New model for savings reduces risk of shortfall
Research proposes targeted, flexible savings plans
A new method for calculating regular savings contributions that reduces the risk of a deficit at a saving fund's maturity has been developed by Cass academics, Professor Steve Haberman, Dr Iqbal Owadally and Dr Denise Gomez-Hernandez.
The research has implications for investors across all portfolios from short-term savers to long-term pension schemes.
The new model highlights potential deficits at an earlier stage in a fund's lifecycle, allowing investors to adjust their contributions accordingly. The model considers current and historic investment performance to target contributions according to these parameters. These factors reduce the risk associated with the conventional approach of calculating a regular fixed contribution from an estimation of future return.
Their findings add to the growing pool of academic research suggesting that traditional fixed rate savings plans are systematically failing to deliver optimal results. The researchers demonstrate how the problem of calculating savings contributions can be addressed using the economic theory of consumption and investment. By setting contributions and asset allocation as variables, the loss function of the formula can be dynamically optimised over the cycle of the fund.
Dr Owadally says: "Dynamic optimisation is not used regularly by financial planners at a retail level because of the complications caused by real world features such as taxes, transaction costs and investment charges. We suggest a flexible targeted contribution savings plan which has variable contributions depending on current and historic investment performance, thereby reducing the risk posed by these real world complications."
For the purpose of this study the model was tested over a five year period, however preliminary investigations into long-term funds, such as pensions, have demonstrated encouraging results, reducing the risk of shortfall significantly. The report states, "The average deficit (of the pension fund) is therefore almost zero with the targeted contribution method, whereas it is never completely removed under amortization and a higher contribution is permanently required on average."
Whilst acknowledging that further research on longer term plans was necessary, Dr Owadally said: "A practical implication of this research for financial planners is that savings plans can be designed that are more flexible for individuals. A suitable design, that is both flexible and targeted, can achieve more robust outcomes for individual investors."
The research was recently published in the highly regarded Journal of Risk and Insurance. It comprised of a study of two savings plans, one where a level contribution was paid monthly on the advice of a financial planner's estimates of returns and the other where contributions were calculated on a monthly basis according to the deficit or surplus of the fund at that given point in time.