Dominic McCormick looks at investment portfolios for retirees and considers the best ways to minimise stress.
My parents have had plenty of stress in their lives. Running a sheep/cattle farm on the usually dry plains near Hay in southwestern New South Wales, my father encountered the usual farming challenges including, but not limited to: drought (often), fire (occasionally) and floods (very infrequently).
My mother, originally from Brisbane, arrived to somewhat sparse conditions at the end of the 1950s.
Before the 1960s were over she had seven children, (at one point, six of them under age six, including one with terminal leukaemia), helped out on the farm and later worked as a nurse at the local hospital (often night duty) to help put six children through Sydney boarding school.
Then there was the stress that six, sometimes difficult, children created.
Fortunately, since selling the farm and retiring in early 2002, they have had less stress (at least financial) than most, including through the global financial crisis (GFC).
However, this is certainly not because they had plenty of money. The proceeds of the farm sale would not have covered the purchase of a two-bedroom terrace in inner Sydney.
Rather, this lack of financial stress reflects the simple way their financial affairs have been organised (at least from their perspective).
And while I am not suggesting their arrangements, described below, should be copied, I do think they provide some valuable insights into developing ‘low stress’ portfolios that truly work for retirees — rather than those that seem designed primarily to work for the financial services industry.
Selling the farm
Basically, my parents’ total assets following the sale of the farm in 2002 have consisted of two components (excluding the purchase of a modest house in South Hay):
- Roughly half in cash accounts and term deposits that they (mainly my mother) have controlled and managed; and
- The other half as members and trustees of a DIY super fund/allocated pension (of which I am also a member/trustee and oversee from an investment perspective).
The DIY fund has a growth-oriented asset mix with wide diversification and flexible asset allocation across conventional and alternative investments.
The largest, core holding is an investment in a growth oriented multi-asset, multi-manager fund. This is complemented by some direct shares and specialist managed funds.
This growth focus goes against the conventional wisdom for retirees, but it makes sense because the ‘see-through’ allocation of the combined cash/term deposit component and DIY growth component is reasonably conservative (and also because the two other members, which includes me, are accumulation members).
My parents provide no input into the investment makeup of the DIY fund, and in fact pay limited attention to how it is invested.
Their main focus has been the non-super cash/term deposit component that has produced known, but low, income and with certainty of the capital value.
Having said this, the annual allocated pension payment has been vital in topping up this component and/or assisting with expenses.
Between the 4-6 per cent per annum interest earned on the cash/term deposit component and the low teens per annum average total return on the DIY/growth component over the last eight years, the combined return has been in the high single digits, a very satisfactory return given the period covered.
Not being subject to adviser or platform fees has also obviously helped returns, and these returns and arrangements have resulted in minimal if any personal tax.
This is not to say that it was all plain sailing. As with most portfolios some individual investments held have done poorly while some have done very well.
The DIY fund return was negative in financial years 2007-08 and 2008-09, with the worst of these minus 15 per cent.
There were also one or two anxious phone calls in 2008 in particular but with the comfort of the fixed value and predictable income of the cash/term deposit component they were much more relaxed than most investors at this time.
Of course, there were also the challenges of obtaining reasonable interest rates investing in cash and term deposits when official cash rates reached as low as 3 per cent per annum in 2008.
The allocated pension payment is made in June each year and my parents essentially see their total balances only once a year, even though I can provide rough estimates at any time.
They simply have no need or desire to check daily, weekly or monthly valuations or receive frequent reports showing them.
Full reports are produced by an external administrator once a year. They therefore don’t see the greater volatility on this component.
As a result of this overall strategy, my parents have not had to deal with many of the stressful and financially painful issues that many investors and retirees have had to deal with in recent years.
Specifically, they have not had to worry about.
- The high volatility of their total portfolio (if they did consolidate their investments their worst financial year return would have been slightly more than minus 5 per cent);
- Direct share holdings collapsing in value (although they own some indirectly in the super fund);
- Geared or structured product arrangements imploding;
- Fund failures or funds suspending redemption;
- Fraudulent funds;
- Lack of income/cashflow; and
- Lack of access to capital (they could access to their entire portfolio quickly if required).
The arrangements have therefore gone a long way to removing many of the stresses of investment but without abandoning a reasonably well diversified portfolio necessary for the longer term, especially to provide some protection against inflation.
Of course, some of this stress has been transferred to me and to managers that I delegate to, but then that is our job.
Perhaps that highlights a key problem in this industry.
The pressures and stresses of investing are not being delegated to the right people.
Clients are bearing these stresses directly, and many planners are not well placed to handle them either.
Bearing the risk
This is where I disagree with those promoting a risk profiling approach and then obtaining clients’ ‘informed consent’ on the level of risk they are taking.
Apart from the flaws in the simplistic view that a set asset allocation that these approaches lead to is constant risk anyway (it isn’t), many clients don’t understand investment risk and never will — no matter how many questionnaires or tests they are put through.
We therefore need to come up with portfolios that reduce some of that investment risk but in ways that make clients comfortable and do not overly inhibit them meeting their longer term return objectives.
My parents’ approach is one that works very well, for them at least.
At one stage I was tempted to encourage my parents to invest some of their non-super cash/term deposits in a defensive multi-asset diversified unit trust. In hindsight I am glad I did not.
