Solving the risk tolerance paradox for retirees

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By Wade Matterson | 10 June 2016

Retirees find themselves in a predicament.

On the one hand, they are being forced to take greater responsibility to fund their retirement as fiscally constrained governments struggle to meet the growing needs of an ageing population.

On the other, traditional means of generating steady retirement incomes have been weighed down by record low interest rates. It is a situation unlikely to change in the near term as central governments try to stimulate their economies and pay down the hefty deficits they built up to fight the global financial crisis.

It represents a perfect storm for Baby Boomers: accept substantial market risk to fund the necessary retirement income or suffer declining living standards for the first time in decades.

The risk tolerance paradox: A perfect storm

This paradox runs deep and creates a number of challenges for those seeking a secure retirement.

Life expectancies have steadily increased over the last two decades, but women still underestimate their lifespan by an average of about five years and men by about three years, according to a recent Productivity Commission Report.

Meanwhile, superannuation savings have not kept up. The median super balance for Australians aged 55-59 was just $47,000 in 2011-12 according to the Australian Bureau of Statistics and the Association of Superannuation Funds of Australia (ASFA).

And yet retirement expectations remain overly positive. Super savings remain well short of the joint $510,000 a couple needs to achieve a comfortable retirement, according to ASFA.

Figure 1: The perception gap: Expected vs. actual self-funding in retirement a, b

 

Many retirees have attempted to boost their super by moving up the risk curve and increasing their exposure to growth assets, such as high-yielding stocks.

However, the price is significant: greater uncertainty.

Traditional portfolio construction approaches exposed

The global financial crisis exposed the flaws in traditional portfolio construction techniques. Since then, there has been a growing awareness among investors that new approaches are needed to manage portfolios through periods when financial markets are put under extreme stress.

This reflects a growing exposure to sequencing risk – poor returns which strike at the wrong time – as people begin to maximise their retirement savings towards the end of their working lives.

As savings peak, the impact of returns on a portfolio is magnified. A period of negative returns which strikes just as a retiree draws down on their savings can be devastating.

Older investors’ ability to recover is limited because their ability to increase contributions or savings become more limited as their income-earning years naturally reduce.

Their risk profile is asymmetric: they want asset growth but are averse to losses. This loss aversion is a natural bias which prompts many investors to shift to low-risk assets such as cash when markets become volatile.

But this strategy often simply locks in losses while replacing market risk for longevity risk.

Using risk managed solutions to enhance returns

This risk tolerance paradox can only be solved by finding an efficient way to preserve long-term investment objectives while managing the impact of short-term volatility.

Portfolio management approaches that dynamically seek to manage risk and produce returns that are asymmetric are a natural response.

Introducing managed risk equities into the portfolio of clients close to (or in) retirement can provide exposure to higher returns while managing the inherent higher risk.

This can also have a material impact on the amount of income available during retirement while reducing the amount of sequencing risk to which clients are exposed as demonstrated in our paper: The 6% rule.

What to consider when using managed risk equities

There are a variety of investment approaches which tackle this growing issue and we will explore their advantages and disadvantages in detail in a future article.

In the meantime, investors should consider these key points when employing a risk management approach within client portfolios:

  • Predictability: Are the outcomes of the strategy rules-based or will they rely on the manager’s discretionary skill?
  • Reliability: These strategies must perform when markets are under extreme stress, which occurs infrequently. Can the manager demonstrate a strong track record during previous, similar market conditions?
  • Efficiency: Is the strategy implemented in an efficient, low-cost manner? An investor should consider the merits of liquid and low-cost instruments versus expensive alternatives.

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