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.

 

When accumulating savings for retirement, the investment objective is clear – to grow and maximise savings. Risk in the accumulation phase is also well-defined and focused on the loss of capital, as measured by the volatility of investment returns or related downside risk measures. Risk tolerance is then typically used to determine appropriate investment profiles, with the aim of achieving greater wealth to fund retirements.

However, the risk-return landscape becomes significantly more complex once retirement comes into the picture. The primary objective in the decumulation phase ceases to be pure growth and more about using accumulated wealth to sustain a target level of income throughout retirement. Therefore, volatility of investment returns is no longer a suitable risk measure as it does not describe the risk of failing to meet this objective.

Retirement income risk measure

Traditional measures of variance (standard deviation) focus on both upside and downside variation. However, behavioural economists commonly point out that individuals are more averse to downside variation than upside variation. A more relevant risk measure in the context of decumulation is the probability of running out of money, or a measure of income variation. This captures important dynamics such as the sequence of returns, which can be particularly damaging in decumulation.

The risk can be depicted as:

 

The importance of risk measurement in retirement products is highlighted in a Treasury consultation paper which proposes a range of standard metrics to help consumers make decisions about the most appropriate retirement income product for their own circumstances.

The discussion paper proposes that a measure of income variation be provided in respect of all retirement income products and this measure is presented on a seven-point scale.

The finance industry uses terms like longevity risk, market risk, sequencing risk and inflation risk, which are all relevant to the outcome experienced by investors in a retirement income product. However, these terms are not well understood by a lay person, so an income variation measure could help fill in some gaps.

Retirement objectives

Lonsec’s Retirement Lifestyle Portfolios are objectives-based portfolios focused on delivering a sustainable level of income in retirement, as well as generating capital growth. Specifically, the portfolios are designed to assist advisers in constructing portfolios to meet retiree essential and discretionary income needs, while generating some capital growth to meet lifestyle goals.

Differences to Lonsec’s core accumulation model portfolios are:

  • Income objective of 4% p.a. for all portfolios
  • Greater bias to AUD denominated assets – historically higher dividends, franking credits
  • Greater focus on absolute rather than relative performance
  • Constructed to manage capital drawdown risk
  • Fixed income allocations have less duration and greater credit exposure
  • Key building blocks are Yield, Capital Growth & Risk Control

In reality, risk in retirement is multi-dimensional. An individual retiree may have multiple goals, such as leaving a bequest, with a different level of importance attached to each. An individual’s risk aversion in retirement will therefore be defined by a holistic view of their retirement goals, and the risks to those goals across all scenarios that could play out during retirement. Typically, more than one risk measure is necessary, with multiple scenarios required to truly appreciate the risks inherent with each solution.

A combination of factors has created fertile ground for market volatility, resulting in a bumpy ride for super members, who have experienced six negative monthly returns over the past year.

According to SuperRatings, the median balanced option return for August was an estimated -0.5%, with the negative result driven by a fall in Australian and international shares. The median growth option, which has a higher exposure to growth assets like shares, fared worse, returning an estimated -0.9%.

In contrast, the median capital stable option, which includes a higher allocation to bonds and other defensive assets, performed more favourably with an estimated return of 0.3% (see table below).

Estimated accumulation returns (% p.a. to end of August 2019)

1 month 1 year 3 years 5 years 7 years 10 years
SR50 Growth (77-90) Index -0.9% 5.2% 8.8% 8.0% 10.2% 8.5%
SR50 Balanced (60-76) Index -0.5% 5.3% 8.0% 7.5% 9.2% 8.0%
SR50 Capital Stable (20-40) Index 0.3% 5.3% 4.8% 4.8% 5.4% 5.7%

Source: SuperRatings

Investors were caught off guard in August as trade negotiations between the US and China broke down, while a range of geopolitical and market risks, including further signs of a slowing global economy, added to uncertainty.

In Australia, a disappointing GDP result for the June quarter revealed a domestic economy in a more fragile state than previously acknowledged. Action from the Reserve Bank to lower interest rates is expected to assist in stabilising markets but could be detrimental for savers and retirees who rely on interest income.

