Inflation Risk Roundtable

Inflation has not graced the front pages of newspapers or taken political centre stage for quite some time. And yet, economists, analysts and, of course, forward-thinking financial advisers are aware that at some stage the tide must turn. With that in mind, ifa and MLC assembled a number of stakeholders from the investment research and independent financial planning communities to discuss inflation risk, and the impact inflation has on asset allocation strategy and investor behaviour.

Here are some of the insights:

AV: Inflation has not been receiving much press. Is this really a risk?

JA: On the face of it, there aren’t very many inflationary pressures – certainly not in the developed economies. Part of that is a residual from the GFC and the fact that unemployment rates remain pretty elevated and CPI numbers in a lot of developed markets still look pretty benign. But we are in a period where interest rate and monetary policy has entered uncharted territory with ultra-low interest rates in the USA and Europe, and Japan is following that type of strategy. Historically, you haven’t seen this ultra-low interest rate environment not followed by a resurgence of inflation – and I think that that is something people need to be wary of. We have a generation of investors who are used to inflation being pretty benign but if you go back and talk to investors in the ‘70s and ‘80s, they will tell you that the real impact on returns and real impact on purchasing power is pretty significant. So we just have to make sure that our clients – particularly those that are moving into retirement or are in retirement – understand the impact that inflation can have on their savings.

JR: We break it down more into a scenario-based view of the world. I think Jonathan’s right, that if you start looking at the numbers, inflation or stagflation is the thing that is least priced into markets. What’s easy to miss when reading the papers is you have to look at what’s priced in. In the past, a deflationary scenario would have probably been more damaging. But what’s really interesting is that the deflationary scenarios, looking forward, are the ones that hurt you less. Balanced portfolios, conservative portfolios, don’t do that badly. Inflation is still probably a low-probability scenario, but it’s the one that contains the most risk because it’s not the one that people are expecting, and it’s the one that will hit assets, especially fixed income, which it will hit the hardest. People aren’t used to thinking in probability-weighted terms.

AV: How much of a concern is inflation for financial advice clients?

TM: Definitely it’s on the mind of some clients. For younger clients, they’re not that aware of it; they haven’t lived through a period of inflation and so for them, it’s an education process. We like to use the words of Ronald Reagan, who said “inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man”. That makes them take stock of ‘what is this inflation?’ which is an inroad for them to talk about this risk that could really deplete their purchasing power. For our older clients, they have lived through periods of inflation. For those [clients], it’s more of a reminder.

JM: For younger clients, they have no experience of what inflation really means. With older clients, as soon as you mention inflation they recall those Reagan comments and they talk about when their mortgage rates hit 19 per cent and how difficult that was. The other point I’d make is it’s important to talk with clients about how inflation may impact their day-to-day finances, things like cash flow management and modelling for clients.

AZ: [Inflation] applies to everyone and it’s a discussion I am having a lot more with my retired clients. [Over] the last five years there has been a tendency to just sit in cash, but I have been having the conversation about having some equity exposure or property exposure because this will help you beat inflation.

AV: Is moving away from cash a key component of an inflation risk-mitigating strategy?

JA: It’s not about moving away from cash, it’s about having a more flexible approach to portfolio construction and asset allocation and also realising that we are in an unusual set of circumstances in developed markets. We are undertaking a pretty significant experiment and we don’t know what the outcome is going to be. You’ve seen perhaps an early skirmish in how markets might react with the debate about tapering. [It] was a pretty significant move in bond markets around the world, and actually nothing’s happened – there’s been talk about the future but no change in rates, but the follow-through impact was quite significant. The point is, perhaps static asset allocation strategies are no longer appropriate, at least for some clients. That rigidity is just inappropriate and a more flexible approach can actually take advantage of some of the gyrations you see in some of the markets to benefit clients.

AV: Is this ‘outcomes-based financial planning’ something those of you on the client side employ?

TM: From our perspective, it’s different for every client. Again, if the client is aware of that and has an understanding, it’s an easy conversation to have. But a lot of clients are still in that mindset of the defensive nature of their term deposits being a large percentage of their portfolio as they were given adequate yields. So it’s about letting them know [that] the risk of holding cash over the longer term is significant.

JR: We do have to be dynamic but we also have to involve the clients so they internalise it, because there is no right policy portfolio that can deal with an inflationary and deflationary scenario. At some stage you have to make a choice. So there’s still the ‘all weather’ idea that you can find a balanced portfolio to see you through all conditions. You have to have a discussion about decisions and risks, and then you have to look at diversification in a different way – which means putting other things in there, such as alternatives.

