2021: a retirement strategy journey
Financial planners in 2021 will likely find themselves spending more and more time developing strategies specifically tailored for clients who are in retirement.
The shift from “accumulation-focussed” clients to “decumulation-focussed” clients is already well underway, but will become even more pronounced over the next few years.
A key issue for planners is that the strategies required for retiree clients can be quite different to those prepared for clients still in accumulation mode. In order to best meet their retiree clients’ distinct requirements, financial planners will need to be adaptable and flexible in the solutions they offer.
The best approach for any individual client will depend on a mix of factors - the task of financial planners is to find the best strategy to meet the client’s needs, goals, financial resources, and understanding of advice and other financial issues including tax considerations, Centrelink benefits, Age Pension entitlements and the like.
Planners also need to consider a spectrum of retirement investment strategies, from a relatively simple ‘business as usual’ approach at one end to a significantly more complex ‘income layering’ approach at the other end. Chart 1 shows the spectrum of approaches for investment advice used by planners, comparing the different features of each.
Helping clients work out which strategy will best suit them will be an important part of financial planner’s work.
STRATEGY 1: SAME AS ACCUMULATION PHASE
The simplest approach is for retirees to continue with the same investment strategy from the accumulation phase into the retirement phase.
This approach may suit wealthy clients who have a sizable asset base which can generate sufficient income to fund their desired retirement lifestyle. But it may leave other retirees vulnerable. What’s more, a ‘simple’ strategy doesn’t mean that it is without risks.
Using the same investment strategy in retirement assumes that, at the time of retirement, the investment goal remains unchanged – and that the client is still a long-term investor and can continue to tolerate market risk.
For those who focus on the absolute level of real returns over the whole investment horizon, this may be a sound strategy. However, its effectiveness for many retirees is highly debatable and comes at the cost of flexibility. Using a potentially volatile investment portfolio to fund a steady income overlooks the sequence of return risk as well as retirees’ reducing risk capacity as they age.
Furthermore, the strategy focuses on overall lifestyle spending goals but fails to take into account the fact that retirees’ spending behaviour is often adjusted according to portfolio performance and time horizon.
STRATEGY 2: TRANSITION TO A MORE CONSERVATIVE ASSET ALLOCATION
Moving to a more conservative asset allocation strategy in retirement generally means having a portfolio with a large percentage allocated to low-risk and low-volatility assets such as conservative equities, fixed income and money market securities.
The low volatility of this strategy hedges the sequence of return risk and makes it suitable for retirees who value downside protection more than the upside growth.
However, if the downside is overly protected, the relatively constrained upside potential of the strategy may expose retirees to greater longevity risk and inflation risk.
Overall, this strategy is easy to understand for investors and may be most appropriate for those with a lower level of financial literacy.
STRATEGY 3: SIMPLE BUCKETING
Most planners are familiar with the bucketing approach – dividing the investment portfolio into separate components, or buckets, with each bucket serving different objectives.
A simple bucketing approach has only two buckets: a cash bucket and a diversified investment bucket. The cash bucket holds adequate cash (and cash equivalents) to cover retirees’ immediate financial needs – typically a year or two’s worth – while the diversified bucket has an allocation to relatively risky assets with the objective of achieving capital growth.
As the value of the diversified bucket increases over time (assuming good investment experience), retirees can transfer assets to the cash bucket so that their immediate cashflow needs continue to be met.
This approach has the important benefit of providing a short-term buffer against falls. It also allows planners to better manage the implications of rebalancing and selling growth assets on their clients, which is useful for managing sequencing risk and market risk.
This simple bucketing approach may also help reduce the effect of the potentially constrained upside of the conservative asset allocation approach.
STRATEGY 4: COMPLEX BUCKETING
An upgraded version of the bucketing strategy is to take a more sophisticated approach which is specifically tailored to retirees’ more detailed spending needs.
It also follows the principle of dividing retirees’ accumulated savings into discrete pools, each with different objectives. However, in addition to a cash bucket (in this case covering two to three years’ expected expenses) and a diversified investment bucket, it also has a capital-certainty bucket to provide an additional layer of income support.
This bucket blends in some risky asset classes and covers the few more years’ expected expenses (usually three to five years). Specifically, this bucket could be a bond ladder – a selection of fixed-income securities with each security maturing at a different date to replenish the cash bucket or a term annuity.
The complex bucketing strategy manages risk by segmenting retirement investments into different time horizons. Compared to a conservative allocation strategy, which allocates assets based on the largest loss a retiree can stomach in a market downturn and optimises asset allocation to avoid capital depletion, the complex bucketing strategy seeks to broadly match asset duration to the liability (or expenses) duration, ensuring that funds are available as and when expenses arise.
This ‘asset-liability matching’ approach is the cornerstone of the strategy. Matching short-term spending requirements with cash and short-term bonds provides investors with confidence that money will be available when it’s needed, even if investment markets are at that point in decline. Matching long-term expenses with relatively long-term assets, such as equities, provides investors with a greater expected return with that part of their portfolio, with the aim of ensuring capital is available to meet the expected future spending need.
A strength, and a challenge, of the complex bucketing approach lies in replenishing or rebalancing the cash and capital-certainty buckets over time. It is a relatively complex strategy to establish and to manage – it requires regular review and potential manual rebalancing by the financial planner to ensure the buckets continue to serve their intended purposes.
STRATEGY 5: INCOME LAYERING (GOAL SEGMENTATION)
An income layering strategy, like the complex bucketing strategy, divides a retirement portfolio into separate components, but bases those components on retirees’ spending needs for life.
Generally speaking, retiree spending needs can be grouped into four distinct categories: basic living expenses; contingency expenditures; discretionary expenses; and legacy (or ‘leaving something for the kids‘).
The income priority is matched to the spending priority, with income for essential spending being the top priority. Retirees have their own trade-offs between spending more on discretionary items in early years of retirement and being more certain of meeting goals in later years, and the layers of this strategy can be tailored to suit.
The income layering approach separates retirees’ needs from their wants, or ‘nice-to-haves’, and prioritises income accordingly. High-priority needs are protected from market volatility for life, with the portfolio anchored by the age pension (if eligible). Income to pay for essentials can also be secured, and sourced from annuities.
Budgeting and creating income streams for clients’ expected lifetime can be a complex task. An income layering strategy requires close collaboration between planner and client, and regular reviews to ensure the strategy remains effective in light of any changes in the client’s personal circumstances or in market conditions.
Determining the best strategy, or combination of strategies, is a significant part of the value a planner brings to the table.
In addition, planners have legal obligations to clients under the Future of Financial Advice (FoFA) laws – primarily, but not only, the best interests duty and related obligations, as well as ethics requirements. Planners are obliged to make sure the advice they give leaves a client better off than if the client had not sought the advice, and a planner must be sure that the advice provided is clearly understood and agreed to by the client.
Richard Dinham is head of client solutions and retirement at Fidelity International.
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