Pension products shared a similar fate in August, with the balanced pension option returning an estimated -0.6% over the month while the growth pension option returned an estimated -1.0% and the capital stable pension option was mostly flat with an estimated return of 0.3%. Long-term returns are still holding up well, with the median balanced option for accumulation members delivering 9.2% p.a. over the past seven years (in excess of the typical CPI + 3.0% target) and the median balanced pension option returning 10.2% p.a.

Estimated pension returns (% p.a. to end of August 2019)

1 month 1 year 3 years 5 years 7 years 10 years
SRP50 Growth (77-90) Index -1.0% 5.9% 9.9% 9.2% 11.5% 9.4%
SRP50 Balanced (60-76) Index -0.6% 6.2% 8.7% 8.0% 10.2% 8.8%
SRP50 Capital Stable (20-40) Index 0.3% 6.2% 5.5% 5.5% 6.3% 6.4%

Source: SuperRatings

“There will always be negative months for super members, but the timing of negative returns can have a real impact on those entering the retirement phase,” said SuperRatings Executive Director Kirby Rappell.

“For members shifting their super savings to a pension product, a number of down months in relatively quick succession will mean they begin drawing down on a smaller pool of savings than they might have anticipated. As members get closer to retirement, it’s important that they review their risk tolerance to make sure they can retire even if the market takes a turn for the worse.”

As the chart below shows, down months in the latter part of 2018 took their toll on pension balances, although they were able to recover through 2019 to finish above their starting value by the end of August 2019.

Pension balance over 12 months to end August 2019*

Pension balance over 12 months to end August 2019
Source: SuperRatings
*Assumes a starting balance of $250,000 at the end of August 2018 and annual 5% drawdown applied monthly.

Comparing balanced and capital stable option performance shows that the balanced option suffered a greater drop but was able to bounce back relatively quickly. A starting balance of $250,000 fell to $232,951 over the four months to December 2018, before recovering to $252,091 at the end of August 2019.

In contrast, the capital stable option was able to better withstand the market fall, with a starting balance of $250,000 dropping to only $241,746 in December before rising back to $252,201.

While both performed similarly over the full 12-month period, a member retiring at December 2018 could have been over $8,500 worse off if they were in a balanced option compared to someone in a capital stable option. While a capital stable option is not expected to perform as well over longer periods, it will provide a smoother ride and may be an appropriate choice for those nearing retirement.

“Super fund returns have generally held up well under challenging conditions, but there’s no doubt this has been a challenging year for those entering retirement,” said Mr Rappell.

“Under these market conditions, timing plays a bigger role in determining your retirement outcome. At the same time interest rates are at record lows and moving lower, so the income generated for retirees and savers is less, particularly if someone is relying on interest from a bank account. In the current low rate and low return environment, it’s harder for retirees to generate capital growth and income.”

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.

 

A world-beating performance from Australian shares has been overshadowed by the re-emergence of geopolitical uncertainty and a wave of risk aversion in global markets, leading to softer performance for super funds in the final stretch of the financial year.

According to estimates from leading superannuation research house SuperRatings, the typical balanced option return was -0.7% in May as funds were dragged down by falls in international shares triggered by the re-emergence of the US-China trade conflict and uncertainty surrounding central bank policy.

The bright side has been the resilience of Australian shares and property, both of which saw a brief boost from the Coalition’s surprise election win, but this was not enough to save super funds from a month of negative performance.

Markets have since recovered following May’s weakness, but members should not expect a bumper end to the financial year. The year-to-date return is sitting at 5.1% for the median balanced option, which is below the 8.5% per annum return achieved over the past ten years.