AV: How do you know which client is suitable for that approach?

JM: It’s a client-by-client individual philosophy that we have. It’s a good point that we should have more flexibility in portfolio construction, but it’s a really difficult one. We do it by what we call ‘goals-based investing’ which moves away from a classic ‘here’s the pie chart with the various asset classes’ to breaking down the client’s essential goals right through their wildest aspirations. To say that ‘if that works that’s blue sky and that’s great’ right through to ‘this will mean you can gets the kids through school’. The real risk is not how much money they have in the bank, but how can they achieve the goals they have set for themselves and their family. That’s what should lead asset allocation.

JR: Just a question for these guys: do you think risk profiling has less of a role to play?

JM: Traditional risk profiling has not kept pace with compliance, right through to FOFA. It’s a real problem – having real flexibility for the adviser at an asset allocation level is really difficult [under a risk profiling strategy] because if you have a client that has a ‘highly conservative’ risk profile off the back of a questionnaire, [that] might result in an outcome which is a disaster for them in terms of their goals.

TM: I would agree with that. If risk profiling is just putting in a few multiple choice questions and coming up with a solution, that’s not real risk profiling. Done properly, risk profiling is brilliant because it helps us understand the clients better. It’s one tool that we use in asset allocation and it’s a useful one because it exposes conflicts within couples or within an individual’s preferences.

JR: So it needs decoupling from the compliance process…

AZ: The problem with static risk profiling is that there are times when you want to be in and out of the market. So we have developed a risk-on and risk-off option for each of those traditional risk profiles. It’s dynamic and allows them to change. The day of ‘set and forget’ is well and truly over in my opinion.

AV: What could be done from a regulatory or legislative perspective to foster this approach?

JR: It’s about making it more nuanced and complex so that it sits between the planner and the client. The most compliant portfolio out there is 70 per cent in fixed income with no real chance over three to five years of achieving a CPI-plus two per cent outcome – so the compliance is making people do things that just don’t make sense. There’s a term of contradiction. There need to be frank conversations about realistic returns and income derived from investments, but clients shouldn’t be hamstrung by a compliance process that pushes them in the wrong direction.

TM: This is one of my personal bugbears. I’m tired of our industry turning to government for solutions. We’re the experts in this area, we’re a profession – we need to set our own standards rather than relying on the whims of the government of the day. We need to set our own standards and adhere to them.

AV: Is outcomes-based financial planning gaining traction?

TM: I know with a percentage of planners it is. I work with the SMSF Professionals’ Association of Australia (SPAA), the Financial Planning Association (FPA) and chartered accountants and I know this is where all three want the industry to head, but I can’t really speak to the rest of the industry.

AV: So how does behavioural finance fit in?

JA: For the past few years there has been a view that since the GFC people’s aversion to loss has changed quite dramatically; perhaps not surprising, but it definitely impacts your behaviour. Depending on what stage you’re at – pre- or post-retirement – this will have an impact. Research conducted in the USA suggests that aversion to loss has gone up five times post-GFC and people’s ability to stomach losses will very much depend on when they started. If you started in the ‘80s or ‘90s you likely had a sustained period of real returns, but if you started in 2006 you probably had a couple of years of a benign climate, followed by the worst downdraft since the [Great] Depression.

So perhaps it is incumbent upon those who produce products, but also the people that are advising, to help people through that – not only aversion to loss but aversion to risk – and for all of us in the financial services industry we need to do that education on this and help guide them and know when to put risk on the table and when to take it off.

AV: How do you approach that risk/loss aversion as an adviser?

AZ: At the same time there has been a trend towards clients wanting to be involved and wanting to learn. The things they have experienced in the past are going to cloud their judgement but if you can get past that [you can] have the conversation. A lot of conversations I am having with my clients are not so much about risk profiling as saying ‘can you take this level of risk?’

JM: The experience both of the client and the adviser is very important. Some of our younger advisers for example have never seen positive returns, so they are going to be quite jaundiced in terms of what they believe is possible. But at the end of the day, it comes back to the client’s goals. The failings of traditional risk profiling are such that if you don’t approach client engagement in that way, helping them alleviate roadblocks to those goals, then you could end up with portfolios that are vastly too risky with little justification. Planners since the GFC have probably dialled back their clients’ portfolios more out of their own fears than due to what their client needs.

TM: I think if I tried to introduce models to my clients their eyes would glaze over, but the point is a good one in that they’re aware of dividends. I think especially for our older clients, their key concerns are their health, their family and [the] third is actually inflation. They don’t call it inflation but they’re worried that they’re not going to be able to pay for the things they need and funnily enough, health is a major driver of inflation. So they are worried about it, but don’t call it that. It harks back to ‘how much risk do they need to take to be able to afford the things they need?’

