In this month's interview, John Mulvey, Professor of Operations Research and Financial Engineering (ORFE) Department at Princeton University, Anil Suri, Managing Director and Head of Portfolio Analytics & the Innovation Development Center at Merrill Lynch Wealth Management and Lionel Martellini, Professor of Finance at EDHEC Business School and Director of EDHEC-Risk Institute, discuss the newly-launched EDHEC-Princeton goal-based investing indices, based on academic research that was supported by Merrill Lynch Wealth Management. They reflect on their long-term relationship, explain how it led to this new joint initiative and discuss the goals and usefulness of the indices.
In 2012, EDHEC-Risk Institute and Princeton ORFE department formed a partnership to facilitate the development of joint research and conferences in the area of investment solutions for institutions and individuals. Can you remind us how this partnership project between EDHEC-Risk Institute and Princeton University emerged?
John Mulvey: Over the past decade, Lionel Martellini has spent a lot of time with us, including a visiting Professorship within the ORFE Department. During these visits, it became apparent that collaboration would be fruitful, leading to events such as jointly-sponsored one-day conferences in New York City and, more recently, the four-university rotating conference on FinTech and Robo-advising (next edition to be held in Paris during the 2019 spring). Both Lionel and I have had extensive experience assisting large institutional investors manage their asset allocation and ALM decisions. We believe that individuals are hard pressed to develop and implement systematic financial planning strategies. To help these individuals, we constructed the EDHEC-Princeton index based on fundamental research.
As part of this partnership, EDHEC-Risk and the ORFE Department at Princeton launched the EDHEC-Princeton Goal-Based Retirement Investing Indices at the beginning of May 2018. What are the goals and usefulness of these indices?
Lionel Martellini: With the need to supplement retirement savings via voluntary contributions, individuals are increasingly responsible for their own saving and investment decisions. This global trend poses substantial challenges as individual investors not only suffer from behavioural limitations but also typically lack the expertise needed to make educated investment decisions. There are reasons to believe, however, that currently available retirement products fall short of providing satisfactory solutions to the problems faced by individuals when they approach investment saving decisions; this is largely because of a critical lack of focus on replacement income needs in retirement.
Against this backdrop, EDHEC-Risk Institute and ORFE have teamed up to launch the EDHEC-Princeton Goal Based Investing Index Series based on joint academic research conducted with the support of Merrill Lynch Wealth Management on the application of goal-based investing (GBI) principles to the retirement problem. We regard this initiative as a strategic effort to help increase the awareness around the need for improved retirement solutions. This initiative should also provide incentives for asset managers to introduce flexible investment solutions that can be used by individuals to secure a minimum level of replacement income in retirement, while generating an attractive probability of achieving higher target levels of replacement income.
MLWM has been supporting EDHEC-Risk in its research for three years now, with a research chair that has a specific focus on goal-based investing, and then with a private research project on retirement solutions. To what extent is this new research important to Merrill Lynch Wealth Management's clients and advisors?
Anil Suri: This research is very useful and relevant to our clients and the advisors they rely upon. Across most of the wealth and income spectrum, Individual investors are deeply concerned about achieving investment and financial goals for their personal retirement. By developing a strong yet practical analytical foundation to better help achieve these goals with widely held and relatively liquid investments such as stocks and bonds, this research serves as an important step forward for all stakeholders involved.
Individuals are becoming increasingly responsible for their own retirement savings and investment decisions but most people do not have the tools nor the training to make such complex decisions. How will these joint research efforts help them in the decision process?
John Mulvey: The creation of an index will provide a sound benchmark for individuals and their advisors who have extended horizons and wish to ensure the availability of a minimum level of funds at their retirement date with an upside opportunity. Ideally, investment firms will set up tracking funds so that individuals who support the ideas can make contributions without having to implement their own rebalancing and adjustment decisions. The goal of the funds would be to match the index as closely as possible with relatively low fees and other transaction costs. These concepts will provide a much easier approach for individuals who do not have the time or the background to conduct a systematic decision framework.
The EDHEC-Princeton Goal-Based Retirement Investing Indices rely on a dedicated goal-hedging portfolio, also known as a retirement bond, with cash flows designed to match the needs of investors preparing for retirement. Can you tell us more about this retirement bond, the price of which is given by the corresponding EDHEC-Princeton Goal Price Index?
