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.

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