Using alternative investment to address pre- and post-retirement issues

Walter Davis, Alternatives Investment Strategist

Ashley O’Connor, Investment Strategist, Invesco Australia

Introduction

Investing in financial markets requires investors to balance return and risk, short-term and long-term goals, and cyclical and structural factors. To do so effectively, investors must also balance the human emotions of greed and fear. Greed drives investors’ desire to build wealth by seeking investments with attractive return potential, while fear drives investors’ desire to avoid losses by investing in low risk investments.
These two emotions are particularly acute for individual investors who have identified (and become emotionally attached to) a specific goal for their savings, be it retirement, funding a college education or buying a house. In such situations, investors want to ensure they generate attractive returns on their investments so they have sufficient wealth to fund the event, while at the same time avoiding damaging losses that could permanently impair their ability to do so. This issue is even more complicated for investors seeking to provide for a comfortable retirement, given the significant variables involved (such as the unknown duration of retirement and highly variable expenses) and the potentially devastating consequences of failure to achieve the goal.
This challenge is not limited to individual investors. Institutional investors, such as defined contribution pension plans, defined benefit pension plans, insurance companies and government-sponsored retirement plans, all face a similar dilemma. In many cases, these investors have plans that are underfunded and need to generate strong returns to meet future liabilities, while at the same time avoiding losses that would undermine their ability to do so.
In technical terms, the two primary risks that these individual and institutional investors face are longevity risk and sequencing risk. Translated, longevity risk is the risk of living longer than your savings last, while sequencing risk is the risk of large negative returns occurring at a time that makes losses difficult to recoup.
The solution to longevity risk is to seek investments that offer attractive return potential in order to help build sufficient wealth to fund retirement. Conversely, the solution to sequencing risk is to seek stable, low-risk investments in order to avoid potentially devastating losses that could permanently impair the investor’s ability to fund retirement. The challenge for investors is to build a portfolio that balances these competing needs.
This paper will explore the issues and challenges associated with longevity and sequencing risk, especially in the current market environment, and examine how alternative investments offer investors potential solutions for these risks.


Longevity risk

While longevity risk can be simply explained as the risk of living longer than your savings last, this risk is exacerbated by the fact that many of the variables associated with this risk are unknowable. For example, no one knows how long they or their spouse will live, or whether or not they will face unexpected costs in their retirement.

In 2011, the National Institute on Aging, National Institutes for Health, US Department of Health and Human Services, and World Health Organisation produced a report entitled Global Health and Aging. Several of the key findings of the report illustrate the complex and changing nature of longevity risk.

The challenges associated with longevity risk have implications not just for individuals and families trying to save for retirement, but also for society, governments, defined benefit pension plans, defined contribution pension plans and insurers. Specifically, the individuals and entities charged with helping people save for retirement need to ensure that they are doing two things: 1) saving and investing a sufficient amount, and 2) earning a return on their investments that enables them to have sufficient assets to afford retirement.

Unfortunately for investors, the ability to achieve attractive returns has been hindered by the fact that equity returns have declined sharply since 2000 on a global basis. Using the US as an example, in both the 1980s and 1990s, the S&P 500 generated an annualised return of over 17%.1 Between 2000 and 2010, however, equities experienced two bear markets and posted a negative annualised return of less than -1%1 for the decade. Since 2010, equity returns have rebounded, generating an annualised return of over 13%,1 through May 2017. For the period since 2000, equities have achieved an annualised return of just under 5%,1 well below the returns achieved in the 1980s and 1990s. As a result of declining equity returns, the returns achieved in the classic 60% stock, 40% bond portfolios have similarly declined, as shown in the chart below. While this example focuses on the US, the story of falling returns is consistent globally as most developed economies have experienced similar declines in returns.

Just as equity returns have declined, so too did interest rates as central banks responded to the Global Financial Crisis by drastically cutting rates in an attempt to support the markets and economy. In some parts of the world, interest rates have turned negative, causing investors to pay for the safety of low-risk investments. The current low level of interest rates, which can be seen in the below chart2, has dramatically impaired investors’ ability to earn an attractive yield on lower-risk assets.

While the decline in interest rates accelerated after 2000, interest rates have steadily been declining over the past 30 years as bonds have enjoyed a historic bull market. Again using the US as an example, during the 1980s the yield on 10-year US government bonds ranged between approximately 7% and 10%.3 In the 1990s, yields declined but remained attractive, ranging between approximately 5% to 8%.3 In the 2000s, yields fell further and generally ranged between approximately 2.5% and 5%.3 Since 2010, yields have often fallen below 2% and today yield approximately 2.3%.3 The US experience with falling rates is broadly consistent with the experiences of other developed economies around the globe.
Taken collectively, an investor saving for retirement faces the following challenges related to longevity risk:

 The need to fund a retirement of unknown duration, which could last far longer than expected due to increasing life expectancy
 The risk of increased expenses and medical costs in retirement due to illnesses associated with extended life expectancy, such as dementia
 A prolonged period of modest equity returns and low yields on low-risk government bonds.

In order to address this risk, there are two steps that investors can and should take: 1) increase the amount of money being set aside for retirement, and 2) seek to prudently increase the return potential of the portfolio. As the chart below illustrates, even modest increases in return can significantly improve an investor’s ability to fund retirement.


Sequencing risk
Sequencing risk is the risk of large losses occurring in a portfolio at a time when it is difficult to recoup them. For example, a 45-year-old who incurs large portfolio losses has 20 years before reaching the retirement age of 65, and therefore has a long time horizon over which to recover. The situation is very different when a 65-year-old incurs large losses in their first year of retirement. This also tends to be when an investor has the greatest amount of invested wealth during their life to date, making them more vulnerable to large losses. Such losses can force the retiree to return to the workplace and/or may require a more limited retirement than planned.

