Finding the right inflation-plus products for your clients

What are the types of inflation-plus products that will resonate with a wide variety of different clients to help them achieve the financial outcomes they want? A Money Management roundtable investigates.

Mike Taylor, managing editor, Money Management: Welcome to the Money Management/NAB/MLC roundtable dealing with a particular type of inflation-plus product in the market.

I thought we’d try and set the scene of it all by talking about the underlying market conditions, and I guess the biggest impact on that was the recent decision in the US regarding quantitative easing and how we think that’s going to impact the underlying market sentiment.

So given what we know, given what was discussed last week, what do we think that impact is going to be? I’m going to start with you, Peeyush. What’s your view on that? 

Peeyush Gupta, chairman, State Super Financial Services: Well I guess we’ve seen markets react instantly, haven’t we, with a rally.

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It’s funny: at one level we think that the markets would know that at some stage the taper has got to end, but until it actually arrives I guess people are able to put it out of their minds. 

So we’re in unchartered territory with the extent of quantitative easing. Exactly what the consequences are when it does unwind you can only speculate.

But I think we do need to think about how portfolios can be put together which might minimise volatility when that time comes.  

Jonathan Armitage, CIO, MLC: Following on from something that Peeyush raised, the initial reaction has been a little bit of confusion.

You see markets react instantaneously, but I think as people digested the news what you’ve seen is some question marks around how the Fed communicates going forward.   

That has added a level of doubt into the way that the Fed will communicate, whether or not it’s about tapering or another part of policy.  

I think you’re going to see great volatility come back into these markets, whether or not it’s around Fed announcements – or whether it’s as markets continue to digest the unchartered territory that we’re operating in, with ultra-low interest rates not just in the US but across most of the developed world – and the impact that has more over the medium term rather than just in the short term. 

Tim Farrelly, principal, Farrelly’s Investment Services: I’ll just pick up that one. I think the really critical piece is the medium-term impact rather than the short-term outlook. 

Short-term we’re going to get all kinds of volatility around this one. I think in the medium-term actually it’s a non-event.  

With the original comments that the tapering will take place, bond rates went up a per cent: I think that’s about the extent of it. I don’t think we’ll see very much more from here on in. 

The really critical question from here on in is when they start fiddling with the short-term cash rates; they’ve been at 0.2 for a long time. I think when that happens – I think that’s two or three years away – that’s when the real excitement starts. 

So for the time being I think we just see volatility, but we always see volatility so it’s nothing unusual in that it’s just a label we put on the cause. I think from here on in the whole QE is a bit of a non-event. 

Lukasz Du Pourbaix, head of investment consulting, Lonsec: I think it’s had a very clear effect on asset prices. If you look obviously at equity markets and other assets, a lot of their appreciation has been fuelled by QE, so it’s certainly had an impact on that. 

I think the challenge is the Fed is in a difficult position because in the last announcement when they announced tapering, it was counter-intuitive how the market reacted because it should have actually been a positive signal. But that’s not how the market reacted.   

Then subsequently when they said they’re going to continue with QE, the markets reacted positively. So I’d agree with everyone there’s just going to be ongoing volatility.

But I think the medium-term consideration is what are the asset prices, because you have had asset prices being fuelled to pretty high levels and not necessarily all driven by fundamentals.   

Graham Rich, principal, PortfolioConstruction Forum: The issues that have been touched on haven’t pushed into the fact that tapering is only one piece of a set of contributors to this ongoing volatility.

Tim and Jonathan have talked about short-term interest rates and to me that’s a far more significant issue than tapering, but you need to also take into account I think that there’s a Fed chairman change: we don’t have a clear picture on that. 

There’s the Japanese experiment: we don’t have a clear picture on how that will play out. There’s the European issues which I think have still got a long way to run.

And so all of those things are going to continue to contribute to volatility, not just this prospect of tapering.

