Hammering away at asset allocation is only part of the retirement income solution

If the only tool you have is a hammer, the temptation to view everything as a nail can be overwhelming. For much of the financial services industry, asset allocation – and investors’ ongoing need for growth assets – is the nail which is currently being pummelled.

But no amount of hammering will make this problem go away. A superannuation portfolio needs to be weighted towards growth assets to help fund an increasingly long retirement, which raises the risk of greater volatility and losses. But shifting a portfolio to more conservative lower-returning investments simply raises longevity risk and the chances that a lifetime of super savings won’t actually be enough to fund a long retirement.

But asset allocation is not the only tool in an investor’s toolkit – it needn’t be a blunt instrument used as a proxy for risk.

During the global financial crisis, nearly every major asset class declined in value, forcing investors and advisers to reevaluate the risks that lurk in traditionally-constructed portfolios.

Not a one-off event

It was not a one-off event. Other large downturns and periods of volatility – systematic risks that can’t be diversified away – have occurred in 1973-74 and during the tech-wreck of 2000-02. No doubt more will occur again, prompting average superannuation investors to wake from their slumber and shift their portfolios to more conservative assets at the worst possible time.

Staying invested in the market and riding out the downturn may work for those investors in their 20s and 30s. But for the growing number of Australians who are approaching retirement, tweaking asset allocation won’t lead to more stable and predictable retirement incomes when the underlying issue is risk.

The ‘nail’ here more closely resembles a ‘screw’ and perhaps a better solution lies in delving back into the toolkit before trying to hammer away at the foundations.

The benefits of diversification are many but they have their limits when systematic shocks such as recessions and economic crises wash over markets. They threaten extreme volatility – an increasing risk for retirees in drawdown mode – and heavy capital losses that take years to (hopefully) recover from.

The volatility mismatch

But even short-term volatility can cause a mismatch between investor expectations of risk and return. The average historical volatility of a simple, balanced 70:30 portfolio (split between the S&P 500 Index and the Barclay’s US Aggregate Bond Index) is about 13 per cent.

Shorter-term volatility makes a mockery of such averages: volatility (on a rolling 21-day basis) was at least 1 per cent above or below the long-term average in 21 of the 23 years between 1989 and 2012.

The limits of diversification to solely manage risk is also now being recognized in the US, where lifecycle funds or target-date funds – which mechanically shift a portfolio to more conservative investments as an investor approaches retirement – are being over-hauled since posting poor returns during the GFC.

In April 2014, the US Securities and Exchange Commission’s Investor Advisory Committee recommended that the commission develop an alternative “glide path” illustration (which shows changes in asset allocation) based on an appropriate, standardized measure of fund risk.

“Asset allocation is a particularly unreliable proxy for risk where the asset classes are defined quite broadly,” the IAC wrote, “because assets within those broad classes may have markedly different risk characteristics, such an approach may serve to mask significant differences in the risk levels of funds with apparently similar or even identical asset allocation glide paths.”

Smarter funds

The Australian super industry is increasingly shifting towards lifecycle funds but smarter-constructed funds will recognise that this is just one path to tackle underlying risk. The answers are not always easy but that does not mean the questions should not be asked.

With an increasing number of investors approaching retirement and memories of the GFC still fresh in their minds, it is incumbent on financial advisers to explore a more diverse range of risk management approaches. Investors deserve more than advice to “ride out the storm”.

With more tools in the toolkit, the temptation to try and hammer the ‘risk’ away can be put back in the attic where it belongs.

This article was first published in Professional Planner.