expected future wages shrinks (since she is approaching retirement). To keep total risk constant, she will have to reduce portfolio risk, since the low-risk human capital component of wealth is getting smaller. So, even with CRRA preferences, the good professor will follow the conventional wisdom and reduce her portfolio risk over time.

What will the new hedge fund manager do as he ages? When he begins his career, he will have a small investment portfolio, since he just graduated from college. Since his expected wages are so risky, he can't afford to incur much investment risk. Therefore, he will invest his small portfolio in something safe (probably not his own hedge fund). As he grows older, his assets-in-place become a larger proportion of his total wealth. Since his human capital is so risky, he will actually have to increase his portfolio risk over time to keep total risk constant. If his hedge fund is successful, he will enjoy a much higher standard of living due to all the fees that he charges his clients. Habit formation may compel him to reduce portfolio risk in order to minimize the likelihood of returning to a lower standard of living. It's not clear which of these two offsetting effects would be stronger.

These examples show that the behavior of target asset allocations over time will probably depend on the investor's individual circumstances. This seems a more satisfying answer than simply saying that everyone should follow the same strategy. It also highlights the need for investors to obtain personalized professional advice when making these decisions. The asset allocation decision is too important to rely on a one-size-fits-all solution.

One final comment: Whenever the possibility of changing asset allocations is mentioned, some people immediately leap to the conclusion that short-term, tactical asset allocation is a viable strategy. Please note that the foregoing discussion deals with long-term shifts as the result of life changes, not short-term trades in response to perceived market conditions. I have yet to see any evidence that the latter strategy is consistently effective.

1. See Bodie, Merton and Samuelson (1992) for a discussion of the effect of wages on portfolio choice.

2. Samuelson anticipated the possible violation of some of his assumptions, when he discussed the example of a middle-aged physician who might want to take on a higher level of risk. See page 245 of Samuelson (1969).

Abel, Andrew B. 1990. Asset prices under habit formation and catching up with the Joneses.*American Economic Review Papers and Proceedings*80:38-42.

Bodie, Zvi. 1995. On the risk of stocks in the long run.*Financial Analysts Journal*51:18-22.

Bodie, Zvi, Robert C. Merton, and William F. Samuelson. 1992. Labor supply flexibility and portfolio choice in a life cycle model.*Journal of Economic Dynamics and Control*16:427-449.

Bollerslev, Tim, Ray-Yeutien Chou, and Kenneth F. Kroner. 1992. Arch modeling in finance: A review of the theory and empirical evidence.Journal of Econometrics*52:5-59.

Jorion, Philippe. 2003. The long-term risks of global stock markets.Financial Management*32:5-26.

Samuelson, Paul A. 1969. Lifetime portfolio selection by dynamic stochastic programming.*Review of Economics and Statistics*51:239-246.

Siegel, Jeremy J. 1994.*Stocks for the long run. New York
 

Duke of Marmalade

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Marc you left out one assumption viz. that investment risk delivers an expected superior reward in the long run, the so called Equity Risk Premium. If there is no ERP only a gambler would take on equities with their volatility.

After the last two weeks, after the last 10 years, I am losing my faith in ERP.

I think those utility theories may have some validity in analysing human investment behaviour at the macro level, I don't think they help in advising any particular individual.

An interesting side debate is that Tracker Bonds are hugely popular with older people these days. Yet most professional advisors (especially on this site) dismiss the product with a host of theoretical arguments, some valid some not. The fact is that security of capital with a share in any stockmarket bounce makes great appeal to many people. So it seems to me that the "emotional" side of an investment proposition is more important than its theoretical financial merit.
 

Marc

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Duke

You make two very important points.

Firstly on the equity risk premium. It can be difficult for investors to accept that they may have to wait 14 years for the risk premium to show up. But this is the nature of risk just because equities have a positive expected return doesnt mean that you will obtain a positive return over your investment timeframe. This is the nature of risk.

However I think many Irish investor's perspective of equity returns have been influenced by the returns of the Iseq or Irish banks shares and many have concluded that equities have gone nowhere for ten years.

This home bias has caused many investors in Ireland to miss out on the positive returns achieved around the world in the last 10 or 11 years. When I look at the evidence from the peak of the market in December 2000 to date, the equity risk premium looks alive and well.