A primary reason that losses are such a concern to investors is that after a loss is incurred, the investor must achieve a return greater than the percentage of the loss in order to recoup the loss. This is due to the fact that the losses reduced the size of their portfolio and thus require a higher return to offset the smaller portfolio size. This point is illustrated in the diagram below;

For example, if an investor loses 50% on a $100,000 portfolio, the size of the portfolio shrinks to $50,000. The investor must then achieve a 100% return on the remaining $50,000 portfolio in order for the portfolio to return to its pre-loss size of $100,000. The larger the size of the loss, the greater return, and the longer it will take, to recover the losses. The impact of such losses on an investor is highlighted in the chart below.

When building a portfolio, volatility and risk of loss should always be a primary focus of investors, as market downturns occur more regularly than many investors realise. Many investors, however, have short memories and discount the potential risk of incurring outsized losses, despite several historical examples of large market declines, as shown below:

  • Dow Jones Industrial Average (DJIA) — In 1929, the Dow hit an all-time high of 381.17, before declining 89% to 41.22 in 1932. It took until 1954, a period of 25 years, before the index achieved a new peak.3
  • DJIA — On October 19, 1987, the DJIA declined 22.6%, the largest one-day decline (in percentage terms) in its history. It took 15 months for the index to return to pre-crash levels, and 24 months for it to hit a new peak.3
  • Japanese Nikkei — The Nikkei hit an all-time high of 38,916 on December 29, 1989. As of May 31, 2017, the Nikkei sat at 19,650, approximately 50% below its all-time high.3
  • NASDAQ — On March 10, 2000, the NASDAQ hit a record high of 5048.62 before declining approximately 80% by October 2002. It took 15 years for the index to achieve a new peak.3
  • S&P 500 — The S&P 500 hit a then record high of 1565.15 on October 9, 2007. From that lofty level, the index declined 56.8%, due in large part to the Global Financial Crisis, hitting a low of 676.53 on March 9, 2009. Over five years later, in March 2013, the index achieved a new peak.3

In order to mitigate sequencing risk, investors have long been counselled to reduce the risk of their portfolios as they age by shifting away from stocks toward bonds and cash equivalents. A common rule of thumb for investing was to subtract the investor’s age from 100 to determine how much to invest in stocks, with the remaining balance being invested in bonds and cash equivalents. Under this rule of thumb, a 30-year-old would invest 70% of their portfolio in stocks, while a 65-year-old would invest 35% in stocks. This same general principal can be seen in target date funds, as these funds typically reduce the risk exposure of the portfolio the closer they get to the target date.

This approach works well for the select few investors and pension plans that have comfortably funded their retirements and plans, but presents a challenge for investors who are dealing with underfunding or issues related to longevity risk. Furthermore, this approach worked much better for investors in the higher return era of the 1980s and 1990s, when equities achieved annualised returns of 17% and 10-year US government bonds yielded 5% to 10%.1 Since 2000, however, it has become much more challenging with equities having achieved annualised returns of less than 5% and 10-year US government bonds yielding between 2 and 3%.3 Additionally, investors in bonds may potentially face a bear market when interest rates inevitably increase from their current low levels.

The investment strategy of steadily reducing risk over time involves a clear return and risk trade-off. Specifically, by decreasing the allocation to equities and increasing the allocation to cash and bonds, investors are reducing the return potential of their portfolios in order to decrease the risk of their portfolio. This approach helps the investor address sequencing risk, but potentially exacerbates the investor’s longevity risk.


Balancing longevity risk and sequencing risk

Just as investors need to balance greed and fear, they need to strike a balance in addressing longevity risk and sequencing risk. Longevity risk pushes investors to invest in riskier assets in order to achieve higher returns and grow their portfolios, while sequencing risk does the opposite and pushes investors to increase their exposure to low-risk assets in order to reduce the risk of losses. Addressing the conflicting nature of these risks is critical, and extremely challenging, for investors.

While there is no magic solution to this issue, investors’ ability to balance these competing risks can potentially be improved by looking beyond traditional investments in stocks and bonds and considering alternative investments.

Alternatives have the potential to provide investors with unique return and risk characteristics that can help them address the issues of longevity and sequencing risk. Specifically, there are some types of alternatives that have the potential to address longevity risk by generating returns equal to, or greater than, equities, or generating current income well above that of bonds. There are other types of alternatives that have the potential to address sequencing risk by offering investors downside protection and volatility reduction. Lastly, there are some types of alternatives that can help investors simultaneously address both longevity and sequencing risk by generating equity-like returns with lower volatility and lower drawdowns than equities.


What are alternative investments?

While there is no one common definition for alternative investments, Invesco defines alternatives as investments other than publicly traded, long-only equities and fixed income. Based on this definition, investments that have any of the following characteristics would be defined as alternative investments:

  • Investments that invest in illiquid and / or privately traded assets, such as private equity, venture capital, and private credit.
  • Investments that engage in “shorting” (i.e., seeking to profit from a decline in the value of an asset), such as global macro, market neutral and long / short equity strategies
  • Investments in asset classes other than stocks and bonds, such as commodities, natural resources (i.e. timberland, oil wells), infrastructure, master limited partnerships (MLPs), and real estate.

(Please note that the above definition is intentionally broad and inclusive. Different investor types often have their own unique definition of alternatives and may classify specific investment types differently.)

Alternatives can be broadly categorised as liquid or illiquid. Liquid alternatives predominantly invest in underlying instruments that are frequently traded and regularly priced, and provide investors with the ability to redeem their investment on a regular basis, be it daily, monthly or quarterly. Alternative mutual funds, alternative Undertakings for the Collective Investment of Transferable Securities (UCITS) funds and most traditional hedge funds are examples of liquid alternatives. Alternative mutual funds and UCITs are available for investment by retail investors, high net worth investors (i.e., individuals with a net worth in excess of $5 million) and institutional investors (i.e., pension plans, foundations, endowments and sovereign wealth funds). Traditional hedge funds, however, are typically only available to high net worth and institutional investors.

