A more tailored investment approach

Portfolio construction priorities change when individuals enter retirement. Richard Dinham, head of retirement income at Fidelity International, examines some investment strategies that may be more suitable for people in this stage of their lives.

It is 30 years since the superannuation guarantee was introduced in Australia, establishing a retirement income structure that is the envy of many countries around the world.

During that time, there have been any number of changes to the superannuation system – some good and some not so good. But overall, the outcome has been a positive one, establishing a structured form of savings people can live on during their retirement years.

More recently, there has been a significant shift in thinking about superannuation and its role. Up until now, the main focus of the superannuation system has been on the accumulation phase – encouraging Australians to contribute as much as possible to their super and ensuring it is invested in an appropriate and supportable way.

Now, however, the focus is shifting to the postretirement stage of decumulation. This shift is a result of the wave of baby boomers reaching retirement and starting to draw down on their superannuation and other retirement savings.

This shift to decumulation strategies requires a change in thinking about how to invest. More consideration needs to be given to strategies and investments that suit retirees, rather than those still working and contributing to their super, in order to generate stable and reliable retirement income.

There is no doubt achieving this kind of income is more difficult than it was in the past. The current market environment of low cash rates and low yields means retirees will need to take on a degree of appropriate investment risk in order to generate the desired level of income, rather than relying on the traditional forms of income, such as term deposits and even bonds, which are no longer delivering the required level of return.

In addition to income needs, retirees will generally need to be exposed to the return potential of equity markets to maintain and grow the spending power of their super over their retirement. Of course, equity markets inherently come with relatively high levels of market volatility, but if there are ways to manage and reduce this risk and still give exposure to the longer-term return potential of equities, then that should be a welcome addition to any retirement portfolio.

Therefore, a key element in a successful retirement strategy is to find ways to offer downside protection, that is, mitigate against the full impact of market downturns, while still capturing the upside as markets rise.

History shows market falls are, on average, bigger than market gains and that when markets fall, they are more volatile than when the market is rising. For retirees who are no longer able to build up their superannuation, a market fall can have a devastating impact on their retirement.

An appropriate growth strategy in retirement therefore combines investments in such a way as to have low downside capture (that is, in a falling market the portfolio will fall less than the market) and high upside capture (that is, when markets are rising the portfolio will keep up or outperform the market).

To explain why this approach is beneficial we need to remember the beneficial impact of compounding over time. In investing, this is often called dollar-cost averaging. Its power is generally well understood in accumulation phase, where contributions to retirement savings when markets are depressed tend to do especially well when those markets recover. However, what is less well understood is that the reverse is true when investors are drawing an income from their retirement savings. Taking money out of retirement savings at a time when markets are falling means the effects of compounding are applying, but in reverse.

There are ways to manage this situation that can have a significantly beneficial impact on the retirement portfolio using investments that give better protection on the downside which can perform much better over time when we have a pool of capital from which we are drawing a regular monthly income. Where a fund may lag the market in up-markets (eg: 80 per cent upside capture), its strong performance in down-markets (50 per cent downside capture) means it may deliver the best outcome for investors over time.

The power of this type of investment is that the investor does not need to try to time the market. Instead, simply staying invested over time in an investment offering good protection on the downside and riding the markets over time will more likely deliver a better outcome.

Other risks

Of course, equity market risk is not the only risk retirees need to consider when developing appropriate investment strategies in retirement.

Longevity risk is a growing issue. This is the risk of outliving one’s savings. As life expectancies for both men and women continue to increase in Australia, retirees are facing the task of generating income over a period of time that is consistently lengthening and representing a growing proportion of the time available to them to accumulate savings.

Another risk is inflation risk. While inflation hasn’t been a significant concern in recent times, it is increasingly expected inflation will start to rise more rapidly in the years ahead. And as the costs of goods and services increase, the income required to acquire a given basket of those goods also increases. If retirement income does not increase over time by at least the same rate as inflation, retirees will find their income allows them to buy fewer of those goods and services.

A key point to remember is that inflation varies for different types of households, depending on what they spend their money on. For example, self- funded retirees tend to spend more money on luxury items and on recreation and leisure pursuits and, as they get older, will spend more on healthcare. Employee households, on the other hand, tend to spend more on things like housing, kids’ education and transport. So the headline inflation figure, as measured by the Reserve Bank of Australia, may not represent the true inflation faced by retirees.

Since the goal of retirement planning is to maintain a level of consumption that supports a certain lifestyle, it is important to factor in price inflation relevant to retirees’ own lifestyles.