Example index performance period December 2000 (peak) to end July 2011 (latest data)

ISEQ Overall -3.94%pa
MSCI World Index -1.55%pa
Global Core Equity 1.22%pa
Global Value Index 2.42%pa
Global Small Index 4.85%pa
Global Small and Value Index 7.56%pa
MSCI Emerging Markets Index 10.21%pa
Emerging Markets Value Index 16.85%pa

A balanced risk (50% cash and bonds and 50% real assets) multi asset class portfolio (stocks, bonds, real estate etc) would have averaged 5.52%pa net of fund management costs over this period.

Note annualised performance is calulated by mutiplying the monthly performance data by the square root of 12.
A number calculated from annual performance data may differ from this calculation.
Performance does not reflect expenses associated with management of an actual portfolio. Indexes not available for direct investment.
Source: MSCI, DFA


Secondly it's a difficult pill for many of us to swallow, but sooner or later we need to realise that the biggest obstacle to enjoying investment success often is not the market itself, but our own behaviour.

This tough lesson about investment is never more important than in the volatile markets like we saw in 2008 or last week. It is at these times, more than any other, that people tend to make bad investment decisions.

Those mistakes include neglecting to diversify, failing to track expenses and ducking in and out of the market in counter-productive attempts to miss the worst of the losses and capture the sweet spot in the rebound.

The fact is that as fallible human beings we tend to over-rate our own abilities and imagine that we can see things that others can't. In an extremely competitive arena such as the financial markets, this can be ruinous.

Just how ruinous poor individual judgement can be to your financial health is revealed in a annually updated annual quantitative analysis of investor behaviour by the US financial services research group Dalbar.1

Their surveys which cover a two-decade period illustrate that returns are far more dependent on investor behaviour than on fund performance and that most fund investors who buy and hold typically earn higher returns than those who try to time the market.

In the 20 years to December 31, 2007, the average US equity fund investor would have earned an annualized return of just 4.48 per cent, Dalbar found. This was more than seven percentage points below the return of the S&P 500 index (11.81 per cent) and less than 1.5 per cent over the inflation rate.

Fixed interest investors would have fared even worse. Their average annualized return over the same period was 1.55 per cent, below the index return of 7.56 per cent and not even keeping up with inflation. In other words, the average fixed interest investor went backwards over that time.

Dalbar concluded that investor returns are markedly different from the returns promoted by fund managers because most people try to time their entry and exit points—and often get it wrong. Secondly, the holding periods of individual investors tend to be shorter than those of fund managers.

Interestingly, the survey also found that investors are more likely to make 'correct' timing decisions when the market is going up. Correspondingly, they are more likely to mess things up when the market is down.

In other words, most people fail to exercise patience in tough markets. The consequence is they fail to secure the rewards available to them.

It seems that you are correct that investors emotions and not the markets per se really can be their own worst enemy.

It would seem the answer to this question is investors understanding their own emotional responses and Maintaining a long term perspective rather than paying others to bear risk for them in the form of a structured product.
1. Quantitative Analysis of Investor Behaviour, 2008, Dalbar
 
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Duke of Marmalade

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It seems that you are correct that investors emotions and not the markets per se really can be their own worst enemy.

It would seem the answer to this question is investors understanding their own emotional responses and Maintaining a long term perspective rather than paying others to bear risk for them in the form of a structured product.
I think there is genuine risk reduction in a structured product. The providers of this "risk" use delta hedging techniques which would be way beyond the capacity of a retail investor. Of course the charges may be too high on some versions but the proposition itself is totally valid.

BTW I have a 10 year old equity SSIA invested in a Global Fund. Breaking even, so the lack of ERP is not entirely an Irish domestic phenomenon.
 

Marc

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Duke

On your first point I completely understand the emotional attraction of Structured products. I think you also made a comment about with profits too recently. As someone who spent about 5 or 6 years of my career winding up missold With Profits bonds in the UK I can see why one might be attracted to these concepts as a cautious or nervous investor.

If the financial services industry had a track record or offering fair, transparent and value for money products I might even agree with you.

But we know that financial services companies in general cannot be trusted.

"The biggest disappointment of my time at the FSA has been the failure of firms, and particularly their senior management, to learn the lessons of past mis-selling. Sadly, the recent history of the British retail financial services industry is proof of the adage that those who fail to understand the mistakes of the past are condemned to repeat them. Though the pensions mis-selling debacle, which cost the industry over £11 billion in compensation, should have been a stark lesson of the dangers of uncontrolled and unsuitable selling, it is hard to see evidence that that lesson has been widely understood. Again and again we find examples of High Street firms disregarding the suitability requirements in our rulebook. Requirements which merely, in my view, describe what most service companies would regard as good customer service.

