I have been involved in building and implementing investment strategies for various clients for over a decade now. Some of these clients are investors with a long-term focus like pension schemes and life insurers, while others are investors with a short-term focus like general insurers and trusts. All of them have investment goals they would like to achieve. For example, a pension scheme would like to see their members retire and able to afford the lifestyle they expected, while the insurer would like to be commercially viable  by putting shareholder capital to work. Therefore, when it comes to building investment strategies, these goals form the foundation on which the strategy is built and its success measured.

This brings me to goals-based investing. The phrase might be new, but the concept is not. It has been around for a number of years in the pension world in the form of liability-driven investment or LDI. I recall attending the first conference on LDI hosted in Amsterdam in 2004 where Dutch and Nordic pension funds spoke about how they apply LDI principles within the goals set by their regulatory framework which is essentially a solvency framework for pension funds. With LDI the investment goal is defined by the financial liability created by the fund rules of a DB pension scheme and the ability of the assets to cover that liability or member expectations through the funding level.

Unlike in South Africa, most pension schemes in the rest of the world are still DB schemes and LDI has remained the exclusive tool employed to set investment strategy, especially after the global financial crisis in 2007/2008 that sent funding levels tumbling. Many schemes in Europe are now attempting to achieve funded status over a set time horizon. These   trajectories are referred to as their “flight path” where the scheme for example aims to be 90% funded in 2 years’ time with 90% probability and/or 95% funded in 3 years’ time with 80% probability, etc.

Although LDI was originally developed around DB scheme liabilities, over the years, in South Africa, the concept of LDI has been generalised and applied to other types of clients like DC schemes, insurers and trusts, where investment strategies have been built around these varying client goals. For example, a DC scheme may not strictly have a liability determined by the fund rules, but there is an expectation by the member as to the type of retirement they want to buy. It means that every member in a DC scheme is in essence running their own DB scheme, as expressed in their targeted replacement ratio. Another example is where an insurance client wanted their return on capital to exceed the cost of capital by some margin, 75% of the time over a one-year period. These are all examples of generalised LDI or goals-based investment approaches. However, have these LDI and broader goal-based investment strategies worked for investors and what message is there for investors interested in goals-based investing? To answer these questions, we need to draw an analogy with another kind of strategy: corporate strategy setting.

The parallels between setting and evaluating corporate strategy and setting investment strategy are clearly  evident. Let me explain. You measure your success in achieving your company strategy at the hand of the goals that were set and met based on your vision statement over a period. For example, you are the CEO of a company that sells thingamajigs and your vision is to be the number one online retailer of these thingamajigs. Textbook company strategy would tell you to set goals in line with this vision. For example, one of your goals could be to double your online sales of thingamajigs by the end of the year. Year-end comes and your online sales have trebled. Were you successful in achieving your goal based on your vision? Yes, definitely. Were you successful in beating your competitor’s profit numbers? Perhaps not, but does it matter? No two companies are exactly alike and comparable on an apples-for-apples basis. What is more important is that as the CEO, you have set yourself a vision and you have put down tangible goals to measure your progress against as you move towards realising your vision. This is ultimately your guiding principle.

Now let’s apply the company strategy analogy to say a DC pension scheme. As the Board of Trustees, your vision is to keep pensioners from eating cold baked beans one day and therefore, one of your goals is to deliver at least a targeted replacement ratio of 75% for those members who have 40 years of membership in the fund. Your measure of success would be how many members retire with an actual replacement ratio of 75% or more. At year end, you pull the statistics and see that 90% of retiring members had a replacement ratio of 75% or more. Were you successful in achieving your goal based on your vision? Yes. Were you successful in beating your peers’ performance numbers? Perhaps not, but does it matter? No two pension schemes are exactly the same. What is more important is that as a Board, there is a vision and you have put down tangible goals to measure your progression against as you move towards realising your vision for the scheme. This same analogy could also be applied to any other type of investor, whether you are an insurer, a trust or even an individual.

Continuing on the corporate strategy analogy, I would summarise my message to investors who already implemented or thinking of implementing a goal-based investment approach in the following three points:

1. Think like a CEO about your investments. What is your vision for your investments? What do you want your investments to achieve? A DB scheme wants to pay liabilities as and when they fall due. A DC scheme wants to provide the retirement to members they expect. An insurer wants to the maximise return on shareholder capital to be commercially competitive. Once you have established what this vision for your investments is, make sure that your service providers also understand and buy into your vision. This will ensure all parties’ interests are aligned.

2. Make sure your investment goals are SMART, meaning Specific, Measurable, Attainable, Relevant and Time-bound. Too often an investor is fuzzy about their goals and this leads to confusion and expectation gaps are created when investment strategies get built, implemented and monitored. A client once defined their investment goals by saying that they want the return on their capital to exceed the cost of their capital by at least 2% with a 75% probability over a one-year period. That statement was so powerful, yet so clear, that it brought tears to my eyes.

3. You can’t manage what you can’t measure. To manage your progress in realising your vision you need to measure, on an on-going basis, whether you are achieving the goals you set. Think of it as keeping an eye on your satnav: you don’t want to find out too late that you should have turned left instead of right, it wastes valuable time and opportunity and you could quickly end up in a dodgy part of town. Measuring your investment performance is obviously important, but don’t forget to also check on how you are measuring up to the goals you set.

– Petri Greeff
Head of Research & Strategy, RisCura

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Published in Finweek