Illiquid alternatives predominantly invest in underlying instruments that are privately traded, priced on a periodic basis (often quarterly) and require investors to hold the investment over a prolonged period (typically several years) with little to no ability to redeem the investment prior to its maturity. Private equity, venture capital, direct real estate, private credit, direct infrastructure and natural resources are examples of illiquid alternatives. The availability of illiquid alternatives varies from country to country and is dependent on each countries individual regulatory environment. Generally speaking, illiquid alternatives are typically only available to institutional investors and high net worth individual investors, and are not typically available to retail investors.

When looking at alternatives, Invesco divides the universe into two baskets: alternative asset classes and alternative investment strategies:

  • Alternative asset classes are investments in asset classes other than stocks and bonds. Investments in real estate, commodities, natural resources, infrastructure and MLPs are all examples of alternative asset classes. Alternative asset classes can be accessed through either liquid or illiquid investments. Examples of liquid alternative asset investments include investing in real estate through REITS, investing in the equity and / or bonds of publicly traded infrastructure companies, or investing in commodities by using futures. Examples of illiquid alternative asset investments include direct, private market investments in real estate, natural resources, and / or infrastructure.
  • Alternative investment strategies are investments in which the fund manager is given increased flexibility with how to invest. The manager is often given the ability to trade across multiple markets and asset classes such as stocks, bonds, currencies and commodities, as well as given the ability to short markets. Common hedge fund strategies such as global macro, long / short equity, market neutral, managed futures and unconstrained fixed income are all examples of alternative strategies.

Strategies such as global macro, market neutral, long / short equity, and managed futures all typically invest on a long and short basis. The ability to short has the potential to significantly impact the return stream of these investments, as shorting gives these strategies the potential to generate positive returns in a falling market environment. At a minimum, the use of shorts provides these strategies with a powerful tool to potentially limit losses during such an environment.

Additionally, alternative investment strategies often are frequent users of derivatives, such as futures, forwards, options and swaps. While derivatives are often misunderstood and viewed as risky, within the context of alternative investment strategies, derivatives are commonly used to improve portfolio diversification, hedge out market risks, help protect on the downside and efficiently establish market exposure.

Given the myriad alternatives available to investors,4 one of the major challenges for investors is to understand the unique aspects of the various strategies. To help investors navigate this challenge, Invesco has created the below framework that organises the alternatives universe into six unique categories based on an investor’s investment objectives. The first five alternative categories (Alternative Assets, Relative Value, Global Investing and Trading, Alternative Equity and Alternative Fixed Income) represent liquid alternatives, while the sixth alternative category, Private Markets, represents illiquid alternatives.


How alternative investments can help mitigate longevity and sequencing risk

The ability of alternatives to help investors mitigate longevity and sequencing risk can be seen when looking at the historical performance of alternatives. To this end, the table below shows the historical performance of the various categories within Invesco’s Alternatives Framework compared to equities (i.e. S&P 500) and fixed income (i.e. Barclay U.S. Aggregate Bond Index). (Please note that the data used for the various categories of the framework reflect quarterly returns rather than monthly returns. While the liquid alternatives categories all have monthly returns available, the indexes used for private markets only report returns on a quarterly basis. In order to ensure consistency, quarterly returns were used.)

Examining the historical performance of these various alternative categories allows investors to gain a better understanding of the performance characteristics of each category, as well as how different types of alternatives can help address the challenges of longevity and sequencing risk. Based on an examination of the historical performance of the various categories, the chart below illustrates which risks the various alternative categories are best positioned to mitigate:

As a general rule, alternative investment strategies are effective tools to help reduce sequencing risk, while illiquid alternatives are well positioned to help reduce longevity risk. By combining both liquid and illiquid alternatives within a portfolio, investors can simultaneously address both longevity and sequencing risk.


How to implement alternatives into a portfolio to address longevity and sequencing risk

Once investors have made the decision to allocate to alternatives to address longevity and sequencing risk, they then need to decide how best to implement that decision. Invesco believes that the asset allocation process is as much an art as it is a science, and that there is no one-size-fits-all approach. That said, there are key issues that every investor should address when considering adding alternatives to their portfolio. Specifically, investors contemplating adding alternatives to their portfolio in order to meet longevity and sequencing risk should consider the following questions:

  • What risk or risks are they seeking to address? Determining the risks an investor is seeking to address will drive the decision as to which alternatives to add to the portfolio. Investors primarily concerned about longevity risk will focus on alternatives that have the potential to deliver returns equal to, or greater than, those of equities. Investors primarily focused on sequencing risk will focus on alternatives that can reduce performance volatility and risk of loss. Finally, investors concerned about addressing both longevity and sequencing risk will focus on those alternatives that can simultaneously address both risks and/or will seek a combination of alternatives that can address each risk individually.
  • Which types of alternatives do they have access to? Many liquid alternatives strategies are available to all investors in familiar structures such as mutual funds or UCITs. Private market strategies, however, are typically only available to high net worth and institutional investors.
  • What are the risks associated with the alternatives they are considering? As with any investment, alternatives have unique risks associated with them. It is important that investors fully understand all associated risks before investing.
  • How much should they invest in alternatives? The percentage an investor allocates to alternatives varies widely. For most investors, a typical allocation to alternatives would range between 5% and 30%. There are several institutional investors, however, such as the Yale Endowment, that allocate over 50% of their portfolio to alternatives.5
  • Should the allocation to alternatives be funded from equities or fixed income? The decision of how to fund the allocation varies greatly from investor to investor, and is often driven by the investor’s return and risk objectives for both the portfolio and the investment being considered.

The answers to these questions will significantly impact which alternatives an investor uses, how they incorporate them into their portfolio, their impact on the return and risk characteristics on the portfolio, and subsequently, their effectiveness in addressing longevity and sequencing risk.

