The protection equation

As the memory of a retirement funded by a 'risk-free' investment in bank term deposits fades into history, the current generation of retirees must come to grips with the challenge of maintaining income over a much longer retirement period than the generations before them. 
 
And as advisers know all too well, in the context of delivering sound (and safe) retirement outcomes, with interest rates close to zero, traditional sources of safety and protection for capital have been turned on their heads.  

INVESTMENT OF FIRST OR LAST RESORT? 

It's no secret that since the Global Financial Crisis (GFC) – and in a trend accelerated by COVID-19 economic policies – returns on the once income-investment-of-first-resort, term deposits have fallen by 96% (Chart 1).
In practical terms, that has seen annual term deposit income on a capital base of, say, $1.25 million fall from over $100,000 down to just $3,750 at current rates. 
 
There is no doubt that advisers have been forced to seek income from riskier assets such as equities and bonds – asset classes that have both benefited in the era of falling discount rates.
 
But as well as taking on greater drawdown danger (sequencing risk) from an increased weighting to equities, retiree portfolios balanced with higher passive bond exposures are worth looking into, having accrued the less well-appreciated interest rate risk. 

DURATION (PASSIVELY) CREEPING

Fixed income indices, which many investors have exposure to, have seen average duration – the sensitivity of a bond to a change in interest rates – spike since the GFC while yields have plummeted.
 
For example, the Australian Composite Bond Index (Chart 2) saw average yields fall 86% post the GFC, while duration roughly doubled from three years in the pre-crisis period to six years today.  
The incremental rise in bond index duration since 2009, sparked by a mix of macro- and micro-economic factors, has effectively doubled the risk of capital loss from interest rate rises. 
 
In this scenario, those with active fixed income exposure, will be benefitting from adjusted risk factor exposures. But for the ~$10 billion sitting in traditional passive bond exposures, the picture is likely one of high-duration interest rate risks and paltry yields.
 
Before the GFC when duration in the average fixed income benchmark stood at three years, a 1% increase in interest rates would create a capital loss of 3% in a bond portfolio. 
 
Now, under the current average bond index duration of six years, the same 1% rate rise would lead to a capital loss of 6%.
 
Clearly, an outcome that could surprise many retirees.  
This conundrum of low-interest rates means retirement portfolios could benefit from a higher portfolio allocation to shares and other risk assets. 
 
Theoretically, advisers could simply up weight portfolio exposure to higher-yielding defensive assets in the hunt for more attractive returns. Or, to equities, to capture the well-demonstrated superior long-term returns available from the asset class.  
 
But the reality is the defensive qualities of these higher-yielding 'defensive assets' can often be questioned in times of market correction. 
 
And the downside of an equities-heavy retirement portfolio, of course, is the higher drawdown risk that can decimate retiree funds while leaving them little time to recover (sequencing risk). Many retirees may also lack the risk tolerance (extreme loss aversion) or time required to ride out market downtimes. 
 
In practical terms, we know that when retirees are faced with riskier assets, they'll adjust their spending or downgrade their living standards, unnecessarily preserving too much of their capital. 
 
BUCKETING DOWN: TRADITIONAL RETIREE INCOME STRATEGY
 
Many financial advisers have adopted the ‘bucketing’ strategy to manage financial risks in retirement – namely sequencing and longevity – in a portfolio design that essentially allocates funds to three separate asset classes usually designated as cash, defensive (bonds) and growth (equities).
 
Depending on the risk profile and goals of the retiree client, advisers would allocate more or less to each ‘bucket’ (Chart 3). 
The cash bucket, for instance, can help offset sequencing risk by covering a few years of anticipated retiree spending requirements, reducing the need to sell down growth assets in the event of a market slump. Cash buckets typically centre on a portfolio of term deposits and at-call money in a 'liquidity ladder' designed to ratchet the most income from the asset class.
 
Meanwhile, advisers would put the remaining retirement portfolio in a mixture of bonds (for the defensive component) and equities (to drive the growth necessary to fund a retirement period of 30 years or more). 
 
In the case of, for example, a new retiree client with a ‘balanced’ risk profile and $1 million of superannuation savings to invest, the standard bucket investment strategy would go something like:
  • $180,000 in cash supporting a ‘comfortable’ living standard for three years requiring $60,000 or so each year;
  • $220,000 in defensive bonds for diversification benefits and stable income; and
  • The remaining $600,000 in growth (equities / alts) for long-term growth. 
 
Effectively, the above allocation works out as a 40% split between ‘safe’ assets (cash plus bonds); and 60% growth component. 
 
If we hone in on the defensive allocation (Table 1), based on current rates, the combined cash and bond buckets would deliver annual returns of 0.96% (comprising about 0.3% from cash and 1.5% from traditional defensive assets).
Obviously, the portfolio's cash/defensive buckets are grappling to keep up with inflation in the current low yield environment. Not ideal for clients keeping up with mandated minimum drawdown requirements. 
 
Despite offering a simple solution to the retirement income problem of balancing sequencing and longevity risks against market volatility, the bucketing strategy – as it stands today – might benefit from an enhancement. 
 
THE PROTECTION EQUATION 
 
It does not have to be a binary choice for retirees between a defensive portfolio (of lower-yielding assets subject to interest rate rises) and volatile share markets that are currently priced high based on many metrics. They can actually achieve both – safely. 
 
A number of new products are now available that fill the growing need for 'defensive alternative' strategies to sit alongside traditional defensive assets. The overall aim is to build defensive portfolios that provide retirees with returns from another protection building block, independent of the bond market.
 
This is where the power of the bucketing strategy – with its wonderful simplicity – can be enhanced even further by adding a fourth protection bucket. By allocating a portion to a purpose-built protected retirement product, advisers can provide retirees with exposure to growth assets essential to securing long-term returns while including a mechanism to limit losses from equity market drawdowns. Thus, addressing the 'protection equation' for retirement portfolios (Chart 4).
This ‘protection bucket’ has the ability to efficiently mitigating sequencing and behavioural risks, and allows cash to provide liquidity (what it does best). It can also generate potentially higher levels of return in a constrained low yield environment. 
where do protection strategies belong in retiree plans?
 
While annuities (which exchange capital for an agreed lifetime income) are generally well understood, protected retirement income strategies are relatively new in the Australian market.
 
Yet, the Government’s impending Retirement Income Covenant should broaden the appeal of such strategies, as it looks to “improve retirement outcomes for individuals, while enabling choice and competition in the retirement phase”. 
Typical protection products offer investors a choice of ‘cap’ and ‘floor’ return levels that provide a respective upper limit on market returns and a minimum capital protection.
 
For example, retirees could opt for a protection level that allows for losses of between 0% to 10% of the original investment in exchange for lower levels of protection investors will receive increasingly higher return potential up to a cap.
 
Protected retirement products that allow access to a number of ‘protection floors’ are usually backed by the safety and security of a life company regulated by the Australian Prudential Regulation Authority (APRA). 
 
Institutional-scale derivative investment strategies use ‘put’ and ‘call’ options to manage market exposures – and enable retirees to access the returns of growth assets without fear of losing the capital which underpins their lifetime income aspirations.
 
Fortunately, these new protection products are now opening up as a building block for those looking to defend long-term retirement income at sustainable levels.  
 
Tim Dowling is an investment specialist at Allianz Retire Plus.



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