Retail Financial Services Trends and Opportunities

For many years, I worked for a management consulting company, and did many projects in the financial services industry. As many of our readers are either advisers or sophisticated users of their services, we thought you would appreciate a short overview of how we see the industry is evolving, and the opportunities it presents.

Let's start with our theory of the competitive environment, and focus on customer needs, technology, and competitor offerings. Future customer needs are being driven by a number of very clear and accelerating trends. The first is the rapid ageing of the population in most OECD countries, driven not only by the baby boom generation, but also by the fact that all generations are living much longer.

HSBC Bank recently published a comprehensive survey of this subject, titled "The Future of Retirement." Based on interviews with over 20,000 people in multiple developed and developing countries, one of its key conclusions was that "when given the choice between higher taxes, lower pensions, working longer and compulsory saving (in the form of enforced additional private savings) nearly 40% of all respondents choose compulsory saving. In almost every country and across all age ranges, more people choose compulsory saving than any other solution. Only in Singapore, Japan, China and Sweden do other policies receive greater support. In Singapore and Japan people say they would prefer the retirement age to be raised; in China and Sweden the largest groups support tax rises. Throughout the world no fewer than 93% of people - young and old - reject a reduction in pensions. Although many governments have shied away from compulsory savings, people recognize the necessity for them. They want to be in control and they are happy for pensions to be funded by private rather than tax-financed savings - but they need help to help themselves. This call for compulsory savings is a reflection of the confidence gap. Around the world people are saying to their governments: 'We need to finance our old age and are willing to do so, but we do not feel confident that you can do this for us. Nor are we confident, if taxes were raised, that the proceeds would be spent on providing for us in retirement."' These findings also reflect a natural and growing concern with longevity risk.

The survey also found that "family, friends, and fitness" were the perceived as the keys to a satisfying retirement, while poor health was people's biggest fear. Two thirds of those surveyed wanted to travel during retirement, while 50% wanted to do more volunteer work or take up a new hobby. Substantial percentages of people around the world plan to work part-time in retirement, though for different reasons. In the USA, France, India and Japan, the primary motivation is to earn money; in Germany and the UK it is for the mental stimulation work provides; in Sweden it was for the social connections; and in Canada and Japan it was because work provides a meaningful way to spend their time. Despite these similarities across countries, there was a significant difference in the extent to which retirement was associated with positive feelings, from a high of 84% in North America, to 68% in Europe and only 60% in Asia.

Individuals today are being forced to bear more than just the risk associated with accumulating the savings needed to achieve their retirement income goals. Health care is a growing worry for many people, even in countries with national health insurance systems, where rapidly rising costs are forcing governments to consider limiting coverage for some "luxury" type services, while allowing consumers to buy optional coverage for them in the private market. And in the United States, the cost of health insurance is rapidly rising for many people, as deductibles and copays are increased. Recent efforts to hold down these costs via the use of tax advantaged health savings accounts have created an even more explicit linkage between health and investment risks.

Education costs are also a growing worry for many investors, as poor public school quality forces more parents to bear the cost of private school, and government financial support for universities is cut back, forcing students (and their parents) to pay higher prices. And university costs continue to rise much faster than the rate of inflation.

Many of these same investors are also significantly exposed to interest rate risk, as they have substantial amounts of floating rate mortgage and credit card debt on their balance sheets. All of these factors make it hard to save as much as people might want. However, as HSBC found, they are equally unwilling to reduce their retirement goals. This has forced many of them to take on more investment risk than they might otherwise prefer.

Rising taxes are also a concern for many investors, as strong public sector unions, generous social programs, and growing pension and health care costs continue to exert upward pressure on government spending. All of these risks are compounded by what may be the biggest change of all: the increasing uncertainty and anxiety that many investors feel about their future income in a world characterized by intense global competition and substantial economic imbalances. They have seen the middle class shrink, as more and more people shift to either end of the income and wealth distribution. And they fear their next move may be down.

In sum, investors today face significantly more uncertainty and bear more risk than in the past, and feel much more anxious about it. In many cases, this is undoubtedly compounded by the overall time pressure in their lives, and the information overload they encounter when trying to educate themselves about the issues they face and their options for managing them.

Broadband and search technologies have made it much easier to access relevant information; in addition, voice mail, email, TiVO, MP3s, streaming video and a host of other technologies have enhanced convenience by making time shifting possible. In the face of the flood of information produced by these technologies, the focus of software development (as noted elsewhere in this issue) is more and more on helping users make sense of the huge amount of data they confront. This is in line with another trend, which sees people paying premium prices for attractively designed, easy to use, well-integrated offerings that work right the first time. The Apple iPod epitomizes this trend. Yet at the other end of the spectrum, these same customers are aggressively seeking to save money by minimizing the price they pay for offerings that have effectively become commoditized.

In the retail financial services industry, we see a number of important changes in competitors' offerings. To begin with, there has been great emphasis in recent years on improving electronic accessibility and customer service. There has also been a great emphasis on delivering a broader offering to clients, that aim to satisfy the full range of customer needs, including forecasting and planning, making payments, borrowing, making and managing investments in real and financial assets, hedging risks and minimizing taxes. However, one gets the sense that the execution of many of these initiatives has been uneven, with weak integration across customer needs and a lingering traditional focus on products and transactions. In addition, these initiatives appear to be increasingly in conflict with growing customer price discrimination between differentiated and commodity offerings. Hence we are seeing a shift away from the product-centric approach, and toward the marketing of outcomes and results (which could also be called "solutions") that directly respond to customers needs. Tax managed products and lifecycle funds are examples of this. We also seeing the gradual appearance of more structured products that attempt to better address customers' risk management needs (e.g., new types of annuities), and an increasing split between low cost beta (index) products and higher cost products (like hedge funds) that seek to deliver low or uncorrelated alpha (i.e., returns with a low correlation to those on broad asset class indexes).

Where then, are the opportunities today in this market? Clearly, we believe that the separation of alpha and beta in the retail market has yet to run its course, and that the demand will continue to grow for offerings that help customers make sense of the flood of information, and better educate themselves about the challenges they face and the choices they can make. And, as noted above, there are still many opportunities to improve the integration of existing offerings into more customer-friendly solutions. However, we believe that by far the biggest opportunity in the market is to deliver a much more comprehensive risk management offering to retail investors. The potential coverage of such an offering can be established by dividing risk between its cash flow and balance sheet components, as shown in the following table.

The Risks Individuals Must Manage

| 2006-2007 Benchmark Portfolios | This Month's Issue: Key Points | Retail Financial Services Trends and Opportunities | Product and Strategy Notes: Technology and Active Management; Hedge Funds Update; and Update on H5N1 | Global Asset Class Returns | Asset Class Valuation Update | What Happened to the Financial Markets in May? | This Month's Letters to the Editor: Convergent/Divergent Investment Strategy; EMN Funds vs Long/Short Equity Funds; Equity Market Neutral in Portfolios; YTD PCRDX Performance; Japan Overvalued?; Forecasting Volatility; Portfolios During Economic Downturn; Timber and Residential Property; Concentration of Swiss Equities in Swiss Portfolios; and Changing Asset Allocations |