In fact the prospect of tapering or the reality of tapering as and when it comes is far less of an issue to me than the global increase in interest rates that is also inevitable, but when.  

Mike Taylor, Money Management: There’s been a lot of talk here about volatility and volatility has been with us now for a considerable period of time.

How long are we going to see this? I know a lot of financial planners have a lot of trouble reading how long it’s going to be a factor, and how they position themselves with their clients.

Tim, how long do you see volatility being the factor it is at the moment? 

Tim Farrelly, Farrelly’s Investment Services: I’m not sure how long the elevated degree of very short-term volatility is going to be with us for.

But the medium-term volatility, how much prices move over months and years, I think it’s just a permanent feature of the market.

It’s been with us a hundred years and it will be with us another hundred years – it’s just kind of ‘get used to it’. 

We’re going to see bear markets of 20 percent every three or four years or five years. We’ll see bigger bear markets every 10 years, it’s just the way it is.

And most of the time it’s pretty hard to predict when they’re going to come about. So I think it’s just a matter of getting used to it. 

Lukasz Du Pourbaix, Lonsec: Yeah, I agree volatility has always been part of the market but I think we are in a period where the market reacts more pronouncedly to some of these things, whether it’s QE or go back a couple of years ago, everything that came out of Europe and you suddenly saw markets shocked. 

These are things which are being driven by fundamentals.

So that type of environment is likely to continue because we are in unchartered waters and there is no blueprint for this.

But then I think it’s more about, from a practical perspective, how do you potentially manage for that volatility? 

I think that’s something that everyone constructing portfolios has to think about, and there’s different ways to do that. 

Graham Rich, PortfolioConstruction Forum: The volatility we’ve been experiencing is externally-induced, distorted volatility from the normal market cycle, in the sense that it’s government intervention that has been materially different from how things have been perhaps prior to five or so years ago. 

My suspicion is that government intervention is addictive to those in power and they’re going to keep wanting to fiddle the levers and sometimes those levers will have artificially induced lack of volatility.

We saw that maybe a year ago when there was a lot of comment about ‘all these low-volume funds are a waste of time because you’re paying for stuff and there’s no volatility’. 

So it’s the artificially induced circumstance of the smashing together of geopolitics and politics into economics that is the unpredictable thing.

My suspicion is that unpredictably will carry on for a long time out into the future. And underpinned with that are general market changes that are going to occur anyway as the markets try and find ways to act normally. 

Jonathan Armitage, MLC: You raise a very good point in terms of policy volatility.

I think one of the things that we’ve seen over the last three or four years is that governments have played a much more important role in markets and market volatility than we’ve seen for some time. 

If you look at both the United Kingdom and also the United States, the top banks there have market shares that were illegal in 2007, certainly in the United States; there was no barrier in the UK.  

But government policy in the face of the financial crisis has created situations where markets have been distorted. It’s not just financial markets, it affects consumers on a day-to-day basis. 

There are already three or four banks you can go to in the United Kingdom; in 2007 there were about nine. And that has an impact across not just personal consumers but one also that goes into the functioning of the economy as a whole. 

I think that we’re probably seeing the after-shocks of some of those policy decisions rippling through.

Volatility is always something that you will see in financial markets and I don’t think that’s going to change, but I think that the nature and perhaps the shifts in that volatility have become greater in the last four or five years. 

The important thing for investors is to look at constructing portfolios that try and minimise the volatility to your clients, manage the risk as well as the return.

And where at all possible provide your clients with a slightly smoother ride than they might necessarily have if they were just investing in the market as a whole. That is a significant challenge. 

Peeyush Gupta, State Super Financial Services: Yes, I’d agree with everyone’s comments that volatility is likely to continue and for the reasons mentioned.  

I think Mike Smith, the boss of ANZ, had a pithy term post-GFC. He said we’re in a workout situation and financial workouts typically take a decade, we’re five years into it. 