Unfortunately, much of the industry remains focused on short-term gain from shifting product. Indeed many firms are happy to see themselves described as "product providers", terminology which in itself distances them from their customers, many of whom assume that they are being given advice which takes their personal circumstances into account and who see their relationship with their bank or life insurance company as one for the long term and not solely transaction-based.
"


Sir Howard Davies former chairman of the Financial Services Authority in the UK.


So I repeat below a recent post on the subject of structured products.

In recent years, structured products have gained favour among retail investors in Europe and the US. Investment banks promote these securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.

Sales have grown briskly since 2006, and despite a decline after the 2008 market crisis, some industry sources expect a rebound in sales and a flurry of new products in the future.1 With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering one in your investment strategy.

Basic design
A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is typically linked to a preset formula. Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes.2 The notes offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it. Since the product typically is issued by an investment bank, the investor is exposed to the credit risk of that entity.

One common product, a principal-protected note, generally offers a minimum return equal to the original investment, plus a potential return tied to performance of an underlying asset, such as a stock market index. If the index drops during the term, the investor gets his money back, but if the index rises, he may receive the upside gain, but usually only a part of the underlying asset's gain. Structured products can be replicated by portfolios composed of an interest-bearing instrument, such as a certificate of deposit or zero-coupon bond, equity securities, and options or other derivative securities whose performance is linked to the underlying index.3

The following summarizes a few common characteristics of structured products:

Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.

Substantial cost: These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.

Replication: The payoff of virtually any structured product can be replicated in a portfolio by holding the underlying securities, then buying or selling derivatives written on those securities. In many cases, the costs associated with the replication portfolio are much lower than the structured product itself.

Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. When evaluating a structured payout, remember that there is no free lunch in the risk-return tradeoff. To pursue higher expected returns, you must accept more risk. If you do not want to bear the risk, you must transfer it to other investors and pay them for taking it.

Multiple Risks: First, there are the inherent risks of the underlying security (e.g., the stock or index). Investors also are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver. Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market. To avoid a potential liquidity problem, investors should consider the time horizon of the product and attempt to match its maturity to their anticipated financial need or objective.

Tax considerations: It is also important to check tax consequences. Some instruments may have certain appeal under the current tax rule. But, often, tax consequences differ according to the investment situation (e.g., whether one buys at the issuance or in the secondary market).

Who might benefit?
A structured product might help an investor who needs a specific payout at a designated point in the future and who is willing to pay another party to shoulder much of the uncertainty. But this benefit generally comes at the expense of lower yield or limited upside potential.

One example may be an individual who currently holds restricted company stock whose value may account for a significant portion of his total wealth. Although he might prefer to diversify this exposure, company rules may prohibit a sale until some future date. A structured product might provide protection against the downside risk of the company's stock (even though this might mean giving up the upside potential of the stock), and at the same time, provide better-diversified exposure to an equity index, such as the S&P 500.

Perhaps most important, investors who are considering a structured product should consider why they even need a highly structured payoff in the future—and if so, whether the payoff can be structured by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk. Many investors would prefer an alternative that is less complex and more transparent. And as the recent credit crisis taught many investors, it is wise to avoid investing in things you do not understand.

"Never invest in anything you can't illustrate with a crayon" Legendary Fidelity Fund Manager, Peter Lynch.

1. Larry Light, “Twice Shy on Structured Products?” Wall Street Journal, May 28, 2009.
2. A reverse convertible bond is one example of a yield enhancement tool. It pays investors a higher coupon rate than other comparable bonds due to its higher risk. This risk comes in the form of the issuer having the option to pay off the debt with either cash or a predetermined number of common stock shares. The method of payment at time of maturity will depend on the stock price, and the issuer will pay with common stock when it is advantageous to do so. The reverse convertible bond was popular until the last market crisis, when many investors experienced heavy losses when they were paid off with lower-value stock shares.
3. A call option provides the holder the right to buy the underlying security at a given price at a certain time in the future. A put option provides the holder with rights to sell the underlying security at a pre-specified price on maturity date. (American-style options can be exercised before the maturity date, whereas European-style options can be exercised only on the maturity date.) An option holder will exercise the put or call option only if the payoff is positive.
 

Marc

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Duke

On your second point about the Ssia you will note my post above includes data for the MSCI world index which over the period returned -1.55%pa.

