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Lonsec   ⟩   News & Insights   ⟩   Insights   ⟩   Most retirees can’t define risk, but they know it when they see it
Veronica Klaus

AuthorVeronica Klaus

TitleHead of Investment Consulting

DateMay 23, 2019

CategoryInsights

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When you ask clients how they think about risk in retirement, you are unlikely to get a textbook response. Instead, you’ll probably get a list of their deepest fears: running out of money, leaving their children with nothing, living too long, retiring during the next GFC, or not having enough cash on hand to pay for necessities.

When we define investment risks, we don’t define them in these terms, but these are the eventualities we’re attempting to guard against when we construct retirement portfolios. There are any number of objectives your client might be aiming to achieve, and each will come with their own set of risks.

Is it the chance of your investments going down? Is it asset class volatility? Is it not achieving the returns you need to meet your required income? In the end, risk is getting your investment strategy wrong by not understanding the relationship between your client’s competing objectives and associated risks.

For this reason, we believe there is a need to focus on retirement investing as a separate strategy. Even moving from the accumulation to the drawdown phase means you are managing a different set of trade-offs. The role of the financial adviser is not to eliminate the existence of these trade-offs but to manage them prudently in line with their client’s preferences and risk tolerance.

Source: Lonsec

Each of these competing objectives requires different investment strategies to achieve. For example, a rental property will provide the most consistent income but at the expense of liquidity. If we’re worried about market volatility we might be tempted to move to a more defensive asset allocation, but by foregoing growth we increase the chance of running out of money. In short, clients will always be exposed to various types of risk.

The problem with determining a client’s most important objectives is that often they are all equally important. Consider the following examples:

Paying the bills

Certainty of income is usually the key concern for retirees, but don’t discount the others. When you ask advice clients what their most important objectives are, the most common answers are things like relaxation, travel, family, and leisure. These all have a price associated with them. Liquidity is also a major consideration for retirees. Not having enough cash on hand for things like motor vehicle repairs and other essential spending can result in significant stress and prevent retirees from enjoying the things they were looking forward to after their working life.

Leaving a legacy

Most people wish to enjoy a comfortable life in retirement but also make sure their children and loved ones are left with some extra wealth. A 2017 ASFA study found that households are retiring with an average super balance of $337,000 (the gender breakdown is $270,000 for men and $157,000 for women). Leaving a meaningful inheritance or bequest would mean there is barely enough left over to support their own needs.

Maintaining purchasing power

As any basic economic textbook will tell you, different asset classes will perform better or worse in different inflationary environments. Inflation of 2% per year will erode more than half of your purchasing power over 35 years, which is the equivalent of a single GFC event. Managing inflation is just as important as managing sequencing risk or the risk of a large drawdown, even in periods where inflation is relatively low.

This adds an additional consideration to the construction of retirement portfolios. Real assets are a proven way of managing inflation risk, while fixed income is potentially the worst asset class for this purpose, with the exception of products like inflation-linked bonds.

Different assets perform differently depending on the inflationary environment

Source: Lonsec

Guarding against a crisis

If successfully timing the market seems more like luck than skill, then timing your retirement is no different. While market bumps are nothing to be feared when you’re building your wealth, a sudden major event like the GFC can spell disaster for those entering the decumulation phase. Sequencing risk refers to the order in which investors experience returns, and it can matter a great deal for retirement. Withdrawals during a falling market have the potential to accelerate the depletion of your asset base.

To see how this works, take a look at the returns from Lonsec’s balanced portfolio over the last 20 years. If you reverse the order of returns, there isn’t really much difference for those in the accumulation phase – both sequences deliver the exact same results over the long term. But for those drawing down on their investments, the reversed sequence results in the retiree running out of money much sooner.

The sequence of returns can mean the difference between having enough cash and running out

Source: Lonsec

Addressing sequencing risk requires advisers to look at a wider range of solutions, including variable beta or absolute return strategies, and even some more illiquid options to reduce volatility and manage drawdowns. Once again, there is a trade-off involved in making these decisions.

The reason we struggle to precisely define risk is that there simply isn’t a single source of risk that can be effectively managed or reduced to zero. Managing risk means understanding the often complex relationships between different retirement objectives. Effectively managing these relationships is the purpose of your investment strategy.

When we talk about risk at Lonsec in a portfolio context, what we are really talking about is the risk that the overall investment strategy is wrong or is not properly tailored to the client’s needs and preferences. This informs the approach we take to the management of our model portfolios as well as the selection of individual products to achieve a particular objective. We think this is the proper way to think about risk without being constrained by a single textbook definition, and it is the way in which advice clients intuitively understand risk as well.

Want to find out more?

Get in touch to find out how we can help you start implementing managed portfolio solutions for your clients. Call us on 1300 826 395 or email info@lonsec.com.au.

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