Households by and large try to work down the dips; unfortunately most OECD governments haven’t.

There’s also a tidal wave of unfunded liabilities coming, be it medical costs and pensions and what have you. So for that reason I think policy volatility as Jonathan said will remain elevated. 

But I think again to Jonathan’s point: pre-GFC we were taught that retirees and older people generally had a two-to-one risk aversion, so they hated the loss twice as much as an equivalent gain. But in reality post-GFC we all learnt that it’s more like 10 to one. 

Given that many people think that we’ll continue to have volatility, the question is how do you construct portfolios that have some hope of keeping up or beating inflation, but also acknowledge the fact that particularly older people are very, very risk adverse.  

Now that’s I think the advice conundrum at the moment. 

Mike Taylor, Money Management: One of the things that has become very evident is that we have a sizable proportion of the Australian workforce now who are probably delaying their retirement and who will probably work through for as long as their employers will choose to have them.

So it becomes a question then of how you position them. 

I think there are a number of products out there, I think there are a number of funds designed to try and sort of give you growth – but it doesn’t give you quite the risk profile there.

One of the reasons we’re having this roundtable is to discuss those sort of products.

So Jonathan, what do you see as being the fundamentals of meeting the needs of people like that? 

Jonathan Armitage, MLC: There are different ways that you can approach this and I think one of them is looking at maintaining the real purchasing power that investors have in their savings, and that’s particularly important in that pre- and post-retirement area. 

I think one of the drivers to that is that I think a number of us have talked about unprecedented times – certainly in terms of very loose monetary policy.

I don’t think there have been any periods where you’ve seen very loose monetary policy without inflation picking up further down the track. 

The headline numbers that we see with inflation, whether it’s in Australia or other developed economies, continue to look pretty benign, but those of us who get energy bills or car insurance or household insurance bills – those prices are moving up ahead much faster than the headline numbers are.  

As people move into retirement those impacts become more and more important.

I think that looking at the medium term, that is really what we should be focusing on rather than the shorter term.

It is the requirement of the products that help maintain that real purchasing power of other investments – and that’s absolutely crucial as people move into the retirement phase.   

Lukasz Du Pourbaix, Lonsec: I think in terms of the retirement piece, there’s one step even before then and this is where I guess a lot of advisers focus on: how do you have the discussion with your clients about what is a reasonable expectation of what your needs are in retirement?

I think that’s fundamental even before you start talking about product. And then what’s your strategy to best address those needs?

And where is the biggest mismatch is to meet those needs, in that conversation? What are your expectations, are they realistic and how do you prioritise those expectations? 

I think you’ve got to have that conversation first. Because in Australia the reality is we’ve got a very aggressive DC model where the liability has been outsourced to the individual, and whether it’s product or strategy or what have you, it has been very much geared to accumulators.  

We know that once you hit retirement there’s inflation, there’s income, there’s protecting your downside, there’s longevity, there’s all these other risk factors that come into play – and I don’t think there’s one product that’s going to hit up all those things. 

But then it’s about how do you have that conversation with the client, and then how do you best manage those different risks and outcomes you want to achieve. 

Mike Taylor, Money Management: Peeyush, I know at IPAC you guys have actually looked fairly hard at this sort of scenario, what’s your take? 

Peeyush Gupta, State Super Financial Services: I’m not associated with IPAC any more, having left there about four years ago, but I think as Lukasz says it is about having those sorts of conversations with clients which articulate their objectives, and then have a look at their household balance sheet both in terms of income, assets and liabilities and try to have a conversation around the portfolio construction as well as the other options. 

We’re looking at clients working longer, spending less and so on. In Australia on a post-tax basis our age pension is not too bad.

I know it’s not great, but I mean comparatively speaking, around the world.  

So I think that’s perhaps a mental mindset that many Australian consumers have – but I think advisers can help their clients to really understand where that age pension sits. 

It is not that great, frankly, relative to people’s expectations.