Estimated median Balanced option returns to 31 May 2019

Period Accumulation returns Pension
returns
Month of May 2019 -0.7% -0.7%
Financial year return to 31 May 2019 5.1% 5.8%
Rolling 1-year return to 31 May 2019 4.8% 7.3%
Rolling 3-year return to 31 May 2019 6.8% 8.1%
Rolling 5-year return to 31 May 2019 6.6% 7.6%
Rolling 7-year return to 31 May 2019 8.7% 10.5%
Rolling 10-year return to 31 May 2019 8.5% 9.7%
Rolling 15-year return to 31 May 2019 7.5% 8.1%
Rolling 20-year return to 31 May 2019 6.8%

Interim results only. Median Balanced Option refers to ‘Balanced’ options with exposure to growth style assets of between 60% and 76%. Approximately 60% to 70% of Australians in our major funds are invested in their fund’s default investment option, which in most cases is the balanced investment option. Returns are net of investment fees, tax and implicit asset-based administration fees.

Members in the median growth option, which includes higher weightings to growth assets like Australian and overseas shares, suffered a larger fall of 1.2% in May, while the median International Shares option fell 4.0% and the median Australian Shares option held firm, returning 1.4%.

“It’s been a disappointing end to the financial year for super, but long-term performance remains robust,” said SuperRatings Executive Director Kirby Rappell. “The median balanced option return over the past 10 years is around 8.5%, indicating that super has delivered solid returns even in a low interest rate environment.”

Downside risks to the Australian economy, including weak inflation, falling home prices, and tighter credit conditions are taking their toll on consumer confidence, while the geopolitical risks in the form of US-China trade negotiations have also contributed to market volatility.

SuperRatings Index return estimates to 31 May 2019


Source: SuperRatings

However, the Australian market has held up reasonably well over the financial year to date, with the S&P/ASX 200 Index returning 7.6% so far to the end of May, outperforming global share performance of 6.3% measured by the MSCI World Ex-Australia Index. Listed property has been the leading asset class so far this financial year, with the S&P/ASX 200 A-REIT Index returning 14.5%. Both property and shares saw a modest boost in May with the negative gearing debate now effectively put to bed following the federal election.

“Labor’s negative gearing proposals were thought to favour developers by limiting tax concessions to new stock, but so far the improvement in sentiment has outweighed any negative impact, which may give some super funds a temporary boost to their property portfolios,” said Mr Rappell.

Long-term super performance steady

The negative performance for super funds in May has been reflected in a slight fall in the Balanced and Growth option indices for the month but long-term performance remains strong. According to SuperRatings’ data, $100,000 invested in the median Balanced option in May 2009 is estimated to have reached an accumulated $217,391 today.

The median Growth option is estimated to be worth $230,873 over the same period, while $100,000 invested in domestic and international shares ten-years ago is now worth $244,382 and $258,181 respectively. In contrast, $100,000 invested in the median Cash option ten years ago would only be worth $129,748.

Growth in $100,000 invested over 10 years to 31 May 2019


Source: SuperRatings

Release ends

When you ask clients how they think about risk in retirement, you are unlikely to get a textbook response. Instead, you’ll probably get a list of their deepest fears: running out of money, leaving their children with nothing, living too long, retiring during the next GFC, or not having enough cash on hand to pay for necessities.

When we define investment risks, we don’t define them in these terms, but these are the eventualities we’re attempting to guard against when we construct retirement portfolios. There are any number of objectives your client might be aiming to achieve, and each will come with their own set of risks.

Is it the chance of your investments going down? Is it asset class volatility? Is it not achieving the returns you need to meet your required income? In the end, risk is getting your investment strategy wrong by not understanding the relationship between your client’s competing objectives and associated risks.

For this reason, we believe there is a need to focus on retirement investing as a separate strategy. Even moving from the accumulation to the drawdown phase means you are managing a different set of trade-offs. The role of the financial adviser is not to eliminate the existence of these trade-offs but to manage them prudently in line with their client’s preferences and risk tolerance.

Source: Lonsec

Each of these competing objectives requires different investment strategies to achieve. For example, a rental property will provide the most consistent income but at the expense of liquidity. If we’re worried about market volatility we might be tempted to move to a more defensive asset allocation, but by foregoing growth we increase the chance of running out of money. In short, clients will always be exposed to various types of risk.