To illustrate the potential impact of incorporating alternatives into a portfolio, consider the following scenarios:

  • An investor is seeking to address both longevity and sequencing risk.
  • The investor’s current portfolio is 60% equities and 40% bonds.
  • Retail investors only have access to liquid alternatives (i.e. cannot invest in illiquid alternatives), and allocate evenly across the five liquid alternative investment categories.
  • High net worth and institutional investors have access to both liquid and illiquid alternatives, and split their allocation evenly between liquid and illiquid alternatives. These investors opt to gain exposure to alternative assets through direct, private market investments, rather than through liquid alternatives, due to the higher return potential of private market investments. Additionally, their exposure to liquid alternatives is evenly allocated across the liquid alternative investment categories, excluding Alternative Assets given they can access this exposure in direct/illiquid markets.
  • To fund their allocation to alternatives, investors allocate proportionally away from stocks and bonds (i.e. a 20% allocation to alternatives will be funded by reducing exposure to equities by 20% and reducing exposure to fixed income by 20%)
  • Investors allocate either 20% or 30% of their portfolio to alternatives.

Based on the above assumptions, the chart below illustrates the impact of adding alternatives to a portfolio:

In each of the above cases, an investor seeking to address both longevity and sequencing risk would benefit from higher returns and lower risk by including alternatives in their portfolio. Each portfolio’s compound annual return increased, thus helping the investor address longevity risk. At the same time, both risk (as measured by standard deviation) and maximum decline decreased, helping the investor address sequencing risk.

While the above example is relatively simple, it illustrates how the use of alternatives can help investors address longevity and sequencing risk by simultaneously boosting return and decreasing risk. Furthermore, by thoughtfully deciding which alternatives to allocate to, investors can alter the return and risk characteristics of their portfolios in order to most effectively address their unique needs vis-a-vis longevity and sequencing risk.


Summary

Investors must address the conflicting natures of longevity risk and sequencing risk if they are to invest successfully. These risks are especially acute for individual and institutional investors seeking to provide for a comfortable retirement.

The solution to longevity risk is to seek investments that offer attractive return potential in order to help build sufficient wealth to fund retirement. Conversely, the solution to sequencing risk is to seek stable, low-risk investments in order to avoid potentially devastating losses that could permanently impair the investors’ ability to fund retirement. The challenge for investors is to build a portfolio that balances these competing needs.

While there is no magic solution to this issue, investors’ ability to balance these competing risks can potentially be improved by looking beyond traditional investments in stocks and bonds and considering alternative investments.

Alternatives have the potential to provide investors with unique return and risk characteristics that can help them address the issues of longevity and sequencing risk. Specifically, there are some types of alternatives that have the potential to address longevity risk by generating returns equal to, or greater than, equities, or generating current income well above those of bonds. There are other types of alternatives that have the potential to address sequencing risk by offering investors downside protection and volatility reduction. Lastly, there are some types of alternatives that can help investors simultaneously address both longevity and sequencing risk by generating equity-like returns with lower volatility and lower drawdowns than equities.


Alternative investments at Invesco

Invesco is a leading provider of alternative investments on a global basis, and believes there are four aspects of its alternatives capabilities that collectively differentiate Invesco from its competitors:

  • Proven and experienced portfolio management — Invesco has been managing alternative investments since the early 1980s, and currently has over 350 investment professionals managing over $155 billion in alternative assets.6
  • Diverse array of alternatives capabilities and offerings — Invesco’s alternative capabilities span the entire alternatives universe with offerings across all six alternative categories: Alternative Assets, Relative Value, Global Investing and Trading, Alternative Equity, Alternative Fixed Income and Private Markets. Furthermore, Invesco’s offerings are available in a variety of structures, as we understand the importance of delivering offerings in the manner our clients prefer.
  • Experience working with retail, high net worth, and institutional investors — Invesco has extensive experience working with and meeting the needs of retail, high net worth and institutional investors. Approximately two-thirds of Invesco’s $858B US in AUM is from retail and high net worth investors, while one-third is from institutional clients.7 Furthermore, Invesco is committed to providing our clients with industry-leading thought leadership on alternatives, in order to help them better understand the unique nature of this asset class and effectively implement alternatives into their portfolios.
  • Robust risk management and corporate governance infrastructure — As a global company with a long history, Invesco understands the importance of building a strong risk management and corporate governance structure to support our offerings, including alternatives.

Given the strength of its alternatives capabilities, Invesco is well-positioned to help investors address the issues of longevity and sequencing risk through the inclusion of alternative investments in their portfolios. To learn more about Invesco alternative capabilities and specific offerings, please contact your local Invesco representative or visit our website at www.invesco.com.

 

1 Source: Zephyr

2 UK 2007 is based on British Banking Association data — discontinued.

3 Source: Bloomberg

4 Alternative investments are subject to various regulatory requirements that vary across the globe. Furthermore, there are often suitability requirements that an investor must meet in order to invest in alternatives. For this reason, not all alternatives may be available to all investors.

5 Source: Yale Endowment 2015 Annual Report

6 As of June 30, 2017.

7 Source: Invesco Ltd. as of March 31, 2017


About risk

Short sale risk. Short sales may cause an investor to repurchase a security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, exposure to potential loss is unlimited.

Alternative risk. Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate.

MLP Risk. Most MLPs operate in the energy sector and are subject to the risks generally applicable to companies in that sector, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk. MLPs are also subject the risk that regulatory or legislative changes could eliminate the tax benefits enjoyed by MLPs which could have a negative impact on the after-tax income available for distribution by the MLPs and/or the value of the portfolio’s investments.

Important information

This document has been prepared only for those persons to whom Invesco has provided it. It should not be relied upon by anyone else. Information contained in this document may not have been prepared or tailored for an Australian audience and does not constitute an offer of a financial product in Australia. You may only reproduce, circulate and use this document (or any part of it) with the consent of Invesco.

The information in this document has been prepared without taking into account any investor’s investment objectives, financial situation or particular needs. Before acting on the information the investor should consider its appropriateness having regard to their investment objectives, financial situation and needs. You should note that this information:

  • may contain references to dollar amounts which are not Australian dollars;
  • may contain financial information which is not prepared in accordance with Australian law or practices;
  • may not address risks associated with investment in foreign currency denominated investments; and
  • does not address Australian tax issues.

