Retirement Insights Archives

Media Release: Lonsec Managed Accounts add over $100M in October

Lonsec’s managed accounts have posted the fourth consecutive month of record growth in October, adding $100m in net inflows across its broad suite of diversified, retirement and listed portfolios.

The results highlight the success of Lonsec’s research-backed managed account model, which combines Lonsec’s portfolio construction expertise with Australia’s largest investment product research team.

Lonsec CEO Charlie Haynes said more advisers were turning to Lonsec for a professional, actively managed investment solution, whether off-the-shelf or tailored to a licensee or practice’s needs.

“The success of our managed portfolios comes down to three things: our investment philosophy, the diversity of expertise on our investment committees, and our research capabilities,” said Mr Haynes.

“Our active approach to asset allocation and asset selection, coupled with our ability to identify high-quality investments based on our extensive research coverage is proving attractive to advisers.”

The growth in Lonsec’s managed accounts reaffirms the importance of knowledge as well as execution, positioning the company as a major provider of investment solutions, along with its traditional research offering.

Part of the appeal is the breadth of Lonsec’s solutions, including diversified multi-asset portfolios, objectives-based retirement portfolios, listed portfolios, and direct equity SMAs. All are underpinned by the same proven philosophy and dynamic approach to portfolio management.

“Lonsec is known for its research and investment insights advisers and investors can trust, but more and more advisers are approaching Lonsec as a one-stop-shop for their investment solution needs,” said Mr Haynes.

Lonsec will add to its suite of investment solutions with the imminent launch of its Sustainable Managed Portfolios. These draw on Lonsec’s latest sustainability research to construct high-quality, risk-managed portfolios that target sustainable themes.

“The Sustainable Managed Portfolios are a great example of how Lonsec continues to develop its offering to meet a wide range of investment needs,” said Mr Haynes.

“We want to help advisers provide a genuinely sustainable investment solution that aligns to their clients’ values and investment objectives.”

Release ends

November 4, 2020/by Gordon Toy

20 Lessons from 20 Years of Quality and Value Investing

The following lesson is one of IML’s ‘20 lessons for 20 years of quality and value investing’, which were recently published by Anton Tagliaferro and the IML investment team to mark 20 years since IML was founded.

We chose this lesson for Lonsec Retire, as it highlights the need for growth assets in retirement, particularly for early retirees who typically have investment timeframes of 20+ years.

The lesson illustrates the benefits of compounding by showing how companies that reinvest back into their businesses can reward investors with increasing dividends and appreciating share prices over the long-term. Increasing dividends is vital for retirees facing significantly lower returns from popular retirement income streams such as term deposits and traditional fixed income funds.

#6 The Power and Benefits of Compounding Over Time in Equity Portfolios

Most people are familiar with the concept of compound interest when it comes to term deposits, where one can earn interest on interest by continuing to roll over a term deposit. However, many investors do not relate the concept of compounding to their investments in the sharemarket.
Compounding occurs in the sharemarket when income from an investment is reinvested back into the business, and investors are rewarded with the benefits of increasing profits and appreciating share price growth over the long-term.
For investors in the sharemarket, there are two ways compounding can work in their favour to enhance their long-term returns.

These lessons are available both in hard copy and e-book format. For a copy of the book please register your interest here or email iml@iml.com.au

**IML and Lonsec Investment Consulting will be holding a webinar as part of Lonsec Retire Program on Wednesday, February 12th, find out more.

January 28, 2020/by IML

Industry Retirement Insights, Retirement Insights

Income, Growth and Certainty

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

Important Information

This document is intended for licensed financial advisers and institutional clients only and is not intended for use by retail clients. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document. Financial conclusions are reasonably held at the time of completion but subject to change without notice.

Talaria Asset Management Pty Ltd ABN 67 130 534 342, AFS Licence No, 333732 assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, Talaria, its directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.

June 25, 2019/by Talaria

Industry Retirement Insights, Retirement Insights

Five Years On: Lessons of Low-Volatility Investing for Retirement

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).

May 15, 2019/by Alliance Bernstein

Industry Retirement Insights, Retirement Insights

Market Volatility: How Is It Measured and Is It Relevant to Investors

To access the insights, please click here.

May 10, 2019/by IML

Industry Retirement Insights, Retirement Insights

Legislated means test changes and advice opportunities

An in-depth analysis of the new social security means test assessment of lifetime income streams and the significant opportunities it presents for retirement income advice.

To access the insights, please click here.

May 10, 2019/by Challenger

Industry Retirement Insights, Retirement Insights

The Future of Retirement Won’t Be a Cliff-edge Goodbye to Work

Imagine a baby is born in Europe at the very moment you finish this article. That child can expect to live for two minutes longer than one born as you finish this sentence. Increasing lifespans threaten to topple the current pensions model. But, then again, maybe it’s time for a change.

