A recent white paper by Lonsec and Milliman explores the conundrum facing retirees trying to balance security of income against the need for investment growth to fund greater longevity. With a variety of new solutions coming onto the market, this could be the time to rethink conventional wisdom, according to James Holt.
While the concept of objectives-based investing is not new, it is now increasingly dominating discussions as our multi-trillion dollar retirement pool awaits a tsunami of retiring baby boomers not yet ready to tone down their spending habits.
Investment researcher Lonsec Research and actuarial firm Milliman recently released a paper entitled ‘Boomers, herding, denial and zeitgeist: Who will be the first to grasp the post-retirement advice opportunity?’ to draw attention to the challenges of providing products for clients in this new paradigm.
With an average Australian likely to spend 20 years or more in retirement, there is an inherent contradiction in conventional retirement portfolios which emphasise security and capital preservation at all costs.
Whilst this paper draws on quite a simple model comprising only equities and cash, the core conundrum posed is clear.
As clients approach retirement there has always been an irresistible urge to shift away from “risk assets” like equities towards more “defensive assets” like bonds – yet at the same time retirees need more growth from risk assets to support the longevity of their retirement capital and maintain an income stream into their lengthening twilight years.
It also comes at the same time as bonds are delivering nearly the lowest yields in history – just when retirees need them the most.
So the question becomes, “Can your clients have their cake and eat it too?” Or, put another way, “Can they draw high levels of income, maintain exposure to some equity market growth – yet with lower volatility – all at the same time?”
In answering the question, a history lesson may prove a useful first step.
The income challenge gets harder
In July 2012 the US 10-year Treasury note hit the lowest level in 222 years. Not since the creation of the Treasury market in 1790 had investors been willing to pay so much for so little; a mere 1.379 per cent annual yield to lend to the US government for a decade.
In Australia, holders of 10-year bonds were receiving just 2.7 per cent. Bond yields have risen in the last year again but remain near multi-decade lows as the impact of unconventionally low interest rates and stimulatory monetary policy ricochet around the world.
The persistence of the so-called “bond bubble” valuations presents a number of risks. Firstly, the yield provided barely covers inflation let alone the income levels clients need to sustain a comfortable post-retirement lifestyle.
Additionally, as the local and global economies return to long-term growth rates, bond yields are likely to rise to more normal levels, resulting in capital losses for bond owners.
Opinion is divided on whether we will witness a spectacular bursting of the bond bubble, as in 1994, or merely a deflation in their value over time which offsets some or all of the income generated.
Our view is that the question of whether bonds deflate quickly or slowly is not the issue – the fact that investors will struggle to make any sort of real return for the remainder of the decade is the core challenge for client portfolios today.
Indeed in the United States research by Blanchett, Finke and Pfau shows that portfolios with higher allocations to equities – not bonds – have a better chance of paying out a 4 per cent income target over 30 years when US 10-year bond yields are between 2 and 3 per cent (as they currently are).
Some of the research these authors cite even suggest that clients with longer time horizons (eg, 40 years) could even consider portfolios comprised of equities only, a very radical challenge to conventional thinking.
Balancing income and volatility
While equities can provide income and more long-term growth to compensate for their higher levels of volatility, there is one special weakness with equities that reduces the willingness of retirees allocating more – so called “sequencing risk”.
Even though equities provide superior returns in the long run there is the risk that significant negative returns, particularly in the early years of retirement, can impair the limited capital retirees have available to them in the first few years of retirement.
With this in mind, there are ways of boosting the total income of a client’s portfolio without radically altering their fixed income component.
Rather, it is by altering the return profile of the equity portion of a client’s portfolio, not the fixed income portion, that can achieve a virtuous circle of results, by;
Raising the total level of distributable income for clients to fund their retirement lifestyles; and
Dampening portfolio volatility to give clients the equity exposure they need without the same level of risk as a normal equity fund.
Not only does this help resolve much of the income challenge but gives clients a better chance of preserving their capital for longer – dealing with the rising importance of longevity risk.
Two asset classes will be critical in achieving these goals.
Firstly, retirees will need to look at the equity income space more. These products use options markets to convert some future capital gains into up front income, or option premium.
Some of this can be distributed to clients and some can be used to control risk, allowing better management of up and down markets.
Properly managed equity income funds have therefore become an excellent way for retirees to generate income and at the same time capture the benefits of equity market exposure to lengthen the life of their portfolios in retirement without enduring the full force of the “sequencing risk” that equities carry.
Another asset class that could suit retirees are Australian Property Trusts, or A-REITs as they are now known. In some respects they have become the “forgotten asset class” as many investors came to treat all Australian equities as one investment sector.
But A-REITs have always occupied a unique space in between equities and bonds, sharing some characteristics of each; better yields than bonds, but less risk than equities, and with some conservative growth of 3-4 per cent p.a. as well.
Studies in the US by Brad Case and Susan Wachter indicate that REITs offer better inflation protection than most assets classes, whilst still providing high levels of distributions – yet another potential future risk that property trusts may help manage.
A new world of solutions
Superannuation has been one of the great success stories of Australia, with assets climbing to over 100 per cent of GDP in two decades.
But as we shift to drawdown phase, carefully protecting the assets that clients have saved over a lifetime can be just as important as creating returns in the first place.
As clients need more income, live longer lives and face more complex needs in different phases of retirement, our industry will need to continue to develop innovative new products – building on the ones outlined above – that meet those challenges.
James Holt is an investment specialist at Zurich.