Lionel Martellini: As already stated, the most natural way to frame an investor’s or a household’s retirement goal is in terms of how much lifetime replacement income they will be able to afford at retirement. Lifetime annuities do allow individuals to secure a minimum level replacement income, but this comes at the cost of a severe lack of flexibility. These products should be used to hedge against late life longevity risk, that is against the risk of living longer than the population’s life expectancy. To finance the first phase of retirement, say the first 20 years after retirement, we argue that investors are better served to invest in a customised retirement goal-hedging bond portfolio that delivers a stable income stream, ideally indexed to inflation.
In a series of recent independent and joint articles, Lionel Martellini, Bob Merton and Arun Muralidhar have suggested that governments and central banks could start issuing such “retirement bonds” (also known by the acronym SeLFIES, which stands for Standard of Living indexed, Forward-starting, Income-only Securities), which would have two main characteristics: (1) payments would be deferred to the retirement date; and (2) interest payment and capital amortisation would be spread over time in such a way that the annual income paid by the bond is constant or preferably cost-of-living adjusted.
In parallel, asset managers can already use standard duration and/or cash-flow matching techniques routinely deployed in the context of LDI solutions to manufacture proxies for the retirement goal-hedging portfolio to be used as the safe building block in static or dynamic retirement solutions.
The investment strategies underlying EDHEC-Princeton Goal-Based Retirement Investing Indices do not fully incorporate longevity risk in their design mechanism. How would you suggest that individuals deal with the risk of outliving their assets?
Anil Suri: Longevity risk, or the risk of living far longer than actuarially expected, while personally a boon, can become an important financial tail risk for any individual. The EDHEC-Princeton Goal-Based Retirement Investing Indices have a pre-determined investment horizon of 20 years starting at the typical retirement age of 65. As such, they do not fully incorporate longevity risk. However, many specific facts and circumstances will influence the approach an individual can take towards managing this risk. For some, spending in retirement often declines at advanced ages, and these individuals may already have sufficient ongoing sources of income, such as Social Security in the U.S. or a pension from a previous job. If there are unmet spending needs beyond what these sources can provide, then evaluating the costs, benefits and risks of other financial solutions such as deferred income annuities becomes more important in addressing longevity risk. Finally, in the Ultra High Net Worth segment, self-insurance may also be viable.
About John M. Mulvey
John M. Mulvey is a Professor in the Operations Research and Financial Engineering Department and a founding member of the Bendheim Center for Finance at Princeton University. His specialty is financial optimization and advanced portfolio theory. For over thirty-five years, he has implemented asset-liability management systems for numerous organizations, including PIMCO, Towers Perrin/Tillinghast, AXA, Siemens, Munich Re-Insurance, and Renaissance Re-Insurance. His current research addresses regime identification and factor approaches for long-term investors, including family offices, and pension plans, with an emphasis on optimizing performance and protecting investor wealth (and surplus wealth). He has published over 150 articles and edited 5 books. He is current a senior consultant for Ant Financial (Alibaba) in Hangzhou China and for First Republic Bank in San Francisco.
About Lionel Martellini
Lionel Martellini is Professor of Finance at EDHEC Business School and Director of EDHEC-Risk Institute. He has graduate degrees in economics, statistics, and mathematics, as well as a PhD in finance from the University of California at Berkeley. Lionel is a member of the editorial board of the Journal of Portfolio Management and the Journal of Alternative Investments. An expert in quantitative asset management and derivatives valuation, his work has been widely published in academic and practitioner journals and he has co-authored textbooks on alternative investment strategies and fixed-income securities.
About Anil Suri
Anil Suri is Managing Director and Head of Portfolio Construction & Investment Analytics at Merrill Lynch Wealth Management. He has been with Merrill Lynch since 2004, where he previously led investment strategy development & analytics in the Alternative Investments area and worked as a Senior Investment Strategist on the Merrill Lynch Research Investment Committee (RIC). Anil earned an M.B.A. with honors from the Wharton School of the University of Pennsylvania, an M.S.E. from Princeton University and a B. Tech. from the Indian Institute of Technology at Delhi.