Although this is not the only measure for global equities it is frequently referenced and consequently a relevant benchmark for many investors.

My guess would be a typical SSIA product would underperform this by 1%pa if passively invested and anything like 2 to 3%pa if actively invested.

A balanced portfolio should have earned around 4.42%pa net of ARF and adviser fees.

Clearly this makes more sense than cash deposits or structured products where there is a risk of a 0% return over the term?

Remember I am not suggesting an all equity strategy here.
 

Duke of Marmalade

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Marc a lot of material there much of which I would agree with. Where I have a fundamental disagreement is the statement that retail punters can DIY a structured product. I think for a reasonably modest sum a DIY conventional portfolio is realistic but to expect an ordinary investor to pursue a Black Scholes replicating portfolio strategy is like asking people to make their own cornflakes.

A vanilla Tracker Bond can be very transparent indeed. Punters can grasp "money back after 5 years plus 80% of the growth in the S&P index", much more transparent than "trust our investment managers". With the Consumer Protection Code we now have good transparency of the underlying costs as well, though it is not perfect.

I agree that the exotic versions which are based on contorted formulae which make the product look much better than it really is are very misleading. An example of these is where there is individual capping of a chosen portfolio of stocks. Brendan Burgess has been a sharp critic of these type of constructs.
 

Marc

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Duke,

To be clear I'm not suggesting that all retail investors literally DIY their own products, but rather that this is something that could be replicated where it is appropriate by a compentent adviser without all the costs associated with a packaged product.
 

Duke of Marmalade

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Duke,

To be clear I'm not suggesting that all retail investors literally DIY their own products, but rather that this is something that could be replicated where it is appropriate by a compentent adviser without all the costs associated with a packaged product.
Okay, by DIY you mean buy an Option and a Deposit separately. The real action is in the Option which involves the investment bank maintaining dynamic Black Scholes portfolios, you are not suggesting that retail investors or their advisors would actually get involved in this activity. The CPC shows overall margins in the range 4% to 8% for a typical 6 year product. No doubt an advisor with the right access to the OTC options market could compete with this. There are other aspects of the packaged product though, such as tax, which would make a DIY approach problematic.
 

Marc

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By way of an update to this thread I have recently completed some research into this subject and the results can be found here

http://wealth.goldcore.com/sites/default/files/blog_files/Reckless conservatism.pdf

I ran a series of "clients lives" all starting in Jan 1970 and plotted the real returns of an ARF adjusted for inflation from a range of investment strategies ranging from 100% in cash through 100% in equities.

The conclusion being that the all cash portfolio not only left the smallest inheritance for the family but also resulted in the smallest income for the retiree.

I aim to run 10,000 simulations based on these results to obtain some probability data.

The initial conclusion is that cash is recklessly conservative for an ARF with a statutory requirement to take a 5% withdrawal.
 

Monksfield

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Investing for the elderly & ARFs in particular

Some very interesting material posted above. However I would like to remove the discusion from the seemingly academic to the real world .

Those faced with converting lump sums into income will in very many cases not enjoy the luxury of selecting a portfolio at their preferred(typically low-risk) end of the spectrum - returns will simply not be sufficient to generate the required level of income.

It is time for a grown-up debate and probably regulatory change on this issue : advisers are terrified to suggest putting ARFs into higher-risk products/portfolios but that may in fact be dealing correctly with the client's over-riding financial priority.

Where the client needs an income from the ARF the adviser should be obliged to show that the recommended portfolio has a realistic probability of delivering the required returns(net of charges). I do not see why the regulator should not issue return assumptions which advisers should have to use - a similar regime exists for SORPS (though the assumptions here originated with the Society of Actuaries and are well out of date).

Except where the optimum course of action is very clear a good adviserr should present a range of likely risk/return/depletion scenarios from which the client would pick - he/she can still pick the 'low-risk' option but will have been shown the likely timeframe to depletion.
 

SPC100

Frequent Poster
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Marc, I have seen other people work out the scenarios based on historic prices (although I think it was US based) and come to the same conclusion. I think It might have been Richard Ferri, or William Bernstien.

If I remember correctly, the optimal results from the model, was relatively high in equities (maybe 80+%), but required you to take no more than a fixed percentage each year (i.e. if times are good you got more out of your pension that year)

Anyway, after reading about it 5 years ago, I decided that staying invested in equities after retirement seems to be the way to go.
 
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