To access the insights, please click here.

May 10, 2019/by Fidelity International

Industry Retirement Insights, Retirement Insights

Australian Quarterly Update

What are the real underlying structural forces bewildering the RBA? Is cash the king once again? Find out more about these and other interesting topics in Pendal’s latest review of fixed interest markets.

To access the insights, please click here.

May 10, 2019/by Pendal

Industry Retirement Insights, Retirement Insights

20 lessons from 20 years: #4 Dividends are key

I have learnt over my many years of investing that there are three reasons why dividends are key for investors:

1. Dividends are an important part of the return of an equity portfolio

2. The level of dividends is not impacted by the level of the sharemarket

3. The dividend yield on stocks can act as a ‘safety net’ in times of volatility

Dividends are an important part of the return

Over the long term, returns from an equity portfolio come from 2 sources – the capital appreciation from the shares held in the portfolio as well as the dividends received.
When one analyses the returns of these two components from the Australian sharemarket (the ASX 300) over the last 20 and 40 years the results are as follows:

Source: Calculated using IRESS data indices 31 December 1979 – 30 June 2018

As can be seen from the table above around half of the returns from the Australian sharemarket in the last 20 and 40 years have come from dividends – emphasising how important the dividends received from one’s portfolios are to the total return received from that an equity portfolio over time.

The level of dividends received are not impacted by the level of the sharemarket

While the level of capital returns from an equity portfolio over any period depends on the movement in the share prices, the level of dividends received by an investor from an equity portfolio is dependent on the performance of the underlying companies’ earnings. The level of dividends and the dividend payout ratio of any company is set by the Board of the company and is generally a reflection of the overall profitability of a company – independent of its share price.

This is an important point to remember as it means that in negative periods in the sharemarket, an investor’s level of dividends from a diversified portfolio – if made up of quality companies with the right attributes – should not vary greatly from year to year and is largely irrelevant of what is happening on the overall sharemarket.

The chart below demonstrates this by comparing the volatility of the level of capital return to the level of dividend from the ASX 300 over the last 20 years.

Chart 1: volatility of returns of capital and income of the ASX 300 over 20 years

Source: IML, S&P ASX300 31/03/1998 – 30/06/2018

As can be seen from the chart above while the level of capital returns’ volatility has been quite high over the last 20 years – not surprisingly perhaps as it contains periods such as the tech boom and bust and the GFC and Eurozone crisis – the volatility of the dividends received by an investor from the ASX 300 has been very low – depicting the steadiness of dividends and this part of an investor’s returns.

The movement in the sharemarket particularly over shorter time periods of 6 to 12 months is more often than not dictated by the mood of investors. The mood of investors is impacted by things such as the predictions for future level of economic activity, inflation and interest rates as well as perceptions of geopolitical stability.

Often with hindsight what are quite minor events from an economic standpoint can cause the mood of investors to sour markedly and lead to large declines in the sharemarket. For example, Iraq’s invasion of Kuwait in 1991 led to all sorts of gloomy predictions about an impending global recession by many market analysts and economists.

Times of a perceived crisis can cause many investors to panic, and the prices of most shares can fall heavily initially as many investors/traders reduce their overall level of sharemarket exposure by rapidly selling shares indiscriminately and independent of their quality. What I have observed over the many years of investing is that once the panic subsides and some sort of normality is restored, those companies with sustainable earnings that can support a healthy dividend stream are often the shares that recover the quickest.

The reason for this is fairly obvious – rational long-term investors are always attracted to companies that pay a healthy dividend from a sustainable earnings stream as they understand that the level of returns from dividends is not dependent on future share price performance.

In other words, once shares in quality companies fall to a level where the dividend yield is attractive, this attracts long-term investors to start buying these shares as they ‘lock in’ the attractive dividend yield, despite a volatile sharemarket.

Concluding remarks
The lesson for investors is to always remember the importance of dividends when investing in the sharemarket. Dividends provide sharemarket investors not only with a consistent part of their total return but can also act as a ‘safety net’ in down trending markets. Dividends also provide investors with a relatively stable part of returns through the delivery of real cash flow, irrespective of the sharemarket cycle.

As a bottom-up value manager, fundamentals are crucial to deciding which companies are included in IML’s portfolios – mainly the quality and transparency of the earnings, cash flow generation, gearing levels or balance sheet strength – which ultimately is what is important in the level of dividends paid by companies to investors.

While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.

Anton Tagliaferro, Investors Mutual Limited

August 10, 2018/by IML

Industry Retirement Insights, Retirement Insights

Natural or artificial? The choice for retirees on reducing portfolio volatility

When it comes to investment objectives, many retirees―quite understandably―want to have their cake and eat it: they want enough income to enjoy an adequate lifestyle for their remaining years, and they want to preserve enough capital so that they have some insurance against adversity.