Issued in Australia by Invesco Australia Limited (ABN 48 001 693 232), Level 26, 333 Collins Street, Melbourne, Victoria, 3000, Australia which holds an Australian Financial Services Licence number 239916.

 

Many retirees struggle to have enough income to fund a comfortable retirement because of an over-reliance on so-called “low risk” asset allocations, a problem that requires innovative solutions to overcome according to the team at Legg Mason’s Martin Currie.

Access the full article here.

 

Balancing the Needs, Challenges and Dilemmas of Retirement Investing

Retirement investing is necessarily complex.

The median super balance when entering retirement can’t support a comfortable lifestyle in the years ahead. In the first part of this series we outline the major investment building blocks and how they’re used to deliver better lifestyle outcomes for retirees.

Australians spend 40 years of their working life building an asset base to retire. For the majority1 this asset base on Day 1 of retirement is insufficient to pay for their remaining life costs should they wish to live comfortably2.

Specialised approaches to investing are the only way to breach this shortfall for retirees. Conceptually, growing our asset base in the accumulation phase is easy, we engage the growth investment engine and our risk is defined as opportunity cost.

In retirement, the engine of accumulation is still required.

Throughout the accumulation phase the investment engine was set to asset growth. For retirees, that engine must engage new gears, set for the unique combination of investment goals specific to retirement needs.

We spend 40+ years working to build an asset base to support us in retirement and in retirement we need that asset base to deliver 3 outcomes:

  • Income generation, but not at the expense of capital loss;
  • Growth of assets, but not risk losing all our savings;
  • Certainty of outcomes…

…and do all this for an unknown number of years.

The investment engine now requires three components to successfully drive retirement outcomes:

Income, growth and certainty are important individual investment components but paradoxically are not always complementary to each other. However, it is only by combining them that retirees can meet their overall retirement needs – this makes retirement investing complex.

Whilst the sub-components of retirement investing may be complex, the investment framework and discussion of its rationale need not be. Simply put:

  • Retirement investing has three core standalone objectives: Income, Growth, and Certainty which in combination are hard to balance. Each objective solves a specific Need, each Need presents a Challenge, and each Challenge has its own Dilemma

Based on the guidance provided by the ASFA Retirement Standards3, it’s clear that the Median Superannuation Balance4 isn’t enough to support a comfortable retirement.

We also know that the longer we live, the longer we’re expected to live. Thus, increasing the stress / responsibility on our savings to provide for retirement:

Life Expectancy At Age:

Age At Birth 65 75 80 85 90 95 100
Males 80.5 84.7 87.1 88.9 89.3 94.3 98.1 102.1
Females 84.6 87.3 89.1 90.4 89.9 94.9 98.3 102.3

Source: ABS 3302.0.55.001 – Life Tables, States, Territories and Australia, 2015-2017

With these data points in mind, aligning the investment engine to an investment strategy that meets client needs while engaging them in why and how this will help solve their problem isn’t easy, but it doesn’t need to be incomprehensible. Below we present each of the required retirement investment outcomes with their individual Need, Challenge and Dilemma concluding with a robust framework for delivering improved retiree lifestyles in retirement.

Income

Need: Income generation, accounting for inflation, avoiding the risk of capital loss.

Challenge: To generate enough income from retirees’ existing asset base.

Footnote: Yield required from asset base based on ATO Median 64-69 year old superannuation balance, accounting for pension payment for homeowning couple (Male and Female), using ASFA Comfortable spending requirement, ASFA Inflation assumption of 2.75% p.a.

Dilemma: Income generation isn’t as easy as it once was. Today, with income levels either too low (for our needs) or too risky (as standalone investments), focusing solely on generating enough income from our asset base introduces significant risks that our asset base may be eroded while not adequately rewarding for the risk of running out of money and diminishing quality of lifestyle in retirement. Alone, investing for income is not an adequate solution for this unique challenge.

1990 2000 2010 2019
RBA Cash Rate 17.5% 5.0% 3.75% 1.25%
Inflation 7.8% 1.9% 2.1% 1.3%
Real return on cash 9.7% 3.1% 1.65% -0.05%

Source: ABS, Inflation – Consumer price index; All groups, March 2019 (Series ID: GCPIAG)

Growth

Need: Growth of assets, but not at the expense of losing my asset base.

Challenge: Investing for growth is the only way to extend the duration of a comfortable retirement. However it can significantly increase the risk of reducing the extent of a comfortable retirement by eroding retirees’ asset base through poor returns. The ultimate measure of risk in retirement is “will this investment increase my risk of running out of money earlier?”, or in other words “what does this investment do to the range of outcomes for when I’ll run out of money?” To test what this risk is we add equities5 to cash, to build some simplistic scenarios to assess the impact of investing to achieve an expected 6% p.a. return6. This provides a picture of what the real risk of investing for growth to a retiree looks like.

Dilemma: Investing for growth is a prerequisite, but achieving growth and increasing the duration of a comfortable retirement isn’t risk free. Growth investing isn’t a straight-line reward, we all remember the GFC and the impact on invested savings. The risk to our asset base is real, finding the appropriate balance of this risk and appropriate growth assets can only come with a genuine understanding of the possible investments and how each may impact on retiree lifestyles.

Certainty

Need: With only our asset base to support our living standards, providing certainty is critical to maintaining those standards.

Challenge: Investing is uncertain. Retirement requires a level of certainty that traditional approaches may not facilitate. Certainty has an opportunity cost: lower risk necessitates lower expected peak returns.

There’s also a client engagement necessity of certainty. Australians are under-advised, so presenting them with comprehensible solutions and building trust as their partner is critical. It’s not hard to imagine that this trust would never eventuate if we were to introduce too much uncertainty, ultimately losing retirees through the diminished perception of the value of advice.