AV: What specific asset allocation strategies can help with inflation risk?

AZ: It’s about making sure that shares and property are still part of the mix. Many people are influenced by their friends who aren’t getting advice who are all in cash. It’s more the people who aren’t getting advice that are 100 per cent still in cash – and the realisation that 3 per cent on my cash isn’t that great is prompting them to seek advice.

TM: Clearly property is attractive in an inflationary environment, a) because you can renegotiate the rents and drive up returns; and (b) if it’s leveraged, then the debt that you’ve got against it you’re paying off with cheap dollars. On the equities side, it’s a bit of a mixed bag. If there is unexpected inflation then equities can actually go backwards – so it’s not a panacea for inflation – though over the longer term, companies as their costs go up they can put their income up over time. On the bond side, there is clearly a risk for fixed interest, but for floating-rate and inflation-linked they are clearly attractive for some clients, and some will actually ask for inflation-linked products which are ahead of the curve. I think you will see more of that.

JA: One of the other things that is interesting about the current climate we’re in is the duration risk in investment portfolios. Particularly for clients that have a fixed income allocation, vanilla stuff, they are invested in a handful of stocks – mainly defensive stocks such as banks – and as well as their residential home, probably a few REITs because they’ve producing good yields. But the capital appreciation on all these investments has been driven in the last two or three years by low interest rates, and I think there’s a bit of a health warning with all this. You need to provide a health warning and explain to clients that largely their returns have not been driven by diversity. They’ve been driven by the same thing and there is a genuine risk that as we move back to a normal situation, that adjustment could be quite painful. Those risks are a little more painful than people realise.

JM: It’s interesting that if you see the language from clients – and we’ve also had a few ask us about inflation-linked products – they have all been focused on the ‘chase for yield’ and it’s just starting to change now. People are starting to understand inflation – as Jonathan said, it’s not that inflation is going to go rampant, it’s that it will normalise. The difficulty I think will be if we do have some poorer outcomes on equities there will be questions over where will I get returns from. What is going to be the solution? I think looking at some historical examples can be helpful there.

JR: We get very technical about the terms we use to classify inflation. In the ‘70s we were wrong-footed when it didn’t materialise in the way people expected and we had ‘bad inflation’ and then we got used to the idea that it was upward sloping and it was ‘good inflation’. The thing that could wrong-foot us this time is asset-price inflation.

JA: That’s a really important comment and again it will depend on the age bracket that you’re in. Certain inflation benefits certain types of savers and workers. If you’re in retirement, your ability to keep real savings up to speed with inflation – particularly given health care – is one of your key portfolio concerns. There is good and bad inflation. It’s about having the flexibility to deal with that and achieve the outcomes the client seeks.

JM: While it’s true that retirees won’t talk about inflation risk as such, they will talk about how much their electricity bill has gone up and in the same breath they will tell you about their last trip and how incredibly cheap the airfares were. Educating people and helping them understand what they need and how we help them through the periods of good inflation and bad inflation and what those two things mean is really important.

AV: How should the financial advice industry respond to this issue of inflation risk?

AZ: We have the luxury [of our own AFSL] and it’s a selling point for us, but as an industry we need to be doing that advocacy around traditional risk profiling and recommending a product suite to fit that risk profile is out-dated. As an industry it’s our job to voice that to the regulator so they can build in that flexibility we all desire.

JA: It’s about recognising both the risks and benefits. There is a place for outcome-focused investment funds for those who are nearing retirement or in retirement. I can’t tell you when inflation might pick up again – I’m fairly sure it will do – and it may well creep up, to use the mugger analogy. We need to make sure that we have educated our clients and also that we have the products and options our clients need as part of their investment portfolio.

JR: Look at government bonds: you don’t need to know when they’re supposedly going to blow up. Government bonds in the short term will probably still be less risky than things you might otherwise go into. So you have to be aware when you’re talking to clients that a perfectly rational thing to do with a ten-year time horizon is to stick more in equities, but if there is an inflation scare those equities will get hit harder than government bonds. So the silent tax is already happening and that will just grind on.

TM: I joked earlier that I didn’t know when inflation will come in but that it will at some stage. I think that’s the value of financial planning advice though. We sit in front our clients and say ‘if X happens then XYZ’ and we build a plan, a contingency around these scenarios. You need to bring it back to how inflation can affect their retirement. «