Portfolio Construction

Retirement portfolios

Defining objectives

Background

For many, approaching retirement is often characterised by heightened emotion and anxiety associated with competing life goals and financial objectives. Each of these will typically have different time horizons and be prioritised in different ways. Most retirement portfolio construction approaches rely solely on risk profiling as the primary mechanism to then implement a traditional investment portfolio.

The problem is that such an approach is unlikely to capture all that is important to retirees who typically have multiple investment objectives. Additionally, many investment decisions are investment product driven, rather than strategy driven. Lonsec believes the focus should be on investment strategy, with product selection simply being a vehicle to execute a strategy, rather than the driver of the strategy.

Objectives-based approach

One of the key differences with Retirement portfolios is the fact that they should not be created with just the traditional “set-your-asset allocation and get what the market gives you” approach.

Rather, they should be designed to meet the specific needs & objectives of investors in the retirement phase seeking a sustainable income and some capital growth, while limiting risks that are particularly relevant to retirees, such as market and inflation risk. This is reflected in the underlying exposures to certain asset classes, as well as the types of investments that can be selected for the construction of the portfolios.

Defining retirement objectives

Defining investment objectives is a critical part of any investment strategy. When in the accumulation phase of superannuation, goals typically focus on maximising wealth. However while in retirement, the primary focus is typically on maintaining lifestyle.

The primary goal for most retirees is to have and maintain a certain standard of living. The ‘rule of thumb’ income replacement goal in retirement is 75 percent of an investor’s pre-retirement income. The ability to generate that level of income is dependent on a number of factors, most notably, a member’s superannuation balance. For many retirees this will be an unrealistic goal and there will be a requirement to prioritise objectives and manage expectations.

Another reference point is the ASFA Retirement Incomes survey, which estimates how much may be needed for a ‘modest’ and ‘comfortable’ retirement.

While income generation is an overarching goal for most retirees, it is important to segment and prioritise retirement objectives, and then identify investments to achieve each of these objectives. This enables investors to ensure that the level of risk taken to achieve these goals is appropriate.

Three broad types of retirement goals

Most retirees will have multiple investment objectives, different time horizons and sensitivity to risk. Lonsec broadly segments these goals into basic income, lifestyle and aspirational goals.

Basic income

The non-negotiable level of income required to meet everyday living expenses, such as utilities, food, shelter and clothing. Determining the level of basic income will generally be captured in the fact find questionnaire, which typically includes an assessment of an investor’s individual balance sheet (i.e. income and expenses). For the majority of Australians, the Age Pension will form at least part of their basic income requirements.

Lifestyle

Lifestyle goals will generally include a mix of income and capital objectives that will match individual lifestyle goals eg. annual holiday, new car, or building long term wealth.

Aspirational

Meeting basic income and lifestyle objectives will satisfy retirement objectives for most retirees. However, for some with sufficient assets, aspirational goals such as intergenerational wealth transfer or philanthropic goals will be relevant. The characteristics associated with these objectives will generally have different timeframes and tolerance to risk associated with them.

For the rest of this series, we will largely focuses on the basic income and lifestyle segments as they are relevant to most Australians.

In the next article in the series, we look at the problem with traditional risk profiling.

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