Being a genuine source of value to retirees throughout the most important part of their financial lives is of significant mutual benefit. This trust is facilitated through the use of solutions that provide increased certainty to investment outcomes.

Investment certainty and growth aren’t positively associated so approaches to retirement investing need to take certainty into account far more than in the accumulation phase. As a retiree knowing that my asset base will support a comfortable retirement for as long as possible is, arguably the most important goal to achieve.

Source: Bloomberg, based on calendar year total returns

Dilemma: People need advice to navigate the most complex of investment problems any of us face. Building trust in what we provide as fiduciaries is critical. The marriage of “complexity of challenge” and “simplicity of solution” isn’t straight forward or always self-evident, but is necessary to earn the trust of retirees.

Conclusion

In retirement, the investment engine of accumulation is still required. The task we set our engine is very different as finding the right mix of strategies providing Income, Growth and Certainty is imperative. Simply put, we have different needs as retirement investors.

Different needs require a different approach. The same strategies we employed in accumulation won’t work in retirement. We know this balance is imperative but equally important is the balance of the message for clients.

What remains constant, if not more important, is the trust we must maintain with retirees. We believe an understanding of the three key pillars of retirement investing, along with the challenges in achieving each and the dilemmas presented is essential. Having retirees’ needs at the centre of this understanding provides the best position to engage in the successful pursuit of a longer, more comfortable retirement.

Life is full of certainties, in retirement it’s no different: doing nothing leads to having nothing.

The solution isn’t easy, it requires; forgetting our investment approach in accumulation, different actions in the consideration of building investment structures and the adoption of unique investment approaches to truly ensure the retirement investment engine is working for retirees.

Specialised approaches to investing are the only way to breach this shortfall for retirees. Growing our asset base through a mix of growth, income and certainty increases the likelihood improving retirees’ retirement lifestyle for longer.

1 ATO Taxation Statistics 2016–17, Median super account balance, by ages 65 – 69, 2016–17 financial year
2 The Association of Superannuation Funds of Australia Limited, Retirement Standard for retirees, March Quarter 2019, Comfortable Lifestyle
3 The Association of Superannuation Funds of Australia Limited, Retirement Standard for retirees, March Quarter 2019, Comfortable Lifestyle
4 ATO Taxation Statistics 2016–17, Median super account balance, by ages 65 – 69, 2016–17 financial year
5 Lonsec Risk Profiles 2018, Step 3: Long term asset class return and risk assumptions, October 2018
6 ASFA, Retirement Standard March 2019, assumed investment earning rate
7 Calculated using Lonsec Risk Profiles, Long Term Asset Class Return and Risk assumptions to generate 6% p.a. expected return and using +/- 1 standard deviation to determine range of outcomes with c.66% confidence

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As it continues to grapple with the challenges facing retirees, the Australian retirement industry in some ways resembles a research institution―continually coming up with ideas for solutions to those challenges, testing them, then implementing them and reviewing the results.

For those involved in such an enterprise, it’s always interesting to see how well (or badly) those solutions work in practice, and the extent to which they’ve validated their research hypotheses.

At AllianceBernstein, we’ve been running the numbers on an investment strategy we launched five years ago, primarily for investors saving for retirement.

The strategy was developed in collaboration with a major Australian superannuation fund which had asked us to look for ways to “smooth the ride” for its members―that is, to help them earn meaningful investment returns while reducing the downside risk in their portfolios.

Reducing downside risk is, of course, important for investors who are in retirement or approaching it: the less their portfolios lose, the more money they have left over to deal with future market drawdowns, and the risk that they might live longer than expected.

There are several aspects to the strategy but, at its heart, is a portfolio of low-volatility stocks and a focus on aiming to limit downside risk to 50% of what the market experiences, while seeking to capture 80% of the upside when the market recovers.

Our research indicated that this might be achievable by combining careful stock selection (about which more later) with the so-called low-volatility paradox (the well-attested fact that a portfolio of low-volatility stocks can outperform the market over time on a risk-adjusted basis).

It’s been an eventful five years with several market ups and downs and our research hypothesis has been well tested. What have we learned?

SMOOTHER, BUT STILL THE OCCASIONAL BUMP

Pleasingly, the strategy has performed well, outperforming the market over the period (Display) and providing investors with a smoother ride, particularly when the market fell.

Downside Protection Generated Outperformance

April 1, 2014 to March 31, 2019

Source: S&P Dow Jones and AB; see Performance Disclosure.

As of March 31, 2019

Past performance does not guarantee future results.

Based on a representative Managed Volatility Equities account vs. S&P/ASX 300 Franking Credit Adjusted Daily Total Return (Tax-Exempt)

The returns presented above are gross of fees. The results do not reflect the deduction of investment-management fees or Fund costs. Performance figures include the value of any franking (or imputation) credits received. Numbers may not sum due to rounding. Periods of more than one year are annualised.

*For determining months when index is up or down, performance of S&P/ASX 300 (i.e., excluding franking credits) is used.

In fact, the strategy’s buffer on the downside contributed most to outperformance: the portfolio’s mean monthly return was 1.4% higher than the index when the market dipped and 0.3% lower when the market rose.

It’s interesting to note, too, that the strategy exceeded our aims in terms of upside/downside performance, with the portfolio suffering only 47% of the downside when the market fell (compared to our 50% target) and capturing 90% of the upside (our target was 80%).

There is a compounding effect at work here: limited downside means that the portfolio has less ground to make up when the market recovers, and this can contribute to outperformance over time.

It turns out, however, that even a strategy carefully designed to withstand volatility can experience the occasional bump, as happened when banks and mining companies performed very strongly after Donald Trump was elected US President in November 2016.

Bank and mining stocks tend to be volatile and, because they don’t figure highly in our low-volatility strategy, they were underweighted by our portfolio at the time. Financials and materials, of course, are the Australian share market’s biggest sectors. As they drove the market up, our portfolio lagged.

But the effect was short-lived and had relatively little impact on overall performance, appearing to validate one part of our hypothesis, that a low-volatility portfolio can outperform over time. What about the other part, regarding stock selection and portfolio management?

