Managing an ARF has almost nothing to do with an ESMA risk score
If you are an Approved Retirement Fund (ARF) investor and your financial adviser asked you to complete a risk profile questionnaire and then said something like “you need an ESMA 4 portfolio” then you need to look for a second opinion immediately.
ESMA stands for European Securities & Markets Authority
The graph below shows maximum value drop in the first quarter of 2020 for a range of ESMA 4 multi-asset pension and ARF products here in Ireland. The decline ranges from -11% to almost double that at -21%.
Clearly the journey an investor will go on has nothing do with the ESMA labelling of a fund.
Source: FE Analytics
Another way of looking at the same data is to plot the risk (annualised volatility) vs the average annual return. Again, if these were all expected to deliver the same outcome for investors they should be very closely grouped on the “y” axis and if they are expected to be equivalent risk, then they should be closely grouped on the “x” axis, which, clearly, they are not.
Source FE 3 years ending April 2020
The interesting point to note is that over the last three years, not one of these multi-asset funds has achieved the target 4%pa return of many ARF accounts.
Even extending to five years, none have achieved the 4% target shown here by the red line
Looking back over 7 years we see the following results as at the end of July 2021
Not one of these portfolios has average a 4%pa return over this 7 year period. Yet we estimate that the amount of investors cash held across these strategies is almost €10 Billion.
From this we can conclude that “an ESMA 2 or 3 portfolio” is not the right answer for an ARF investor.
How should one approach investing an ARF?
As we set out in our guide for retirement planning in Ireland, an investor’s risk tolerance is only one of several factors that go into the decision to go into an ARF.
A far more appropriate way to approach this question is to ask; “what rate of return am I looking for?”
For most people this is the imputed distribution requirement of 4% or 5%pa of the fund required by the Government, but another very relevant comparison (as we set out in our guide) is the income forgone from the annuity that could have been purchased instead.
We can see that based on the current fund value of €150,436, our client could purchase an annuity today at a fixed rate of 3.625%pa so we might conclude that the ARF is more suitable than an annuity purchased today.
But the real test is can the ARF support that level of income that could have been provided originally when the ARF was established? Since it is that annuity that the client gave up when making the decision to take the ARF in the first place.
Annuity Rates in 2016 for this client were 3.23%pa so we can conclude that, for this client at least, the decision not to purchase an annuity has worked out very well. They have received more income that the initial annuity would have provided and can now purchase a guaranteed income greater than the original annuity would have provided.
Step 1 Find the portfolio with an expected forward-looking return of 4-5%pa after charges
We can see that the selected portfolio has a Net expected return of CPI +3.05%pa.
The ECB target for inflation is 2% and therefore this is the least risky portfolio any investor can hold and expect to meet an annual imputed distribution requirement of 5%pa. The bottom three cautious portfolios will result in a decline in account value in nominal terms and most portfolios can expect to decline in real, inflation-adjusted, terms.
We can see how the portfolio has performed compared to the expected return (highlighted in red) and shown by the dotted green line in the chart below. We can see that the portfolio is doing a fairly good job of keeping on track with the expected return.
How does this translate into a real client’s actual investment experience?
We can see in the chart above that the client originally invested €145,035 on the 4th April 2016 and an additional investment was made of €17,163 on the 4th January 2018.
As at Friday 1st May, the account was standing at €150,436 an annualised return (allowing for outflows) of 1.78%pa.
We can see from the time weighted performance analysis below, that aside from the first quarter of this year, the account has performed extremely closely to the expected return.
From time to time, the current asset allocation will drift away from the target asset allocation and this requires action to “rebalance” the portfolio back towards the correct overall mix of investments.
A good example of this was recently following the sharp drop in the market in the first quarter triggered a need to rebalance the portfolio.
We can see here for example that on the 16th March, low volatility equities which had performed relatively well were sold and rebalanced into more risky parts of the market that had declined further.
Putting that into context for the YTD through to the 19th March
We can see that there was an opportunity to buy low and we can see the wisdom of that decision when we compare with the subsequent period for the same funds
Why does all this matter?
We know that many ARFs in Ireland are invested in insurance company unit-linked funds.
Financial Advisers are in the main only using a risk questionnaire to select a portfolio for ARF clients and, as we have seen, there is little consistency between the various offerings in the market.
Another limitation is the lack of transparency around both charges and asset allocations so that it is virtually impossible for an adviser to estimate the expected return of the portfolio and therefore which one to select for an investor.
Finally, when a unit-linked fund generates an income distribution, they do so by selling units in the fund. The downside of this approach, which often is not fully appreciated by financial advisers, is that ALL asset classes are sold in the portfolio including those which have declined in value.
It is not possible for a life company to apply the more granular approach for each account as set out in this analysis.
It is another reason why Global Wealth ARF clients are managed by PortfolioMetrix rather than a life assurance company.
For information and educational purposes only
 Note that some funds do not have a 5-year track record and therefore the data set is smaller over 5 years.
 Current annuity rates source Irish Life