THREE KEY WAYS TO MINIMISE PORTFOLIO RISK IN RETIREMENT. Goals-Based Investing

Transcription

1 THREE KEY WAYS TO MINIMISE PORTFOLIO RISK IN RETIREMENT Goals-Based Investing

2 INTRODUCTION People have different goals depending on their stage of life and these can be split broadly into three categories: essential needs, lifestyle wants and legacy aspirations. These goals are present throughout life, but in retirement, when there is no salary to fund these goals, these categories become most relevant and it is critical that an investment portfolio helps retirees live the life they want. The lifestyle wants category covers non-essential items such as holidays, a new car, luxury items and a higher standard of everyday living; discretionary items that will only be bought after the essential needs (food, clothing and shelter) have been paid for. Many clients want to grow their wealth steadily, at a faster rate than inflation to be able to maintain their desired lifestyle in retirement. LEGACY ASPIRATIONS LIFESTYLE WANTS ESSENTIAL NEEDS Investors desire reasonable growth that rises steadily over time, but many are unwilling to risk large declines. Therefore protecting their investments against market falls is vital. Retirees especially cannot afford to experience a sharp decline in their wealth as they are less capable of returning to work to earn a salary in order to recover. While longevity and inflation risk are key risks retirees face, this white paper specifically discusses sequencing risk and looks at three essential strategies which can be used to minimise portfolio risk in retirement and increase the potential for investments to grow steadily over time. RETIREMENT IS NOT A TIME FOR RISK There s a reason why bungee-jumping octogenarians are a rare sight. Over the years most people s attitude to risk hardens. The carefree days of high-adrenalin activities are replaced with concern around missing mortgage payments, walking home in the dark and worrying about providing for their children. This increased focus on risk is apparent in investing. For some, gradually the thought of losing hard-earned capital begins to cause sleepless nights and capital preservation becomes key. It s vital not to leave this too late; protecting a portfolio from significant losses must be considered earlier than the date of retirement. While working and earning, in the accumulation phase of life, many clients use a traditional strategic asset allocation (SAA) approach to manage risk and consequently this approach is often found in retirees portfolios today. These types of portfolios are designed to provide a diversified mix of assets to help the portfolio weather market volatility. Although such a strategy can be successful when markets are relatively stable, the global financial crisis (GFC) showed this approach to be less effective in reducing risk when markets fall severely. Between November 2007 and March 2009 the average growth diversified fund, which typically uses a strategic asset allocation approach, fell over 30%. This was not a problem for those in the accumulation phase who were investing for the long term, as they had time to recover from the market falls (and would have also benefited from future contributions being cheaper while valuations were low). But this level of fall was distressing for those approaching, or in, retirement. Many retirees were unable to recuperate losses, creating awful scenarios that nobody wants to face, such as returning to work to recover losses through earnings. Due to a severely depleted portfolio, these clients are more likely to outlive their savings and potentially need to rely on the support of loved ones. 2 AMP CAPITAL GOALS-BASED INVESTING: THREE KEY WAYS TO MINIMISE PORTFOLIO RISK IN RETIREMENT