It is therefore important to work out an appropriate risk profile in retirement, taking into account risk tolerance (how much risk an investor thinks they can bear), risk capacity (how much risk they can actually bear) and risk requirement (how much risk they need to take to achieve the targeted outcome), before deciding on the right investment strategy for retirement income.

Following this important exercise, there are a few common strategies that are generally used in retirement, offering a mix of risk and return to suit individual needs.

More conservative asset allocation

A common approach is to transition to a more conservative asset allocation with a large percentage of the total portfolio allocated to low-risk and low-volatility assets, such as conservative equities, fixed income and money market securities.

The low volatility of this strategy helps to mitigate the sequence of return risk (the market risk for a retiree) and makes it suitable for retirees who value downside protection more than the upside growth. However, retirees do need to be careful not to have the downside overly protected and thus overly constrain the upside potential as this may expose them to an excessive shortfall risk.

Simple bucketing

A bucketing approach divides an investment portfolio into separate components, or ‘buckets‘, with each bucket serving different objectives.

In a simple bucketing approach, there are only two buckets: a cash bucket, holding adequate cash and cash equivalents to cover retirees’ immediate financial needs, perhaps for the next year or two, and a diversified investment bucket, with a substantial allocation to relatively risky assets with the objective of achieving capital growth.

As the value of the diversified investment bucket increases over time, the strategy can be rebalanced by transferring some assets to the cash bucket, ensuring immediate cashflow needs continue to be met. If markets are volatile, then the investor would draw their income needs from the cash bucket and need not draw at all on the growth bucket until markets improve. The length of time that the cash bucket can support normal expenditure is the crucial decision in this instance.

This approach provides a short-term buffer against falls from market shocks and allows retirees to better manage the implications of rebalancing and selling growth assets. It therefore is useful for managing sequencing risk and market risk.

Complex bucketing

The simple bucketing strategy can be developed into a more sophisticated bucketing strategy tailored to retirees’ more detailed spending needs.

A complex bucketing approach also follows the principle of dividing accumulated savings into discrete pools, each with different objectives, however, there is an additional bucket to provide an additional layer of income support. This third, or ‘capital-certainty’, bucket blends in some risky asset classes and covers a few more years’ expected expenses, usually three to five years. Specifically, this bucket could be a ‘bond ladder’ encompassing a selection of fixed income securities, with each security maturing at a different date to replenish the cash bucket. A term annuity would also work here.

The complex bucketing strategy manages risk by segmenting retirement investing into different time horizons. Matching short-term liabilities, or spending requirements, with cash and short-term bonds provides retirees with confidence that money will be available when it’s needed, even if investment markets are at that point in decline. Similarly, matching long-term liabilities, or expected expenses, with relatively long-term assets, such as equities, provides them with a greater expected return, with the aim of ensuring capital is available to meet the expected future spending need.

Income layering

An income-layering strategy, like the complex bucketing strategy, divides a retirement portfolio into separate components or layers, but bases those components on retirees’ spending needs.

Generally speaking, spending needs can be grouped into four categories: basic living expenses, contingency expenditures, discretionary expenses and legacy, that is, leaving something for the kids.

The income priority is matched to the spending priority with income for essential spending being the top priority. All retirees will have their own trade-offs between spending more on discretionary items in early years of retirement and being more certain of meeting goals in later years, and the layers of this strategy can be tailored to suit.

The income-layering approach separates a retiree’s needs from their wants, or nice-tohaves, and prioritises income accordingly. High-priority needs could be protected from market volatility for life, with the portfolio anchored by the age pension, where the investor is eligible for this, or perhaps with lifetime annuities.

Term annuities, which pay income in guaranteed amounts for fixed periods, and deferred annuities, which start to pay a lifetime income after a certain delay or deferral period, can be used to produce a tailored income profile over the retiree’s future life. Lower-priority income needs can be met with a market-based portfolio, which may have less certainty of outcome but would likely produce a higher return over time.

Generally, complex bucketing and income layering would need the help of a professional, such as a financial adviser, to help structure the appropriate mix of investments and to manage and monitor the portfolio over time.

Whichever approach is chosen, the overarching goal is for retirees to feel confident they have enough savings to last them through their retirement and generate a suitable income to maintain their desired lifestyle.

Superannuation is likely to be the single largest asset people ever have, outside their family home. Making sure it is managed in the right way, both before and after retirement, is an increasingly important aspect of retirement.