THE BIGGEST LESSON OF ALL

This consisted of five basic principles:

  • choose low-volatility stocks where the underlying businesses are high quality, with good cash flows and strong balance sheets, and the shares are reasonably valued
  • use fundamental research to avoid ‘volatility traps’, or the risk that idiosyncratic factors―such as a takeover bid―can make a normally stable stock suddenly volatile
  • ignore market benchmarks when constructing the portfolio: this makes it easier to focus on low-volatility stocks, and to avoid the volatility inherent in Australian equity indices
  • invest up to 20% of the portfolio in global stocks as a way of reducing risk, and making up for the necessity of limiting the portfolio’s access to the Australian market
  • manage macroeconomic risk―such as the potential impact on the portfolio of Brexit or the US-China trade wars―thoughtfully, so that the removal of one risk doesn’t inadvertently create exposure to another

Applying these principles consistently contributed positively to performance over the period.

Perhaps the biggest lesson we learned, however, is that it’s possible to deliver investors above-market returns with below-market volatility.

We’re happy to share that knowledge, and the benefits it delivers, with our colleagues in the industry who are seeking to create a better retirement future for Australians.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time.

INFORMATION ABOUT THE AB MANAGED VOLATILITY EQUITIES FUND AllianceBernstein Investment Management Australia Limited (ABN 58 007 212 606, AFSL 230 683) (“ABIMAL”) is the responsible entity of the AllianceBernstein Managed Volatility Equities Fund (ARSN 099 739 447) (“Fund” or “AB Managed Volatility Equities Fund”) and is the issuer of units in the Fund. AllianceBernstein Australia Limited (“ABAL”) ABN 53 095 022 718, AFSL 230 698 is the investment manager of the Fund. ABAL in turn has delegated a portion of the investment manager function to AllianceBernstein L.P.(“AB”). The Fund’s Product Disclosure Statement (“PDS”) is available at the following link https://web.alliancebernstein.com/funds/au/equity/managed-volatility-equities.htm

or by contacting the client services team at AllianceBernstein Australia Limited at (02) 9255 1299.

Neither this document nor the information contained in it are intended to take the place of professional advice. Please note that past performance is not indicative of future performance and projections, although based on current information, may not be realised. Information, forecasts and opinions can change without notice and neither ABIMAL or ABAL guarantees the accuracy of the information at any particular time. Although care has been exercised in compiling the information contained in this report, neither ABIMAL or ABAL warrants that this document is free from errors, inaccuracies or omissions.

This document is released by AllianceBernstein Australia Limited ABN 53 095 022 718, AFSL 230 698.

DISCLAIMER

This document is provided solely for informational purposes and is not an offer to buy or sell securities. The information, forecasts and opinions set out in this document have not been prepared for any recipient’s specific investment objectives, financial situation or particular needs. Neither this document nor the information contained in it are intended to take the place of professional advice. You should not take action on specific issues based on the information contained in the attached without first obtaining professional advice. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Current analysis does not guarantee future results.

INFORMATION ABOUT ALLIANCEBERNSTEIN

AllianceBernstein (AB) is a leading global investment management and research firm. We bring together a wide range of insights, expertise and innovations to advance the interests of our institutional investors, individuals and private clients in major world markets. AB offers a comprehensive range of research, portfolio management, wealth management and client-service offices around the world, reflecting our global capabilities and the needs of our clients. As at March 31, 2019, our firm managed US$555 billion in assets, including US$257 billion on behalf of institutions. These include pension plans, superannuation schemes, charities, insurance companies, central banks, and governments in more than 45 countries. This document is released by AllianceBernstein Australia Limited (“ABAL”) ABN 53 095 022 718, AFSL 230 698. AllianceBernstein Australia Limited (ABAL) is a wholly owned subsidiary of the AllianceBernstein, L.P. Group (AB).

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An equity-based investment fund that aims to deliver dependable income is likely to deviate significantly from the Australian share market index. It requires an active approach to manage a set of very different risks.

For a typical return-seeking equity fund aiming to outperform the index, the main risk is ‘relative risk’ associated with the portfolio deviating from the index and underperforming this benchmark. But what really matters for income investors is the risk that the fund does not deliver a sustainable and growing income stream.

A different set of risks requires a different approach.

Risks specific to the income investor

Income investors face several unique risks that are often not acknowledged in traditional investment literature:

  • Income level risk

Typically, income investors aim to generate an income stream that enables them to maintain their standard of living. This is a critical issue for retirees, and to achieve this goal they must tackle income level risk – the danger that the income paid by an investment falls in response to interest rate changes and other factors.

For example, in 2010 one of Australia’s leading banks offered its customers a five-year term deposit rate of 8%. Today, the rate offered is below 3.5% and around 2% for a more popular 90-day term. Therefore, for those investors who have relied on short-term cash rates to provide for their needs, the steady fall in interest rates over this decade has exposed them to heightened income risk. Of course, living costs continue to rise.

In today’s lower interest rate world, term deposit investors need to invest larger sums of capital than historically to achieve the same dollar return. Additionally, these lower rates impact the level of return available from annuity type products and create significant challenges to overcome.

  • Inflation risk

Inflation risk refers to the risk that the real value of an income stream declines as the cost of living rises. For investors to be able to maintain their spending power and to protect, as well as maintain, their living standards they must ensure their income stream grows at least in line with inflation. This is particularly important for people in retirement as they are likely to incur increased costs in areas such as healthcare and aged care services.

To illustrate inflation risk, imagine investing in a term deposit that has an interest rate of 2% p.a., when inflation is compounding at 2.5% annually. In this scenario, even though an investor is earning a nominal return of 2% a year, inflation is eroding 2.5% of that, leaving the investor with a real (inflation adjusted) return of negative 0.5%.

Given retirees will usually have a relatively fixed capital base, inflation protection has to be a central consideration in any medium to long-term income oriented financial plan.