3 Figure 1: Investors in traditional diversified funds were hit hard in the GFC Value of $100,000 investment Performance of diversified funds during the GFC, peak to trough Years Decline -32.5% During the GFC diversified funds fell over 30%. Many clients in these funds who were approaching, or in, retirement would have been unable to recover their losses. 65 Source: AMP Capital, Morningstar. Past performance is not a reliable indicator of future performance. Morningstar Australia Multi-Sector Growth TR AUD category. The Morningstar Multi-Sector Growth category contains multi-sector funds with percent of their investments in the growth assets of shares and property. RETHINKING CLIENT OPTIONS Today, many advisers managing retirees portfolios have begun to move away from the traditional SAA approach used in diversified funds by these portfolios and adjust their strategy to focus particularly on protecting retiree portfolios from severe market falls. Strategies that make more use of diversification and offer protection from significant falls can improve the outcome for those in, or around the date of, retirement and have the potential to deliver strong, steady, inflation-beating returns to fund lifestyle wants. Some advisers are considering funds that have: > > access to a diverse range of strategies, unavailable to many retail investors, which can generate returns in a variety of market conditions > > smoother returns > > a flexible mandate to reallocate capital between asset classes if appropriate and, perhaps most importantly, > > in-built investment strategies to protect against significant market falls SEQUENCING RISK ONE OF THE BIGGEST DANGERS RETIREES FACE Any adviser who had retired clients invested around the time of the GFC can provide testament as to just how critical the timing of market falls is in determining future wealth. The risk of a big downturn in markets (such as the GFC) just before or after clients retire, which is generally the point of maximum wealth in their lives, has the biggest dollar impact and can be devastating. A large fall at this stage hurts more than at any other stage of life. For retirees, in addition to falling with the market their portfolio value is reduced further because they are drawing down an income to fund their retirement. Protecting against sequencing risk is therefore paramount in the years just before, or just after, retirement. As clients approach retirement they become increasingly exposed to sequencing risk. Retirees are especially sensitive, as they don t have the luxury of time to recover and risk outliving their capital. As a result of a decreased retirement pool, clients are left with two options: extend (or re-enter) their working life and/or reduce their standard of living in retirement. 1. Source: AMP Capital 3

4 This is highlighted in the two charts below. Daniel and Kylie saving for retirement. > > Both clients have $100,000 and are contributing a further $5,000 (rising by 2.5% each year) to their superannuation each year for 25 years until they retire. > > The portfolios generate the same total investment returns over the 25 year time horizon, but the pattern of these returns is reversed. Daniel s portfolio delivers three consecutive years of negative returns early in the period, but his portfolio recovers strongly when positive returns are delivered near the end of the term. > > Kylie s portfolio, despite starting strongly, delivers three consecutive years of negative returns at the end of the period, just as she approaches retirement. Figure 2: Losses close to retirement can be damaging Millions Years Three years before the date of retirement Daniel Source: AMP Capital. Illustration only. Assumes a $100,000 investment, portfolios generate the same total investment returns, but the pattern is reversed, additional investment of $5,000 each year starting from year one, size of additional contributions increases by 2.5% each year. Kylie Losing capital in the final years before retirement, when the portfolio value is highest, could mean being forced to return to work to rebuild savings. Protecting against sharp market falls, especially in the final years before retirement, is essential. Bob and Jane in retirement > > Each client s portfolio generates investment returns in the same order as before but both are drawing an annual income of $40,000 (rising by 2.5% each year) from their portfolio each year for 25 years. > > Jane experiences positive returns early in retirement and, despite making withdrawals, her portfolio continues to rise in value through her retirement. Three years of negative returns late in her retirement will not stop her from being able to continue to withdraw sufficient income. > > But Bob s performance is concerning. After 13 years his portfolio has depleted significantly, leaving insufficient funds to pay the annual income on which he needs to live and so he will outlive his savings. Bob is unfortunate to start his retirement with three consecutive years of negative returns and, as the chart shows, making withdrawals can significantly amplify the effect of short-term market falls. > > The need to draw down an income inhibits the ability of the portfolio to recover after market falls. Figure 3: Regular withdrawals combined with early negative returns are problematic for retirees Millions Years Source: AMP Capital. Illustration only. Assumes a $700,000 investment, portfolios generate the same total investment returns, but the pattern is reversed, additional $40,000 withdrawal at the start of each year from year one, size of withdrawal increases by 2.5% each year. Large negative returns in the earlier stages of retirement, combined with regular withdrawals, inhibit the ability of the portfolio to recover after market falls. Bob Jane 4 AMP CAPITAL GOALS-BASED INVESTING: THREE KEY WAYS TO MINIMISE PORTFOLIO RISK IN RETIREMENT

