Hedging the key A key to the new generation of retirement income products is a process called dynamic hedging which, while not a new concept to the institutional market, is a relatively new idea of the retail market. It’s being pitched to retail investors and their advisers as “insurance for your retirement income” – the fee charged for the guarantee is likened to an insurance premium. The issuer takes the guarantee fee and uses it to offset its liability, using futures contracts. But the products also rely on careful risk management. In the case of the ING product, for example, risk management has four dimensions: 1. Product design: Asset allocation restrictions & age specific payouts, biennial ratchet, fund switch restrictions 2. Capital market dynamic hedging: Sophisticated dynamic hedge program designed to optimise return over capital and ensure policyholder obligations are met with high probability 3. Reserves and capital: Regulatory reserves plus additional capital to meet rating agency requirements 4. Underlying fund selection:
Optimal fund selection together with targeted asset allocation designs aimed at minimising volatility risk and maximising “hedgeability”. The minimum income level is set relatively low – around 5 per cent of the fund value. So it’s not likely to be the sole source of income for a retiree; rather it is being promoted as a core, reliable income source, which can be supplemented with other, non-guaranteed (and hence potentially volatile) sources of income. In addition, there’s the issue of the cost of the guarantee. For the North product, for example, the cost can range from 90 basis points a year, to 295 basis points a year, depending on the investment option and term chosen. Generally speaking, the cost of the guarantee is higher for short terms and high growth asset exposures. The guarantee is cheapest when investors choose the longest term (20 years) and the lowest exposure to growth assets.
There’s also a question whether capital guaranteed products are a fad, or at least a creature of their times. Certainly appeal and demand is greatest when market conditions are or have been poor, like during the past two years. It remains to be seen whether demand will still be as high in , say, 10 years’ time if investors have had another decent run of investment returns. The “rising guarantee” feature of the new products is designed to combat the potential loss of appetite. Str ess testing The ultimate test of an income guarantee is to stress-test the product under extreme market conditions, using real market data. Figures provided by ING Australia show how the MoneyForLife product would have performed had it been available and had an investor used it in 1927, immediately before the market crash. If an individual put $200,000 into the fund, right before the market crashed, that initial figure would have been used as the “protected income base’ for the individual’s lifetime.