  • Income volatility risk

Investors worry about movements in the capital value of their investments but for income investors, we believe it is more important to focus on the volatility of the income stream. Putting this a different way – what matters most for income investors is that their investments deliver a sustainable and growing income stream – and the main risk they face is that it does not.

For income-oriented investment solutions, reducing the volatility of the income stream in search of reliable income delivery should be a primary consideration.

Chart 1: Income volatility over the last 15 years – equities and cash

Past performance is not a guide to future performance. Source: Martin Currie Australia, Factset; as of 30 June 2018.*Average ‘special’ rate (all terms).

The chart above compares the volatility of Australian shares (prices and dividends) and term deposit income over the last 15 years. As you can see, the actual volatility of the income stream from term deposits is more than double the volatility of the dividend stream from Australian equities. In addition, the income from dividends has been materially higher.

With this backdrop, equity income investors are increasingly valuing the more dependable nature of dividend streams especially from higher quality companies and are worrying less about short-term capital volatility associated with share markets.

Asset managers have helped with this process through educating investors on the opportunities and risks of equity-based strategies and by developing specialist funds to enable them to benefit from these attractive income streams.

  • Longevity risk

Australians are living longer. As the chart below shows, the average life expectancy of Australian men and women is now over 90 years, having increased by an average of around 20 years since 1960. So, the probability (risk) that we outlive our savings is growing – this is known as longevity risk.

Chart 2: Australian life expectancy (at birth)

Source: Australian Institute of Health and Welfare, Australian Treasury Intergenerational Report, ABS, March 2018

And not only are we living longer but more and more of us are entering retirement.

Over the next 40 years Australia’s population will experience a major shift – a far greater proportion of the population will be older – as the dominant baby-boomer generation moves into retirement, and these older Australians will be living longer. This combination will significantly increase the nation’s pension expenses and upset the balance between retirees and the working age people who are funding the pension system. Currently, for every person aged 65 and over there are 4.5 people of workforce age (15 to 64) contributing their taxes to help fund pensions. This is forecast to decrease to around 2.7 people per retiree by 2055, putting an increased strain on the entire system[1].

This all points towards continued growth in demand for income generating investment solutions, particularly given the prevailing ‘lower for longer’ view of interest rates. In this world, equities can carry much of the burden, especially funds that utilise proven active management focused on uncovering the highest quality, most sustainable, dividend streams.

The real risk/return trade-off for income investors

For the reasons outlined, investors seeking income need solutions that can generate a yield high enough to meet their requirements today, that is sustainable over the long-term, that can be expected to grow at least in line with inflation, whilst also protecting their hard-earned capital base. In our view, this requires a change in investor behaviour and the need to challenge some traditional investment approaches.

Given these specific risks, what is the true risk/return trade-off that applies to income focused portfolios?

The traditional approach to investing looks at the potential total return of an investment (capital plus income) and compares it to the expected risk. The aim is to create a portfolio that can deliver the best possible return for a given amount of expected risk. But this only makes sense if your investment objective is focused on total return. If you are an income investor, your objective is to generate a sustainable and growing income stream. Hence a different approach to investing and portfolio construction is required as low risk in this context is defined as income sustainability.

Chart 3: Expected income versus income risk

 

Source: Martin Currie Australia, ASFA, Factset; as of 30 June 2018. Income is calculated using manager assumptions for each asset class – because of this, the returns quoted are estimated figures and are therefore not guaranteed. *Data calculated for representative Legg Mason Martin Currie Australia Equity Income (1), Real Income (2) and Diversified Income (3) accounts in A$ gross of management fee; gross performance data is presented without deducting investment advisory fees, broker commissions, or other expenses that reduce the return to investors. Assumes zero percent tax rate and full franking benefits realised in tax return.

The chart above examines how the major asset classes fare when the portfolio construction trade-off is redefined as expected income versus income risk (also known as the expected volatility of the income stream).  Term deposits have deeply disappointed as the dramatic drop in interest rates over the past decade means that the volatility of the income offered is high and actually worse than the income volatility from emerging market shares. Australian shares and A-REITs do much better and these can be improved still further by dedicated equity income strategies that target the companies that matter most to income investors – those with high dividends that are both sustainable in difficult economic conditions and are expected to increase in value over time.

Legg Mason Asset Management Australia Ltd (ABN 76 004 835 849 AFSL 240827) is part of the Global Legg Mason Inc. group. Any reference to ‘Legg Mason Australia’ is a reference to Legg Mason Asset Management Australia Limited. Legg Mason Australia is the responsible entity of the Legg Mason Martin Currie Equity Income Fund (ARSN 150 751 821), the Legg Mason Martin Currie Real Income Fund (ARSN 146 910 349) and the Legg Mason Martin Currie Diversified Income Fund (ARSN 169 461 116) (Funds) and Martin Currie Australia, a division of Legg Mason Australia, is the fund manager of these Funds. Before making an investment decision you should read the relevant Product Disclosure Statement (PDS) carefully and you need to consider, with or without the assistance of a financial advisor, whether such an investment is appropriate considering your particular investment needs, objectives and financial circumstances. The PDS is available and can be obtained by contacting Legg Mason Australia on 1800 679 541 or at www.leggmason.com.au. The information in this article is of a general nature only and is not intended to be, and is not, a complete or definitive statement of the matters described in it. The information does not constitute specific investment advice and does not include recommendations on any particular securities. Legg Mason Australia nor any of its related parties, guarantee the repayment of capital, rate of return or performance of any of the Legg Mason Funds referred to in this document.

[1] Australian Department of Treasury, 2015 Intergenerational Report, Chapter 1.

Important information: Any express or implied rating or advice is limited to general advice, it doesn’t consider any personal needs, goals or objectives.  Before making any decision about financial products, consider whether it is personally appropriate for you in light of your personal circumstances. Obtain and consider the Product Disclosure Statement for each financial product and seek professional personal advice before making any decisions regarding a financial product.