Perhaps (it involves) showing them pictures of the house they might be able to live in or the holidays they might be able to go on – if they’re only spending on the age pension – it might be a visceral way to communicate to them the need to be able to endure some volatility in their portfolio if they’re going to have inflation-beating returns.

Otherwise the retreat to cash income, term deposits will really put people into penury 20 years out. 

Tim Farrelly, Farrelly’s Investment Services: Very similar point. It’s having the discussion with the clients. It’s basically an asset liability model, ‘This is the money you’re going to need, when you’re going to need it, what kind of asset mixes may put that together’.

And when you’re having those discussions it can take you down some very different paths than the ones the industry has traditionally been down. 

So there are concepts which we haven’t mentioned today – which we’ll mention hopefully once, then throw it away – is this whole idea of tracking error, which is just an awful concept.

It means nothing to clients, and yet to so many people, particularly on the money management side of industry, trending is uppermost in mind.

It means ‘I’m going to manage my risks, not you, the client’s risk’. And the extent we seem to be putting that behind us is, I think, fantastic. 

The next question is going to be well how can I put portfolios together that give me the best chance of meeting my goals.

Now that may be by reducing volatility, it may be by taking on a whole lot of volatility – but it’s working out what is the right portfolio for an individual given what their liabilities are.

And I think the industry has got a long way to go there but the industry is starting down that path. 

Graham Rich, PortfolioConstruction Forum: To me volatility is a side issue. In effect inflation is a side issue.

This stuff about what the short-term interest rates are going to be and tapering is a side issue. The single biggest focus that we collectively need to be thinking about is outcomes and long-term income outcomes. 

In other words the undeniable reality is that the population is on average getting older in Australia, the population is living longer and the expectations of this older and longer-living population are higher than they’ve ever been and arguably unrealistically high. 

So if you add that set of things to the mindset around ‘I just need to get the biggest sum of money I can for retirement and I’m set’, which is an accumulation mindset – if you take that lot together it’s an explosive and dangerous cocktail. 

In fact, it should be around ‘what is the long-term income that I can reasonably expect from what it is I’ve been doing with my investment portfolio?’.

It’s actually nothing about what the current account balance is, it’s nothing about what the volatility may or may not be, and inflation may or may not be.  

They’re just all pieces in the jigsaw puzzle that should be going into a planning mindset of ‘how can I help you meet your goals’.

But your goals aren’t lump sum goals, your goals are long-term income goals. And how can I (as a planner) maximise the likelihood of you achieving those goals? That’s to me the focus of stuff that we should be thinking about. 

Mike Taylor, Money Management: I think Graham probably draws us to the age-old criticism of both our industry and probably the media covering the industry – that would include Money Management as much as anyone else – which is short-termism. 

Everything we talk about in terms of returns – whether it’s superannuation, which is supposed to be a long-term investment, whether it’s just how a fund is performing, which is to bring it back to what Lonsec is doing - everything is about year-on-year results rather than long-term results.

How can you persuade a retiree not to worry about the short-term when all we ever talk about is the short-term? 

Lukasz Du Pourbaix, Lonsec: I think it’s a more fundamental issue. It’s about looking at the way the industry is structured – and it is big on the product side.   

The reality is a lot of it’s still based on either how you’re tracking a benchmark or how you’re tracking against the peer group. And that’s fundamental, that’s how variable remuneration is calculated, the whole rest of it.  

So if the remuneration structure and the way the industry measures success is based around that – well, that’s quite different to individual objectives which are not measured by that. 

That’s something I think everyone acknowledges, and you are seeing some parts of the industry trying to move away from that.  

But it’s a challenge because with all the processes, even if you look at the advice processes, there’s certain embedded structures – whether it’s compliance structures, whatever it may be - that are not really geared towards an objective outcomes-based approach.  

