I just got back from a long vacation in Italy, and while I intended to work on the blog while I was there, Brooks and Madeleine were taking care of things so well I hardly had to look up from my Chianti. About the closest I got to working was spending some time in Modena at the Enzo Ferrari Museum, photographing cars to use in future blogposts.
The GT pictured above is a very special Ferrari, the 500 Superfast. It was a limited edition car in 1964 that Ferrari based on a “standard” 330 GT – to which Ferrari then added some Pininfarina bodywork and a larger displacement twelve cylinder motor. A few were made with a five speed manual transmission – a rarity then. A Superfast boasted a top speed of nearly 170 miles per hour. They also cost twice as much as a Rolls Royce (there’s been more than a little multiple expansion since then). Ferrari sold three dozen of them. If you’re interested, I noticed one up for auction in Monterey later this month.
Some people can rationalize a car like the Superfast as an alternative asset, but really it’s a 20-standard deviation discretionary expenditure. As in no one needs a collector car. Car collectors don’t need a 50 year old Ferrari. Ferrari collectors don’t need a Superfast. I don’t know how many asset managers will be at Monterey this year, but probably fewer than in the past few years, as it seems like there is a dark cloud hanging over the industry. While conventional wisdom always has value, I’d like to suggest that pessimism is not entirely warranted.
Yyuuggeee Walls of Worry
We have written at length about bearish signs in the RIA space, and valuation metrics seem to generally reflect a reduced growth outlook. We wonder, though, if things are really that bad. Market prophets forecasting tough sledding ahead for asset management usually point to three things:
- Fee schedules are compressing because fees are more visible and clients are more interested in passive products.
- Demographics suggest the populations of developed countries are moving from the asset accumulation stage of their lives to the asset de-accumulation stage (retirement).
- The lower outlook for investment returns means RIAs won’t just be able to ride the market to grow revenues.
For this post, I’ll set aside the first of these. We suspect there is, over all, some phantom fee compression in the industry as assets are allocated to passive instruments and active managers who charge more don’t get the RFP they once would have. This has been written about extensively here and elsewhere. At present it is a trend, and all trends eventually break.
The other two common themes focus on demographics and market outlook which are not, necessarily, bearish for the investment management space.
De-Accumulation is Overrated
Broadly, there is a public policy assumption that people consume more than they produce, save, or invest in retirement and deplete their assets. This is true of the population as a whole, but the investment management community does not serve the population as a whole.
In fact, most wealthy retirees actually accumulate investible assets in retirement, according to a recent article in the Journal of Financial Planning by Chris Browning, Ph.D., Tao Guo, Ph.D., Yuanshan Cheng, and Michael Finke, Ph.D., called “Spending in Retirement: Determining the Consumption Gap”. The paper studies the investment and spending habits of retired Americans in various wealth categories in an attempt to measure the typical “consumption gap” – or the amount that retirees under-consume relative to their potential consumption given certain levels of accumulated assets and investment performance.
I won’t recite all of the detail in this study, but the gist of it is this: while most retirees do experience de-accumulation (spending down their investible assets in retirement), those in the top quintile (rank based on financial assets) do not. These relatively more wealthy retirees consume much less than they could in retirement, and in fact the average financial assets of this cohort increases during retirement. This top quintile is the only quintile served by the investment management community, and this habit of elderly clients actually growing investment assets during retirement is more reflective of what RIAs should experience.
Even though the baby boomer generation is reaching retirement age and a majority are leaving the workforce, this isn’t likely to drain AUM balances in the investment management community as much as some might anticipate.
Low Investment Returns Increase AUM Balances
In theory, lower interest rates and lower expected investment returns should encourage consumption and discourage investment. This basic supply/demand concept is the theory by which the Federal Reserve attempts to manage growth, inflation, and unemployment. Based on this, lower expected investment returns should be negative for investment managers for at least two reasons: 1) clients have a lower opportunity cost of consumption, so they save less, and, 2) investment managers don’t get the benefit of increased revenue from market appreciation. All else equal, the latter is absolutely the case, but all else is not equal.
By definition, saving and investing is deferred consumption. Funding that deferred consumption requires saving enough, with “enough” being a function of expected investment returns. Retirement saving is the biggest category of investment in the United States. If the cost of retiring is held constant – which it pretty much is – and the expected rate of return in a retirement account is reduced, the only way to make up the deficiency is to save more.
You know the math: to produce $100 in consumption in twenty years requires an investment of about $21 if the expected investment return is 8%. Reduce that expected return to 5%, and the investment required to produce $100 in twenty years almost doubles to $38. For defined benefit plans and insurance companies, this equation is very real. Even for individuals with 401Ks or 529 plans or other designated savings accounts, lower expected returns implies higher levels of required investment for a given desired level of future consumption.
We seem to be living in a time where common laws of economics don’t always hold. Low investment returns may spur more savings, as has been the case in Japan for decades.
People are Living Longer, Which Should Delight Pension Fund Managers
Two years ago, the Society of Actuaries officially recognized that Americans are living longer. The revisions to the life expectancy tables added 2.0 years to the life expectancy of an average 65 year old male and 2.4 years to the life expectancy of an average 65 year old female. The study has not been without controversy, but the likely impact on the asset management industry is very positive:
- Defined benefit plan contributions will have to increase, by law.
- Defined contribution plan investments will, similarly, have to increase.
- Many people will use some of their added life expectancy to work later into life, adding to their years of investment asset accumulation
- Retirees will be more cautious about spending retirement assets, which could exacerbate the phenomenon that Browning et al. wrote about in the Journal of Financial Planning.
Add to this further research which suggests wealthier Americans (again, the clients of the asset management community) live even longer than the life expectancy tables suggest, and the AUM required to fund retirement expands even further.
See you in Monterey
Only the financial community could make a crisis out of strong markets and longer life spans. There’s no doubt that the RIA community has plenty to fret over, but there are also plenty of reasons to be optimistic as well. Robo-advisors won’t supplant a relationship business. Indexing won’t outsmart human ingenuity. And clients facing the prospects of longer lives and lower returns will need more help, not less, from their investment managers.