Existing financial products marketed as “retirement investment solutions” do not meet the needs of future retirees, which involve securing their essential goals expressed in terms of minimum levels of replacement income (focus on safety), while generating a relatively high probability of achieving their aspirational goals expressed in terms of target levels of replacement income (focus on performance). Meaningful solutions should therefore combine safety and performance to meet this dual objective.

In a new publication entitled “Mass Customisation versus Mass Production in Retirement Investment Management: Addressing a “Tough Engineering Problem”, EDHEC-Risk Institute analyses how the retirement investing problem can be formally framed within the context of dynamic portfolio choice theory.

The main contribution of this paper is to show that financial engineering can be used to address the “tough engineering problems” posed by the scalability requirements. Indeed, it is hardly feasible to launch a customised dynamic allocation strategy for each investor, and the challenge is to address the needs of a large number of investors through a limited number of funds. To this end, the authors extend portfolio insurance and dynamic core-satellite techniques to the retirement investing context. The solutions make use of a goal-hedging portfolio, which is intended to replicate the value of a deferred annuity, and a performance-seeking portfolio, the objective of which is to efficiently harvest risk premia in order to deliver long-term performance. The allocation to these two building blocks is a function of the risk budget, defined as the difference between the current portfolio value and a suitably chosen floor.

In this study, the authors demonstrate that it is possible to construct strategies scalable with respect to entry point levels, contribution levels and aspirational goals, which vary greatly across investors.

The authors also show that mass-customised retirement solutions perform better than traditional balanced or target-date funds in reaching investor’s goals and have an acceptably low opportunity cost with respect to their fully customised counterparts.

Professor Lionel Martellini, Director of EDHEC-Risk Institute, said “dynamic goal-based investing principles can be used to design a parsimonious set of retirement investment strategies that meet the needs of individual investors preparing for retirement as they secure an essential level of replacement income and also have good probabilities of generating much more replacement income than what they would have obtained by investing in annuities, and this is possible in a cost-efficient and reversible format.”