29 Jul 2013

Constructing and managing retirement portfolios amid global economic uncertainty, a tidal wave of baby boomers set to retire and the ongoing lessons from the global financial crisis (GFC) means a fresh approach is essential going forward. But what factors must be considered to ensure growth, decent income and protection from the unknown?

There is a fine margin for error when it comes to retirement portfolios. Some would argue there isn’t one.

About 5.5 million baby boomers are preparing to leave the workforce and they will cease earning an income. After many experienced significant drawdowns due to the GFC, their retirement portfolios cannot afford to fail them again.

While those involved in building and managing retirement portfolios would agree significant improvements can be made to produce better portfolios, the shift is only just beginning to take place.

Investment managers want to firstly understand what this new world means for retirees before they launch new products and solutions, both for the end client as well as financial advisers to recommend.

Russell Investments Asia-Pacific investment strategist Graham Harman says the industry must comprehend what happened in the past in order to move forward successfully.

“If you go back to the late ‘70s, early ‘80s, retirement solutions were all about having one multi-asset manager because it was a time when asset markets were relatively volatile and when one provider did everything under one roof, so it was closed architecture,” Harman says.

“Nobody was really doing the asset allocation and that didn’t matter because bonds and shares were doing very well.

“You made your money from your strategic asset allocation, which was just buy and hold in those balanced growth options and added some icing on the top via picking the best managers.”

Pre-GFC, cash returns were about 9 per cent to 10 per cent, bonds were around 11 per cent and equities provided 13 per cent, so the industry “fell into a world of 70/30 portfolios”, that is, 70 per growth assets alongside 30 per cent defensive investments, he explains.

“Post-retirement wasn’t a big deal,” he says.

“It was all about accumulation, so in terms of the member circumstances you had this sector- specialist, 70/30 approach and it was all about giving your money to the best manager.

“But now, retirement is longer and starting off with your maximum wealth on your first day of retirement means you cannot afford to stop investing in retirement.”

An overwhelming weighting to equities is obviously unviable and neither is a cash allocation if capital growth is necessary to fund retirement.

But throw into the mix the fact post-retirees are five times more risk averse than pre-retirees, as shown by Russell Investments research, and the fact emerges that there are deep-seated investor behaviour issues that also need to be considered.

“Particularly with the financial crisis still fresh in mind, these people do not want to be swinging the bat with a pure equity exposure,” Harman says.

“That 70/30-type asset allocation was suitable for the market conditions over the last 30 years for pre-retirement.

“If you got 70 per cent of your asset weighting into listed equities, you probably had something close to 100 per cent of your risk allocated to listed equities, but retirees just can’t stomach that rollercoaster.”

Fit for purpose

State Street Global Advisors (SSgA) investment solutions group chief investment officer Daniel Farley says portfolios have to be fit for the purpose of retirement, which means the reason for having a portfolio in the first place needs to be considered.

“We have seen generally that people have been spending time thinking about it from a portfolio diversification perspective, but the challenge there is just focused on the long term and not those levels of detail,” Farley says.

“So it needs to go to the next level: how do you make it fit for purpose and how can you be dynamic across the board?

“Everyone has one line of defence, but there has to be more. What I do think was a wake-up call out of the GFC was this question of whether there are other ways to build portfolios in a better risk-adjusted manner.”

A single option that carries a retiree from accumulation to retirement is not going to be effective, he says.

“You need to build different portfolios for those different stages and as we look to build portfolios, we need to also make sure we do have that broad level diversification,” he says.

Van Eyk head of asset consulting and strategic research Jonathan Ramsay agrees and says the industry has lost sight of asking whether portfolios would actually meet their purpose when it comes to client objectives for their retirement.

“We’re looking to provide advisers not just with information that we use to communicate with them, but information they can give directly to their clients so they can get a deeper understanding of what those risk profiles or balanced products are actually going to do in their portfolio,” Ramsay says, adding the change in the trade-off between income and volatility is also an area of focus.

He says advisers need frameworks and collateral around retirement portfolio construction so they can implement bucket-based objective advice on their own.

Van Eyk is implicitly taking into account asset allocation in a valuation-based and dynamic way, he says.

Diversification

One of the key themes that emerged from SSgA’s discussions around portfolio construction for retirement was structuring low-volatility equities as its core with high dividend-paying local stocks to provide the stability of income.