5 As we can see, the timing of a market shock will dramatically alter investment returns and the length of time retirees capital lasts. Advisers with clients nearing, or in, retirement, at the point of maximum wealth, should take steps to preserve capital and protect against sequencing risk. Reducing risk and sheltering a portfolio from a significant decline, similar to that experienced during the GFC, could make a huge difference to its value and could make the difference between a happy and a miserable retirement. THREE ESSENTIAL STRATEGIES TO REDUCE RISK IN A PORTFOLIO If clients want reduced volatility, protection against severe market falls, smoother returns and to grow wealth over the long term, there are three essential strategies advisers should use. 1. USE DYNAMIC ASSET ALLOCATION Asset allocation is the process by which a portfolio s capital is diversified across different asset classes, for example equities, fixed income and property. The asset allocation decision is vital in determining whether or not investment objectives are met. There are two broad methods of asset allocation, each based on different timeframes. Strategic asset allocation is based on a long-term horizon and the expectation of asset class performance is set. Therefore the allocations between asset classes will not move much over time. Dynamic asset allocation (DAA) is based on a shorter timeframe and requires active decision making and portfolio manager skill to reallocate between asset classes depending on where the portfolio manager sees opportunity. DYNAMIC ASSET ALLOCATION (DAA) Based on a shorter time horizon Influenced by market cycles Can reduce portfolio risk Suits investors who cannot afford a sharp decline in wealth, but want to steadily grow capital, eg retirees STRATEGIC ASSET ALLOCATION (SAA) Assumes long-term return horizons of five years or more Ignores market cycles Often applied by traditional diversified funds Suits investors in the accumulation phase who have time to withstand market fluctuations The benefit of DAA is that it offers greater opportunity to increase exposure to attractive assets and avoid or sell unattractive assets. As well as benefitting from rising assets, there is also greater scope to reduce risk in portfolios as the portfolio manager can apply a flight to safety strategy and, for example, reduce exposure to higher risk assets such as equities and increase exposure to cash or lower risk assets such as fixed income. DAA is most effective when it can be applied to a portfolio that is not tied to a benchmark or peer group, as the portfolio manager has greater flexibility to reallocate capital between asset classes. It can be used as part of a strategy for clients who want to steadily grow their capital. For those with a high exposure to sequencing risk, for example near the date of retirement, DAA can prove beneficial especially when combined with the other two essential risk reduction strategies. 2. FIND DIVERSIFIED SOURCES OF RETURN Diversification works at various levels, for example owning more than one stock and more than one type of asset, in different industries and different countries. Better diversity can reduce the possibility of poor outcomes in unexpected economic environments. Typically an SAA strategy tends to have a large exposure to Australian and global equities. Clients are therefore relying heavily on the performance of two groups of equities for performance. Greater diversity will come from reducing the exposure to Australian and global equities and increasing exposure to a broader range of assets, but also from using a range of diversified strategies that can provide additional return streams to collectively produce returns steadily over time. Some examples of different strategies are: Inflation-linked strategy If inflation spikes higher, this can be particularly damaging for retirees as the value of their savings can be depleted faster, which may ultimately result in them being unable to fund their retirement. An inflation-linked strategy is designed to produce returns that are in part tied to inflation, and therefore have a built in adjustment if inflation rises, helping to protect retirees spending power. Inflation linked bonds and to some extent, listed infrastructure and listed property, provide this benefit (an infrastructure asset, such as a toll road, is able to increase its fees with inflation (or more) each year; likewise commercial properties can usually increase their rents each year). There are three challenges in building a portfolio with reduced risk: 1. Determining the right asset classes and strategies to use 2. Moving capital in a timely way as necessary between the asset classes and strategies 3. Integrating specific strategies into the portfolio so as to mitigate the risk of large unexpected market declines. 5