The problem with determining a client’s most important objectives is that often they are all equally important. Consider the following examples:

Paying the bills

Certainty of income is usually the key concern for retirees, but don’t discount the others. When you ask advice clients what their most important objectives are, the most common answers are things like relaxation, travel, family, and leisure. These all have a price associated with them. Liquidity is also a major consideration for retirees. Not having enough cash on hand for things like motor vehicle repairs and other essential spending can result in significant stress and prevent retirees from enjoying the things they were looking forward to after their working life.

Leaving a legacy

Most people wish to enjoy a comfortable life in retirement but also make sure their children and loved ones are left with some extra wealth. A 2017 ASFA study found that households are retiring with an average super balance of $337,000 (the gender breakdown is $270,000 for men and $157,000 for women). Leaving a meaningful inheritance or bequest would mean there is barely enough left over to support their own needs.

Maintaining purchasing power

As any basic economic textbook will tell you, different asset classes will perform better or worse in different inflationary environments. Inflation of 2% per year will erode more than half of your purchasing power over 35 years, which is the equivalent of a single GFC event. Managing inflation is just as important as managing sequencing risk or the risk of a large drawdown, even in periods where inflation is relatively low.

This adds an additional consideration to the construction of retirement portfolios. Real assets are a proven way of managing inflation risk, while fixed income is potentially the worst asset class for this purpose, with the exception of products like inflation-linked bonds.

Different assets perform differently depending on the inflationary environment

Source: Lonsec

Guarding against a crisis

If successfully timing the market seems more like luck than skill, then timing your retirement is no different. While market bumps are nothing to be feared when you’re building your wealth, a sudden major event like the GFC can spell disaster for those entering the decumulation phase. Sequencing risk refers to the order in which investors experience returns, and it can matter a great deal for retirement. Withdrawals during a falling market have the potential to accelerate the depletion of your asset base.

To see how this works, take a look at the returns from Lonsec’s balanced portfolio over the last 20 years. If you reverse the order of returns, there isn’t really much difference for those in the accumulation phase – both sequences deliver the exact same results over the long term. But for those drawing down on their investments, the reversed sequence results in the retiree running out of money much sooner.

The sequence of returns can mean the difference between having enough cash and running out

Source: Lonsec

Addressing sequencing risk requires advisers to look at a wider range of solutions, including variable beta or absolute return strategies, and even some more illiquid options to reduce volatility and manage drawdowns. Once again, there is a trade-off involved in making these decisions.

The reason we struggle to precisely define risk is that there simply isn’t a single source of risk that can be effectively managed or reduced to zero. Managing risk means understanding the often complex relationships between different retirement objectives. Effectively managing these relationships is the purpose of your investment strategy.

When we talk about risk at Lonsec in a portfolio context, what we are really talking about is the risk that the overall investment strategy is wrong or is not properly tailored to the client’s needs and preferences. This informs the approach we take to the management of our model portfolios as well as the selection of individual products to achieve a particular objective. We think this is the proper way to think about risk without being constrained by a single textbook definition, and it is the way in which advice clients intuitively understand risk as well.

With Australia’s economic expansion under threat, house prices falling, and a wave of people set to retire over the next decade, financial advisers are under pressure to provide advice and solutions that can withstand Australia’s future retirement challenges.

Lonsec’s Retire program addresses the growing need for the financial services industry to work together to come up with those solutions and strategies.

Lonsec has been running its successful Retire program for more than five years, and it continues to go from strength to strength. The schedule of content and events planned for the next 12 months is the largest yet, with nine Retire Partners now on board to deliver in-depth retirement insights, including:                          

Alliance Bernstein Fidelity      Legg Mason
Allianz Retire+  Invesco  Pendal
Challenger Investors Mutual  Talaria

Lonsec’s Retire Partners will be providing a wealth of content to help advisers understand and deal with a range of issues faced by advisers and their clients.

The program will really kick off on May 7th with the major Lonsec Symposium event at the Westin, Sydney. With more than 600 advisers and wealth managers already registered, along with an impressive line-up of high-profile speakers and industry leaders, this is a must-attend event for all retirement professionals.

The federal government has taken a step toward providing better retirement outcomes for Australians with the appointment of an industry panel to advise on the development of Comprehensive Income Products for Retirement (CIPRs).