Not because of reduced returns — they would most likely have been slightly ahead over the long term — but because the additional volatility in the interim would have added stress that they didn’t need, and they were only ever going to get a marginal benefit in terms of extra return.
Critics might say what I have described here is an idealised arrangement that cannot be replicated by an adviser and their clients. However, I think it highlights several important points.
Firstly, perhaps we should be happy to allow some, but certainly not all, retiree clients themselves to partly or fully control the relatively easy to manage and understand cash/term deposit component of their portfolios.
This can make them feel more in control in ways that are not negative for the portfolio. It will also more make them more prepared to delegate the more complex diversified growth component.
As long as they stick to the low risk/very conservative end of the investment spectrum, there is often relatively little value a financial planner or fund manager can add; and subjecting this vital but usually low returning component to adviser, manager and platform fees will just make a big proportion of this return disappear.
At the very least, fee structures need to reflect this concern.
Secondly, we need to get away from the desire to create portfolios that generate a certain ‘income yield’ that the client is supposed to live off. It is total return and cash flow that matter, not yield.
That cash flow can come from drawdowns of the cash/term deposits component and allocated pension payments/super drawdowns as well as the interest and other income on investments held.
The one thing we learnt from the GFC is that if investors/advisers go around obsessing about yield, smart investment bankers will manufacture it in expensive and flawed structures that ultimately disappoint investors.
Just look at what happened to listed property trusts and high yield funds.
Thirdly, we need to ask whether the industry’s focus on the development of platforms with more and more bells and whistles and improved reporting on client investments is actually increasing client and adviser stress and resulting in poor investment decisions.
While it is very convenient and great for planners businesses to be able to transact or produce reports at any time is this really constructive?
Doesn’t it just encourage the investor and adviser to overreact to what is going on in parts of the portfolio and not keep a proper eye on the big picture?
Are the costs of frequent pretty reports justified or even necessary in some cases. Clearly my parents don’t seem to think so.
Finally, advisers should recognise some of the more subtle benefits of using well-run multi-asset, multi-manager portfolios for at least the core of the diversified/ growth components of portfolios.
Specifically, they can provide required growth asset exposure, diverse and flexible asset allocation while some of the inherent volatility involved in individual components does not need to be overly focused upon therefore making it more likely clients will stick to the portfolio in the long term.
Most of the severe problems many investors faced in 2008 that I listed above were totally or largely avoided by investors in diversified multi-manager portfolios.
Reducing client stress
The primary role of a good financial planner should be to arrange their client’s financial affairs in ways that reduce that client’s financial pressures and stresses.
To do this adequately across a variety of client circumstances requires a generalist approach with broad knowledge of investments, insurance, social security, tax, and estate planning — but with access to the appropriate experts when required.
Still it seems relatively few planning groups are structured this way.
Instead, many continue to promote themselves primarily as investment gurus, feeling they have to constantly report on and be seen to be on top of the client’s portfolio, which contains numerous investments to justify asset-based fees.
So they spend their time and client reviews getting worked up about the poor recent performance of a particular investment and thinking of substituting it for something else that has done well recently (and in doing so usually worsening overall investment returns).
All this close scrutiny usually does is increase the stress for both themselves and their clients.
Some planners think they can reduce their clients’ financial stress by using guaranteed and structured products. I disagree — the majority of these are a source for later stress as poor returns, inflexible access and high fees eventually take their toll. Most of these products need everything to go perfectly to work well.
I do see a role for lifetime annuities as part of the mix as long as they are competitively priced and they could partly replace the cash/term deposit component. The annuity debate is at least getting the industry focused on the need to reduce and better manage retirees’ exposure to market risk (both real and perceived), to increase certainty relating to their cashflow and ultimately to make their financial lives less stressful.
Still, I believe my parents’ arrangement shows that there are alternative approaches without using annuities with better returns and more flexibility (and little additional stress).
That said, I am not suggesting that their particular arrangement is feasible for all or even many retirees out there, particularly given my ability in this case to take a ‘hands on’ role in the DIY fund.
But I do think it does provide some valuable insights into the strategies, structures and investment management arrangements that can help to lower the financial stress of clients and still meet reasonable return objectives over time.
As the year winds down and I once again head down to the unusually green, and possibly flooded, plains of Hay for Christmas 2010, I will fortunately be able to report that the DIY fund had a good 2010 financial year and a good 2011 financial year so far; that my parents still have considerably more money than they invested in 2002 despite taking annual allocated pension payments since — and not always the minimum; and that their eligibility for the age pension is still some time off.
My father will probably still joke that he thinks it must be some form of Ponzi scheme. And while there may still be some stresses and arguments around the Christmas lunch table, the financial issues and stresses of my retired parents will not be one of them.
Unfortunately, across Australia there will be plenty of other retirees where this will not be the case.
The development of better, lower stress portfolios that truly deliver for retirees will improve although not eliminate this situation.
However, to achieve this it is necessary for the industry to step back and think about these issues first and foremost, before it focuses on how it can monetise clients’ assets and situations to its own benefit.
Who knows — we could end up with many happier, less stressed and wealthier clients and advisers all round. Isn’t this what clients are expecting from professionals in the financial services industry?
Dominic McCormick is chief investment officer at Select Asset Management.