6 Equity investment strategies Most equity investment strategies are long only and will benefit if their underlying assets rise. But other strategies are long/ short, and can potentially benefit not only when equities rise, but also when equities fall (called shorting ). For example, an investor can buy shares in company ABC if they expect the shares to rise, but they can also place a trade that will benefit if shares in company XYZ fall. Protecting, or even benefiting, from falling prices provides greater opportunity and can reduce portfolio risk. Absolute return strategies These are designed to deliver positive returns regardless of market direction. There is a wide range of strategies that are used by investors within this broad group. A particularly effective method is the use of managed futures that are designed to provide positive returns in both rising and falling markets. These strategies tend to make money when there are strong trends in either direction and they also tend to provide maximum diversification when markets are falling, which can help those in or around the date of retirement who cannot afford to experience a sharp decline in their wealth. Employing diverse strategies, as well as investing in a variety of different asset classes, can produce outcomes that are driven less by share market direction and more by different types of risks. This extra layer of diversification can help produce a consistent stream of returns and assists in providing clients with the highest chance of achieving their objective with the least risk of loss. 3. TAKE OUT INSURANCE As we have seen, extreme, unanticipated market falls can be devastating for clients approaching or in retirement. In some cases they simply won t have time to recover. Dynamic asset allocation and diverse strategies can reduce risk in a portfolio under normal market conditions, but another method is needed to soften the blow of extreme market falls tail hedging. Tail hedging is the process of identifying and purchasing investment assets and securities that could rise in value when other assets in the portfolio are temporarily making losses. A tail hedging strategy is not designed to protect against all market falls, but it could limit the losses from significant market falls. By putting tail hedging in place, akin to insurance, advisers can potentially protect their clients from bearing the full brunt of portfolio loss. This is shown in figure 4, where hypothetical scenarios are used to show how the performance of two portfolios differs, one portfolio using tail hedging and one not. When returns are normal, (without overly pronounced swings in market direction) returns are broadly the same, but when markets fall severely the portfolio using tail hedging falls much less. Tail hedging is similar to having a safety net in place. Falling less than the market could also enable the portfolio to recover quicker from falls which should increase value over the long term and could make the difference between a comfortable and a modest retirement. Performance in normal circumstances is consistent between the two portfolios, but when markets fall sharply there is a distinct difference. The portfolio with tail hedging is much better protected than the portfolio without. Figure 4: Performance of a portfolio using tail hedging versus the same portfolio not using tail hedging Return 4% 0% -4% -8% -12% -16% Asian Financial Crisis 2000 Tech Bubble 2008 Sept - Nov Scenario Portfolio with tail hedging Portfolio Source: AMP Capital, Barra. Note: The chart above is an estimate for illustrative purposes only. 6 AMP CAPITAL GOALS-BASED INVESTING: THREE KEY WAYS TO MINIMISE PORTFOLIO RISK IN RETIREMENT

7 Stress testing is used to assess how vulnerable a portfolio is and whether a tail hedging strategy needs to be in place. This involves: > > simulating how asset classes or strategies may perform in times of crisis > > assessing the potential impact on the portfolio and > > identifying and implementing positions to mitigate potential losses. Using a combination of these three strategies dynamic asset allocation, diverse strategies and tail hedging can help manage volatility and smooth returns and, in the case of tail hedging, protect the portfolio from the worst losses. Mitigating major portfolio losses will help those in or approaching retirement, who either can t afford or are unwilling to experience a sharp decline in their wealth, and help ensure inflation-beating performance over the longer term. ACT NOW TO PROTECT YOUR CLIENTS During the accumulation phase, clients can afford to take on risk as they are earning a salary to help replenish any losses and, more importantly, they have time to recover from market falls. But as clients age, especially as they approach or enter retirement, they simply cannot afford to take that risk. Sequencing risk becomes a major concern; losing a third of the value of their investment portfolio (as was experienced during the GFC) is not an option for those approaching or in retirement, who are drawing down an income and unable to return to work. To ensure clients have adequate protection and don t outlive their savings, many advisers are starting to rethink their strategy for their clients approaching or in retirement, who are around their point of maximum wealth. They are considering portfolios that use tail hedging to mitigate significant shortterm declines and offer access to diverse strategies, which can provide additional return streams to potentially reduce losses and increase returns. Using the strategies outlined in this paper can help retirees: > > remove their fear of a GFC-like severe market fall > > experience smoother returns with less chance of shocks > > beat inflation without unnecessary risk > > ensure they don t outlive their savings > > meet their lifestyle needs, including a better standard of everyday living, holidays and new cars > > make sure they never have to return to work ARE YOUR RETIRED CLIENTS PORTFOLIOS ADEQUATELY PROTECTED? CONTACT US If you would like to know more about how AMP Capital can help you, please visit Important notice: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN , AFSL ) and AMP Capital Funds Management Limited (ABN , AFSL ) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided. Copyright 2015 AMP Capital Investors Limited. All rights reserved.