People have been known to hide under the table in Melrose Arch when these two scary-looking men walk past. There is a tall, pale fellow and his stocky and pugnacious-looking sidekick. Shaun Levitan and Costa Economou certainly stand out in a fund management industry in which so many are George Clooney wannabes. As actuaries they have also turned their business, Colourfield Liability Solutions, into a genuinely out-of-the-ordinary affair. It has a very clear philosophy and Economou sent me its sacred texts, the selected works of Prof Robert Merton, from the Massachusetts Institute of Technology.
The cornerstone belief is that there is a crisis arising from the shift from traditional final salary (or defined-benefit) pensions to defined-contribution, or money-purchase plans. Colourfield’s mission is to bring the focus back from return on investment to retirement income.
You might think that a bigger asset pool will buy a bigger income, but it is much more complex than that, or so it seems after a chat with Economou or Levitan. Investment value and asset volatility are the wrong measures if the goal is to get a particular future income. There is a misguided view of risk: T-bills, which are issued by the US treasury with a maximum term of one year, are very stable in terms of the principal value. But when it comes to converting T-bills into an income stream, the income it buys for retirement is highly volatile, almost as volatile as the stock market.
Merton wrote an example of the practical effect of this in the Harvard Business Review. If he converted US$1m of T-bills into an inflation-protected annuity when the yield was about 4%-5%, he would be getting a reasonable annual income of $50,000. More recently, in the age of quantitative easing, that $1m would have bought an income of just $5,000. Using a long-term maturity treasury bond of, say, 30 years, he would have locked in the yield for the life of the bond. The Colourfield approach still combines risky and risk-free assets, but it defines risk free not as cash but inflation-linked bonds. Colourfield is positively hooked on inflation-linked bonds. They are the main tools in ensuring that employees can purchase an annuity that supports a target standard of living whatever happens to interest rates and inflation.
Ideally, Merton would like to see a risk-free portfolio made up of a bond-like security that makes no coupon payments until the date of retirement, then makes level payments adjusted for inflation every month for life. Liability-driven asset managers such as Colourfield create a facsimile of this bond by dynamically trading inflation-linked bonds to meet the needs of the employee’s target retirement income.
When it improves the chance of achieving the desired income goal, Merton says, some investment in risky assets such as equity unit trusts is permissible — but he advises they are not held indefinitely.
There is a lot of complicated financial engineering behind the scenes, but the right choice of liability-driven portfolio can be worked out with help from the most rudimentary of robo advisers. The four questions are: what is your income target; what is the minimum income that would still be acceptable if you can’t meet your target; how much money are you prepared to contribute yourself, on top of employer contributions; and when do you plan to retire?
I am not a Colourfield true believer just yet. I think that real assets such as equities (public and private) and property should still consistently make up at least 60% of preretirement fund assets. But I am sure inflation-linked bonds can play a bigger role.