Portfolio Construction

Retirement Portfolios

Portfolio construction & strategy

Background

In the traditional approach to portfolio construction, there is a direct relationship between the risk profile and a client’s asset allocation. In contrast, when using an objectives-based investment approach, investor objectives drive portfolio strategy.

Asset allocation critical

Typical portfolio construction approaches rely heavily on a singular view of risk, generally volatility, and do not account for other risks that become increasingly relevant to retirees such as drawdown risk, longevity risk or inflation risk. Such measures also fail to capture market behaviour and their relevance from an individual investor’s perspective.

Once an individual has retired, asset allocation becomes critical as it directly impacts a client’s ability to achieve their investment objectives. Many investors recognise they cannot invest their entire savings in cash-like securities, as this will severely impact the longevity of their portfolio.

Aside from investment objectives, other factors will have an influence on portfolio strategy. These factors will be particular to the individual client and include:

  • Total size of the investment portfolio.
  • Tolerance to absolute risk – i.e. how much money is a client willing to lose to grow their capital base or supplement their income?
  • How much liquidity will be sacrificed to guarantee income?

Using the Basic Income & Lifestyle retirement objective groups outlined earlier, what are the appropriate investment strategies to achieve these objectives and, importantly, the trade-offs involved.

1. Basic income

The ‘basic income’ layer aims to meet essential income needs to ensure all non-discretionary costs are satisfied. While the primary objective is to ensure essential income needs are met, there is also an overarching goal to manage longevity risk or not outlive savings. For many Australians, the Age Pension will be a source of basic income as well as being the last line of defence against longevity risk. However, most retirees will not be able to live solely on income provided to them by the Age Pension and will need to supplement this via their superannuation.

The main investments that meet basic income needs are relatively narrow and include bank deposits, term deposits and annuities. Each of these investments provide a relatively certain level of income, usually with some margin over the official cash rates. There is typically low risk to capital, however each differs significantly in terms and liquidity and inflation risk. In this era of ultra-low interest rates, the returns on these assets is quite low.

2. Lifestyle

The ‘lifestyle’ layer is the most complicated retirement objective set for the investor to determine. Furthermore, unlike the basic income objective, the lifestyle goal will typically involve elements of capital growth, yield and potentially capital protection. Therefore, to select the appropriate mix of investments for this layer, investors need to determine their priorities – for example, capital growth over capital volatility, or income over capital growth.

In most instances the client will need to supplement their basic income requirements with additional income to allow for discretionary spending. Unfortunately, this can occur at the expense of understanding the risks associated with the additional income.

Some retirees are happy to generate a modest level of income but may be motivated to leave a larger bequest or ensure that their savings grow to afford significant costs such as medical costs or assisted living arrangements. It is therefore important to understand the trade-off between capturing yield and preserving or growing capital.

For instance, more aggressive asset allocations might have the potential to deliver higher average returns or higher average yields, and thereby support longer retirement periods (longevity risk); however, their higher risk and volatility also significantly increases the danger of depleting assets early (sequencing risk).

Investments that are appropriate for achieving lifestyle goals have been categorised into three groups – growth, risk control and yield. These have been further divided based on the types of assets/products that may be suitable to consider in executing on lifestyle objectives.

Growth strategies

These include assets that are expected to generate growth over the long term, primarily equities, which can be further broken down into domestic and global equities and the relevant sub-sector such as emerging markets and small caps. The primary purpose of these assets is to grow capital over the long term, which is a core element of a diversified retirement investment strategy.

Risk controlled strategies

These refer to investment approaches that aim to manage some of the risks which impact retiree portfolios such as downside risk, inflation risk and sequencing risk (this is the risk that large negative returns or withdrawals early on in retirement will affect the portfolio’s long term performance). These strategies will generally look to achieve an absolute return target instead of a return relative to a market benchmark. Such strategies are particularly important for retirees, who in most cases require exposure to growth assets to meet their retirement objectives, but are also sensitive to market and sequencing risk, which can have a material impact on the longevity of investment portfolios.

Income yield strategies

These generally look to maximise yield, either by targeting investments that generate a relatively high level of yield or by adopting certain trading strategies to maximise yield. Assets that generate yield will span a wide range of investments, from equity strategies that look to generate a yield higher than that of the market, to fixed income products that generate a yield higher than the cash rate.

These products also span the risk spectrum in terms of capital volatility and other risks, such as sector risk, interest rate risk and so on. Understanding risk in a yield targeting strategy is critical. For example, many fixed income products that generate a high level of yield may be exposed to significant credit risk, while some high yielding equity funds are exposed to increased capital volatility.

Furthermore, particularly in the case of equity yield based strategies it is important to assess the sustainability of those yields, particularly in environments where yields are relatively high. In some cases, yield is generated at the expense of capital growth, hence balancing the two is important. Therefore, a retirement strategy solely comprising yield targeting strategies may be sub-optimal to achieve suitable client outcomes as clients will also need to grow their capital base to extend the life of their portfolio in retirement.

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