But having said that, I think the industry is certainly now moving quicker towards that, particularly with FOFA [Future of Financial Advice] where everyone is looking to articulate the value of the advice, much more so.

In years gone by everyone would talk about this and you had good markets, but now I think there’s other structural things in place that will mean that this is the way things are going to go. 

Peeyush Gupta, State Super Financial Services: I think this is actually a very important point that’s come up. History shows us that our industry has been preaching logic to the media, to clients and so on. But logic alone is not enough - it’s why the climate change thing hasn’t got up.  

The overwhelming scientific evidence is that it’s real, but policy-makers and politicians and the rest of it, we haven’t taken people’s psychology, emotions and behaviour into account.

So the solution needs to be a combination of logic – because at the end of the day you have to do things which are sensible – but you have to acknowledge that people’s decision-making patterns aren’t only purely logical. 

I think the way the whole community constructs advice at the moment – the paradigm – needs to move on.

We’re all based around compliance, risk profiles. The client comes in and you try and assess their so-called risk profiling, and fit them into some sort of strategy. 

There are better ways of doing it. We now know that behavioural psychology matters. We know that people, when it comes to money, think in terms of compartments.

So you use a bucket-based approach where you’re responding to people’s short-term income certainty in the next few years; another bucket which is about core family wealth, and if there’s enough money left over, one for aspirational wealth.

That’s the way the logic our industry preaches can be married to the way consumers think. 

So my plea would be really for all the dealer groups and research houses and advisers together to evolve the paradigm of how we give advice to clients to take account of how clients actually approach money, which is both logical and emotional. 

Jonathan Armitage, MLC: I was going back to something that was raised a bit earlier about tracking errors. It’s industry language that we use and I think it serves to confuse, it doesn’t add anything to our own clients. 

So, you look at something which is outcomes-focused, even if it’s shorter term, whether or not it’s over three or five years.  

But you set a very specific set of outcomes, and keep to those and demonstrate how you’re going to do that. 

Those are products that will resonate with a wide variety of different clients – particularly if you can help demonstrate how that might help people achieve the financial outcomes that they want. It is our role in terms of producing products to fit into that mindset and appeal to not just the logic but also the emotion that comes behind it. 

A reasonable amount of that emotion is probably driven as much by fear as it is by aspiration. I’d have to say I don’t think the industry has done a particularly good job of taking that on.

We bamboozle people with technical language – and actually if we remove some of that and seek to address some of those basic needs, then we would probably be moving several steps closer to doing a better job of helping our clients achieve their financial goals and aspirations. 

Tim Farrelly, Farrelly’s Investment Services: I think one of the really big areas where the industry needs to get better is actually the behavioural aspects of the advisers themselves, much more so than the clients. Because from what I can tell, most of the clients do most of what they’re told. 

The people who are getting most excited and most scared seem to be the financial planners, certainly in my experience.  

And getting the financial planners to start focusing on the longer term rather than the shorter term, I think, is the biggest single step we could make. 

As an example, it has been very difficult for fund managers to pursue strategies that would require them to take big positions which would be like a tracking error, because advisers aren’t very loyal.

You get three years of rotten performance, you’re out of business. Clients are far more loyal to their planners than planners are to their product providers. 

I can’t imagine there’s many clients who are really very happy with the returns they got over the last six or seven years. 

Typically, you talk to planners and say how many of your clients have you lost – two or three. It’s hardly any clients that fire their advisers through this process – and yet they’ve had lousy returns. If fund managers were producing those returns to advisers, they’d all be gone. 

And so there’s this funny piece where the planners show far less loyalty to their suppliers than their clients show to them. I think that’s some of the behaviours that need to start coming around. 

If we can get to the stage where the planning community is taking longer term-views – which they always say they’re doing but they don’t behave that way – then I think we may really make some steps all the way down the line. But there’s a lot to be done there. 

Mike Taylor, Money Management: Thank you, and with that we’ll wind it up there. Thank you very much.