Its brief is to help frame the government’s plans to require superannuation trustees to design and offer appropriate income products for their members in retirement.

The panel’s expertise suggests that the eventual framework will reflect a deep understanding of the legal and technical aspects of retirement as well as the social and financial-planning needs of retirees, and perhaps also their behavioural biases.

Regarding the design of income products, it will be interesting to see whether the framework will point super funds in the direction of annuity-like products or drawdown solutions or a combination of the two―or a more expansive and flexible range of choices.

More interesting still will be to see how effectively the framework synthesises these various elements because, as experience in other markets shows, retirees’ financial behaviour can have a direct impact on the success or otherwise of attempts to develop new retirement income products.

The UK is a case in point.

UK Retirees Sit on Cash

Up until 2015 the purchase of an annuity was effectively the only choice open to UK investors when they retired, but low interest rates and other limitations had made annuities unpopular. From that year, the government allowed retirees to choose between annuities and drawdown products.

Predictably, sales of annuities in the UK have plummeted, forcing a restructuring of the retirement income market. Progress to date has been slow, however, and of limited benefit to retirees.

For example, the drawdown alternatives to annuities are mainly high-cost, being accessed through financial advisers and invested in the markets. Perhaps not surprisingly, regulation of such post-retirement products has increased, making them potentially more expensive and harder to access.

At the same time, new product development has been slow. Inflows into those products which have been launched have been small, providing little incentive for competition.

It’s in relation to this last point that the financial behaviour of retirees appears to be most relevant.

Since the pension freedoms came into effect, many retirees have taken large volumes of cash out of their savings early, despite the higher tax charges this incurs.

They have put that cash mainly into (in order of magnitude) bank accounts earning little to no interest and, anecdotally, into cars, conservatories and cruises.

But that’s not all: large amounts of money have been left invested in plan default solutions. Consequently, the amount of money remaining invested beyond retirement, which is neither being drawn down nor added to but kept for a rainy day, has grown massively.

Little wonder, then, that inflows to new retirement income products in the UK have been small.

What lessons, if any, should the panel―and, indeed, the rest of the Australian retirement industry―draw from this?

Three Angles on Retirement Income

There are three, in our view. One is to integrate into the government’s framework some understanding of retirees’ behaviour with respect to savings and investment, its potential impact on demand for retirement products, and how retirement products might be designed with retirees’ behaviour in mind.

Another lesson is that some thought might usefully be given to the way retirees step from work to retirement. It’s at this point that retirees’ financial behaviour becomes an issue as they make, or fail to make, important decisions for their future.

Their decisions could conceivably improve if they had more time to make them. They could, for example, continue to enjoy some capital growth as well as income for many years before investing at a more advanced age in an income-only product.

The third lesson, which is linked to the second, is to view CIPRs as part of a broader retirement solution which includes equity products that can provide growth while managing downside risk, and fixed-income products that can provide reliable income with better-than-average stability.

As the UK experience shows, the key to creating a successful retirement-income solution might lie in understanding, and allowing for, a range of factors beyond that of simple product design.

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.

In recognition of the growing challenges facing retirees, Lonsec has published a paper on the role annuities can play in retirement portfolios. The paper explores some of the common issues facing retirees such as sequencing risk, longevity risk and market risk.

The main benefits and risks of annuities are considered as well as how annuities can mitigate these risks. The paper examines how annuities can work with the age pension and other investment products to help retirees meet essential spending objectives as well as provide for discretionary spending.

Lonsec believes that annuities are an attractive proposition for retirees looking to secure part of their retirement income stream, including in conjunction with the age pension, to boost the amount of guaranteed income during retirement. Additionally, Lonsec notes that there is a mass market of retirees for whom annuities may be appropriate, typically those with retirement savings of between $250,000 to $1,500,000.

Lonsec does not have a preferred means to best make an allocation to annuities within a diversified investment portfolio but notes there are two commonly held schools of thought. The first is to allocate from the defensive assets within a portfolio and the second is to ‘carve-out’ a separate allocation for the annuity and retain the existing asset class weightings over a smaller asset base.

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.