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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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  • T519.880.0888
  • 1.877.517.0888
  • F519.880.9997
  • The Marsland Centre
  • 20 Erb St. W,
    Suite 506
  • Waterloo, Ontario N2L 1T2

Making Income Out of Assets

July 30, 2013 - 0 comments

To measure the size of your future pension by the size of your accumulated wealth is potentially a costly mistake.

Mr. Darcy, as played by Colin Firth, in the BBC adaptation of Jane Austen’s Pride and Prejudice had a couple of things going for him. The first was his ability to induce mass swooning as he emerged from a lake in a wet shirt (recently commemorated by a 12 foot tall fibre glass statue in London’s Hyde Park1). The second way he captured attention was more conventional: he had an annual income of 10,000 British pounds ($16,000). 

At the risk of losing half of our audience our interest is in the money, rather than Mr. Firth’s physique, which in today’s terms equates to $300,000. Of course, Mr. Darcy’s income didn’t come from anything as mundane as a job, but was from investments, primarily property. The idea of measuring a person’s wealth and security not by their accumulated assets but by their annual income has a long pedigree. When thinking about retirement, most of us are inclined to think about our retirement income. For the dwindling band of Canadians who have defined benefits pension plans this is a known quantity and is usually a proportion of some average of their salary in their last few years of employment.

For the rest of us, life is more complicated, we save money in the expectation that the size of accumulated assets will be sufficient to generate an adequate retirement income, which is often several years away. However, “the size of the pot measured in wealth terms is not sufficient to tell one how much retirement income the pot produces”.  This quote is from Robert Merton, a Nobel Laureate and Professor of Finance at MIT, who has written extensively clarifying the difference between accumulating wealth and managing retirement payouts2. As he points out, the accumulated wealth is a means to an end (a pension), not the end itself.

To see the difference, let’s consider a simple example. If I have $10 and I have to pay $10 for taxi fare this afternoon then my liability (the taxi fare) matches my assets (cash in my pocket) and all is well. Suppose my liability of $10 is 10 years in the future, how much do I have to have set aside now? I can set aside rather less than $10 confident that I can invest in a high quality bond that matures in 10 years and the stream of interest payments along with return of my initial deposit will sum to $10. In other words, the present value of my future liability depends on the size of the liability and an interest rate. To fund my retirement I need to make sure that:

Current wealth minus present value of future retirement income = zero
 

But most investors only focus on growing their current wealth and ignore what might be going on with the present value of their retirement income. This is a cause of muddled thinking:

  • The variability of the liability term is ignored. While the future value of the retirement income is fixed, as we have seen, the present value of the future retirement income is sensitive to changes in interest rates. Because even small changes in interest rates are typically applied over many years the cumulative impact can be greater than changes in the portfolio value due to volatility of returns. In the past few years, for example, we have observed rising portfolio values due to rising equity prices while interest rates have fallen. Falling interest rates means that the present value of retirement liabilities increases and that the prospect for a retiree may be worse, rather than better.
     
  • Investment fund managers know nothing about the individual investor’s retirement plans and only see pooled money.  Thus responsibility for sound retirement planning for members of defined contribution plans is down to the members themselves. As Merton points out this is a task they are not well-equipped to deal with and he advocates for improved decision making tools that relates to four key questions:
  1. What is your desired lifetime income target?
  2. What is the minimum income that would still be acceptable to you if it turns out that your desired income cannot be realized?
  3. How much money are you willing to contribute yourself – on top of any contributions paid by your employer?
  4. When do you plan to retire?

For individual investors it is the role of investment advisors, if they have one, to take the answers to these questions and design a portfolio that is less about maximising capital and more about maximising the chance of achieving the desired level of retirement income.   

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Notes

  1. See http://www.dailymail.co.uk/femail/article-2358180/Colin-Firth-statue-Mr-Darcy-wet-shirt-emerges-Londons-Serpentine-lake.html

  2. For example, http://www.nestpensions.org.uk/schemeweb/NestWeb/includes/public/docs/Merton-Applying-life-cycle-economics,PDF.pdf

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