Farley says this approach is broadly diversified not only across equities, but into fixed income, emerging market debt, commodities and other strategies that are “in that volatility sleeve”, which will have good negative correlations in crises as well as diversification benefits.

“And not only to stop there, but in different environments the mixes of those securities should be different,” he says.

“When we go into very high levels of risk aversion, we probably should be tilted more to defensive assets and that allows us to be not only more dynamic and ideally adding return over time, but also to be able to avoid those troublesome market environments.”

Harman says he believes while it is the only “true free lunch”, diversification needs to be changed itself.

“Not that diversification failed in the financial crisis; what I think happened was that diversification was not properly tried and we still had portfolios that were dominated by listed equity risk,” he says.

Russell Investments is looking to dial down its purely listed equity risk and find other asset classes and other resources of return.

In addition, it will take on a much more “radical” diversification and put the “multi back into multi-asset”, Harman says.

“In the first instance, that’s a risk management circumstance,” he says.

“Just because bonds have historically been the defensive asset class, if we think that US bonds at 2 per cent are absolutely a bad investment, we don’t go there. It has to be good value, stable and blend together for it to be in there.”

SSgA’s approach involves a more flexible portfolio, nuanced for shorter-term adjustments.

It has built in a process called ‘target volatility triggers’.

“We felt that we needed to take it one step further and put on an additional level of risk control to the portfolio,” Farley says.

“The idea in this case is that we are using proprietary research looking to forecast future levels of volatility at the portfolio level and when that forecast and volatility goes above a level we feel comfortable with, we will aggressively start to de-risk the portfolio.”

He explains the trigger will not come into play every day, but when volatility starts to spike, which is typically around a negative equity market event, SSgA expects to de-risk very quickly.

By avoiding a significant drawdown, investors can rebalance faster, he says.

Risk/return pay-off

A hot topic of late, driven by investor concerns globally, is finding the balance between risk control at the portfolio level and adequate returns for retirement, Farley reveals.

“Risk control has been top of mind for several years now, but also there’s been a big realisation that if all you do is worry about risk, you create another problem, which is you don’t have enough return,” he says.

“Setting an allocation and holding it constant through all periods is not enough.”

He therefore believes being dynamic and tactical in a portfolio allows investors to not only be ideally generating an increased excess return, but if done well will also avoid some of the speed bumps along the way.

“We’re not putting the return discussion off the table, but you need to really have that balance of risk/return and always consider that in the end objective,” he says, adding discussions with clients have predominantly been around managing risk differently in order to exploit opportunities in other growth-driven investments.

“In many cases [the use of low-volatility stocks] reduces the equity volatility by about two-thirds. If we reduce risk in one part of our portfolio, we can either accept that as the end goal and be done or we can say that we’ve freed up that risk budget to do other things, [such as] owning more equities, more emerging markets or more high yield – whatever we see as being the driver for growth.”

Lonsec investment consulting general manager Lukasz de Pourbaix says the risk profile ultimately drives the portfolio.

“The problem is the industry is doing this risk profiling exercise distinct from the objective and influencing what type of portfolio you’ll have,” de Pourbaix says.

An objectives-based approach is far more conducive to meeting retiree needs in addition to having an ongoing relationship with clients from a stronger advice proposition perspective, he says.

“It’s challenging when it comes to designing something specific to an objective,” he says.

“With the existing financial planning process, it is what it is and most people recognise where some of the shortcomings may be, but there’s so many ways you can enhance that.”

The way forward

As reported by financialobserver recently, research houses are also looking at ways to support advisers with portfolio construction guidance for retired clients, in order to start prioritising their changing objectives and goals.

De Pourbaix says retirement is a key strategy for Lonsec, which will seek to provide advisers with support around objectives-led solutions.

Earlier discussions with advisers revealed there was a gap between client objectives and the risk profile, which ultimately drives the portfolio.

“There’s an opportunity to provide advisers with some structure around how they can start thinking about those two things and give some measurement around that in terms of how much risk you actually have to take to meet those objectives,” de Pourbaix says.

“I don’t think anyone is going to come out and claim ‘this is the solution’ because it’s an ongoing journey for the next several years and these challenges aren’t going to go away.”

A great article written by Krystine Lumanta in the financialobserver.

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