From an investment perspective, the key to meeting these potentially conflicting demands lies in strategies that can reduce volatility in retirees’ portfolios and produce reasonably consistent total returns that would help meet both these income and capital objectives.

Financial-market turbulence or asset-price volatility work against nearly all investors, but particularly retirees, who―because they are drawing down capital to meet expenses―are less able to recoup losses when markets recover after downturns.

Broadly speaking, low-volatility strategies fall into two categories: those that use derivatives, and those that don’t. From an investment perspective, both have their advantages and disadvantages, and some investors will naturally prefer simplicity to the complexity implied by derivatives.

But how should retirees, given their special investment objectives, weigh these strategies’ relative merits? They should consider several factors, in our view, including volatility, price and performance. Just as importantly, they should also reflect on their own behavioural biases.

Avoiding Index Volatility

Let’s look, first, at how such strategies compare in terms of general characteristics. An equity-based strategy will typically rely heavily on its manager’s stock-picking ability, which will be essential to identifying shares which have relatively low correlation to the market’s ups and downs.

This is important, because it’s a well-attested fact that a portfolio of low-volatility stocks can outperform a broad index-based portfolio over time, on a risk-adjusted basis. It’s a phenomenon commonly known as the “low-volatility paradox”.

There are several types of derivatives-based low-volatility strategies, and one question that a retiree might want to ask in assessing them is: what role, if any, does stock selection play, and does it try to take advantage of the naturally-occurring low-volatility paradox?

Perhaps surprisingly, some derivative-based strategies have little if any concern about singling out low-volatility stocks for their equity portfolios. Instead, the portfolios replicate the broad market index while a derivative overlay attempts to smooth out the inherent volatility.

This need not be a bad thing, but there are two points to bear in mind. The first is that derivatives cost money, and the cost is likely to be reflected in the management fee. How does the fee charged by the derivatives-based strategy compare to its equity-based counterparts?

The second consideration is that the Australian share market, which is small and concentrated by world standards, is inherently volatile. The financials and materials sectors, which are both volatile, make up about 33% and 18% of the S&P/ASX 300 Accumulation Index respectively.

This means that some derivative overlay strategies―for example, put or call options on the S&P/ASX 300―need to offset broad market volatility to be effective.

One of the problems with this is that market volatility can take different forms―a short, sharp fall, for example, or a slow grind downwards―and some derivatives strategies are better able to deal with specific types of volatility than others.

A retiree looking at a derivatives-based strategy, therefore, needs to understand which kind of volatility the strategy is best equipped to handle. Strategies designed to offset many kinds of volatility tend to be expensive.

By contrast, an equities-based strategy using a portfolio of carefully selected low-volatility stocks starts off by being inherently less volatile than the market.

Managing the Upside and Downside

Relative performance is another point to bear in mind. The reason that low-volatility stocks can outperform the broad market over time is that they tend to lose less in a downturn but participate―not fully, but enough―in the upturn when markets recover.

Their limited exposure to downside risk means that they have less ground to make up when markets recover. This, combined with sufficient participation in the upside, explains how they can outperform over the medium to long term.

While the limitations in upside/downside behaviour of low-volatility stocks can be regarded as natural and inherent, however, the limitations on the upside and downside potential of derivatives-based strategies are essentially artificial.

For example, some derivatives-based strategies might attempt to limit downside risk by buying put options on their underlying stocks, and seek to offset the cost of this by selling a call option on the same trade.

The purchased put option would give the manager the right to sell the underlying stock at a predetermined price if the market price of the stock fell, while the sold call option would oblige the
manager to sell the stock at a pre-determined price if the stock’s market price rose.

In other words, the potential for this strategy to participate in market upside is limited by the sale of the call option. Some derivative strategies even target the income opportunity available from selling both calls and puts, thereby limiting both their upside potential and ability to limit downside risk.

Having weighed these pros and cons from a dispassionate investment perspective, what other factors should the retiree consider?

Behavioural Considerations for Retirees

Top of the list should be the retiree’s own risk appetite and financial circumstances―in respect of which there is no substitute for professional financial advice. The issue may not be “Which strategy should I choose?”, but how best to use both kinds as a form of portfolio diversification.

Either way, there are points that both the adviser and retiree may wish to consider, in our view.

One is that retirees tend to take a lot more interest in their investments than they did when they were in the accumulation phase and preoccupied with careers and raising families. Given their likely level of financial expertise, would they prefer to monitor complex or relatively simple investments?

As a general point, equities-based low-volatility strategies tend to be simpler and more transparent than their derivatives-based equivalents, and a lot easier to understand.

The other is the fact―well recognised in the literature of retirement planning―that our cognitive abilities tend to decline after the age of 75. Financially expert or not, it’s unlikely that most retirees would want to be grappling with the minutiae of derivatives strategies during their sunset years.

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August 1, 2018/by Alliance Bernstein