Jeff Rogers explores goals-based investing for retirees, highlighting that retirees’ goal priorities in terms of their needs, wants and aspirations in retirement determine “risk capacity”.
Designing appropriate investment strategies for retirees is more challenging today than it has ever been.
In the past, nominal and real interest rates were higher while average life expectancy was shorter. Furthermore, a larger number of workers had defined benefit schemes, which provided greater certainty over their final account balance and their ability to enjoy a comfortable retirement.
Today, it is a different story. Interest rates are at historical lows and we believe they will remain so for years to come, life expectancy is longer, and most Australians have modest superannuation balances at retirement. Therefore, in order to improve the likelihood of achieving their retirement goals, retirees need to accept market risk.
To this end, most retirees with allocated pensions invest in traditional diversified strategies. However, these strategies were originally built with an objective of wealth accumulation rather than consistency of income in retirement. These are two very different propositions.
Adding to this challenge are the recurring bouts of exaggerated market volatility, which have heightened concern among clients who wish to avoid unpredictable influences on their retirement savings.
This concern has led many to switch to cash and term deposits, a worrying trend which we believe jeopardises their long-term wellbeing in retirement.
While periodically reducing market exposure may be part of a prudent investment strategy, problems arise when customers choose to shun volatility on a prolonged basis and then lack the confidence to re-engage with markets.
According to our modelling of strategies focussed on cash and term deposits, it is highly likely that retirees will not succeed in funding their essential needs, let alone provide for other lifestyle choices, if they adopt too conservative an investment strategy. Retirement is a long-term game. Too large a commitment to short-term assets is likely to lead to poor retirement outcomes.
So it is apparent that retirees need to accept market risk in order to improve the likelihood of funding their key goals in retirement. Indeed, to this end, most retirees with allocated pensions do adopt diversified investment strategies post-retirement.
However, we observe that a large number of customers maintain the same investment strategy post-retirement as they adopted in the accumulation phase of their lives. While this appears understandable given they have demonstrated a comfort with the level of volatility of their fund in accumulation, we note that these strategies have not been designed with the progressive withdrawal of cash flows in mind.
Kicking retiree goals
There is no line of sight between the investment strategy and retiree spending goals. In addition, this approach fails to address one of the most significant investment risks to which retirees are exposed — a significant market event at the point at which their wealth is largest.
The investment problem in retirement differs meaningfully to the investment problems for which our traditional investment strategies and products have been designed.
Solutions should be based on a deep understanding of an individual’s goals in retirement and their relative priority. We assign these goals to three categories – the needs, wants and aspirations of individual retirees — something we call the hierarchy of goals.
These goals include providing a retiree with the confidence that they can meet their regular cash flow needs or that they have the financial flexibility to achieve their discretionary lifestyle goals, as well as legacy aspirations such as leaving a bequest.
In our view, rather than investing in a single diversified fund aligned to their “risk tolerance”, retirees are better served by a series of sub-accounts with specific strategies to separately fund their needs, wants and aspirations in retirement. In this framework the “riskiness” of a strategy is measured in terms of the likelihood of failing to meet the goal. Higher priority goals are funded by strategies with lower levels of “riskiness”. In this approach it is the priority of the goal that determines “risk capacity”.
The approach aims to ensure that current assets will generate sufficient income to meet future obligations for retirees. The ‘goal’ is not necessarily to achieve the greatest return on assets, but to match those assets’ deliverable cash flow profile with retirement liabilities. In essence, this aims to make sure that the ‘surplus’ over the funded status is as smooth as possible.
We can then design investment strategies best positioned to deliver the cash flows which are required to fund each category of goal. These strategies need not conform to the traditional combination of strategic asset allocations and benchmark-focused asset class portfolios. Asset allocations can be more dynamic and sector strategies more focused, and are tuned to provide clients with confidence that they are on track to achieve their specific goals.
Jeff Rogers is the chief investment officer for ipac funds at AMP Capital.
