A safe investment plan for retirement
Elisabeth is a 63-year-old woman from Zürich. Elisabeth lives alone, but has two children with their own families. Elisabeth has diligently saved money all her working career and now has CHF 2.5m in savings. Elisabeth is looking forward to her next phase in life, but she is anxious about making the right investment decisions for her retirement.
Elisabeth’s retirement goals
Elisabeth’s retirement goals can be summarised into three main components:
- Need-to-have: Elisabeth needs CHF 80.000 per year in retirement to cover her essential needs.
- Nice-to-have: Elisabeth would be pleased with an additional CHF 40.000 per year to do more of the things she likes, such as traveling.
- Aspiration: Elisabeth dreams she can pass on CHF 150.000 to each of her kids as inheritance
Making aspirations come true
In order to realise Elisabeth’s aspirations, we will create a portfolio for each goal. The first portfolio will cater to Elisabeth’s need-to-haves with close to zero risk attached to it. This portfolio will invest purely into the Safety Solution. In order to optimise the probability for reaching Elisabeth’s nice-to-haves, as well as her aspiration of passing on money to her kids, the two remaining portfolios will be invested into a Market Participation Solution and seek higher returns. The split is shown below.
Elisabeth can spend CHF 80.000 until she passes away. Her ability to spend more money every year will depend on how well the nice-to-have portfolio develops. If the portfolio generates decent returns, part of those proceedings will go to securing a higher annual spending. Given the simulations of the FINANCIAL LIFE GOALS API, Elisabeth’s guaranteed income is expected to increase towards her target of CHF 120.000 to cover both her need-to-haves and nice-to-haves by 2035 with a 50% probability. But most importantly, with the proposed investment plan, Elisabeth will never have less than CHF 80.000 per year to spend.
From a technical perspective, only investment gains from the nice-to-have portfolio used to purchase more of the Safety Solution that will fund a higher guaranteed income for Elisabeth. This means that capital will be available at the end of the 20-year period for Elisabeth’s aspirational goal of inheritance. With a 80% probability, Elisabeth will have between CHF 800.000 and 1.3m to pass on to her kids, well above Elisabeth’s target of CHF 300.000. Should Elisabeth live longer than expected, this is money that could be used for planning for her additional years also.
As Elisabeth spends money throughout the years, her total wealth will naturally decline. However, being invested in financial markets bolsters he overall wealth. Her total wealth is expected to evolve as shown in the following chart.
When looking at the combination of Elisabeth’s three portfolios, we see that it is dynamically adjusted over time. This is to ensure an optimal risk level for her various goals. Initially, Elisabeth’s total investment portfolio has a high allocation to “secured income” from the Safety Solution, which will be drawn upon as the years go by. The remaining two Market Participation Solutions will seek higher returns and will be tilted towards riskier assets. Over time, the Market Participation Solutions are gradually shifted towards less risky investments as shown below.
Clarity, certainty and convenience
The proposed solution gives Elisabeth the clarity and certainty on how much she can spend every year, as well the upside of being able to enjoy a more comfortable lifestyle during retirement. We believe that such a solution will meet the needs of many heading towards retirement, and help them alleviate the stress associated with it.
The proposed solution can also be the starting point for the conversation with a financial planner and various what-if-scenarios. For instance, Elisabeth might want to raise the need-to-have annual amount from CHF 80.000 to CHF 100.000 as she is very likely to have enough capital to enjoy a more comfortable life. Should Elisabeth have an emergency cash outflow or choose to make a large discretionary spending for a family holiday, car or similar, the scenario analysis of FINANCIAL LIFE GOALS API helps plan for it. We will cover more about scenario analysis and personal risks such as longevity in upcoming articles.
This article was written jointly by Mark Andersen, Bernhard Obenhuber and Nicolas Camenzind. We will be excited to hear your thoughts on our series of investment notes. Contact us anytime via contact@financial-life-goals.com or have a look at our website at www.financial-life-goals.com
ABOUT: The FINANCIAL LIFE GOALS investment API
The FINANCIAL LIFE GOALS API provides access to the investment functionality described in this note. Feel free to reach out on contact@financial-life-goals.com for a further discussion. The FINANCIAL LIFE GOALS API is a product of SWISS FIN LAB.
Appendix
Technical details
Elisabeth does not want to take any risks when it comes to her need-to-haves. Given her income need and preference for certainty, we can calculate the cost for an annuity that gives her CHF 80.000 per year on an inflation adjusted basis, or alternatively invest the amount in safe Swiss government bonds that match her expected cash needs. Given the currently low interest rate environment, such a bond is quite expensive and would cost for different durations:
Elisabeth is of good health and the average life expectancy is around 83 years for a woman. There is a chance that Elisabeth outlives the 20 year bond. There is an even a small risk that she outlives the 30 or 40 year bond. An annuity or life insurance would take care of such a longevity risk but it comes at the cost that the savings cannot be passed on to her kids in the case she dies earlier. An optimal solution seems to be to invest in the 20 year bond structure and into a deferred annuity that starts at the age of 83 years.
We call the bond investment the Safety Solution Portfolio. The remaining part can be invested into the financial market to reach her aspirational goals of higher annual spending and passing on money to her kids. This is the Market Participation Solution and has higher return potential but also carries financial market risks. Market Participation Solutions are invested in diversified portfolios.
Swiss government bonds: Unless the Swiss government defaults on its debt obligations, Elisabeth can count on receiving CHF 80k every year. The difference between a guaranteed income of CHF 80k and CHF 120k of CHF 0.81m is invested in the capital market and optimised based on the remaining time horizon of 20 years and implements a gradual de-risking of the portfolio towards the target date. Each year, if the financial market performed well, we take the gains and buy additional guaranteed income for Elisabeth. If markets perform poorly, Elisabeth remains invested in the markets until the initial amount is reached again (constant watermark). The remaining savings are earmarked for her kids and invested in the financial market; also with a gradually declining portfolio risk.
Further details
- The proposed investment solution is a combination of a liability driven investment that is common among institutional investors. By investing some capital for the essential goal into financial markets, we have a solution that is similar to a Constant Proportion Portfolio Insurance with a dynamic floor.
- The aspirational goal portfolio is optimised and de-risked based on the remaining time horizon, current wealth and target amount.
- Both market portfolios, the aspirational and essential, take the unique utility of Elisabeth into account. Moreover, by considering the actual time to maturity and depending on the wealth situation the solution allows for a more or less risky allocation in a fully dynamic way. The risk constraints of Elisabeth are never violated and stemming from a rich set of allowed constraints. The benefit of showing the interplay between essential and aspirational goal allows her to set specific risk targets and constraints on these different portfolios. This allows her to take risk in cases where she feels confident to do so.
- We applied capital market assumption (CMA) for a CHF investor based on estimates from JP Morgan for 2018. The FINANCIAL LIFE GOALS API is capable of incorporating any capital market assumptions and reference portfolios for all optimisations and forward-looking simulations.
- The reference term structure is taken from www.worldgovernmentbonds.comfor Switzerland as of 07.09.2018.
