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The path to strong investment returns has always been paved with risk. Unfortunately for retirees, the path is now longer and the pavement rougher than ever before.
The coronavirus pandemic was more than a short, sharp shock: It served as a warning about the investment risk retirees face every day. Risks that can destroy a lifetime of saving, yet risks many feel no choice but to take in a world of ultra-low interest rates.
When it goes wrong, financial advisers can become collateral damage.
By the end of March 2020, as the pandemic took hold and global lockdowns took effect, retirees in typical balanced funds were facing a 13%1 decline in their life savings. Yet advisers have had few alternatives other than to recommend more aggressive portfolios given yields on 'safe' bank deposits and government bonds have dropped to record lows.
Fortunately, investors brave enough to stay in the market saw the fastest rebound from a market crash in history. However, there's no guarantee that such a quick recovery will happen after the next downturn.
Building portfolios for retirees that generate healthy returns, while protecting against extended downturns and extreme volatility, is one of the hardest tasks in finance.
Older Australians need solid investment returns to fund an expected retirement of more than two decades. This suggests investing in growth assets is the best option.
A typical growth fund will last for an average of 26 years compared to a cash portfolio lasting 18 years, according to Milliman analysis2. This often leaves retirees with little choice but to invest in riskier assets to fund their retirement, or drop their standards of living. However, retirees are more sensitive to risk.
A 30% market fall that strikes when an investor is 65 can strip 10 years of income from their portfolio, compared to less than one year for a 30-year-old3, who has time on their side to make contributions and benefit from a potential market rebound.
Managing this risk has typically required de-risking to more conservative portfolios.
The trouble is, either path involves an unacceptable trade-off where luck plays far too large a role in determining the outcome.
Diversification remains a fundamental part of the solution. It can increase a portfolio's expected return per unit of risk (where risk is defined as volatility).
However, traditional portfolio construction differs in theory and practice. Nobody can predict precisely how strongly correlated the performance of different asset classes will be under pressure.
Diversification also has its limits. In a severe market crisis, diversification often only comes from government bonds. In the 2008 global financial crisis, most major asset classes fell alongside equities. In the 2020 coronavirus downturn, it happened again.
However, in a market environment where interest rates are now close to zero, allocation to government bonds becomes more costly. Also the risk management benefit gained, per unit of return sacrificed, is lower compared to historical standards4.
Furthermore, looking ahead, as government balance sheets are now significantly more indebted than any point in history, there is a question mark around how much of a flight-to-safety effect there could be in the next crisis.
So while diversification is important from an investment perspective, and a core part of many portfolios, as a risk management approach, in isolation it won't protect retirees from a systemic downturn.
Diversification is not the only risk protection strategy used by large institutional investors. Global pension funds and insurers have been using explicit portfolio strategies that hedge their portfolios against downturns for decades.
Similarly, retirees also have specific future liabilities that can be challenging to manage and predict. By using the same institutional strategies, they can tip the traditional risk-return trade-off in their favour.
The SmartShield range of portfolios brings Milliman's years of experience working with major institutional investors on a global scale to the broader retail market.
These portfolios include a built-in risk management strategy that dynamically hedges portfolio exposure to equities in response to market volatility. This rules-based strategy overlays four managed account portfolios: moderate, balanced, growth and high growth.
The portfolios are invested in exchange-traded funds offered by Vanguard, iShares, and BetaShares to ensure that total investment costs are kept below 50 basis points.
It can help solve the retiree conundrum that is all too familiar to financial advisers: Recommend a more aggressive portfolio to generate healthier returns and risk taking the heat when a market downturn devastates the client's retirement savings. Alternatively, if we keep retirees’ capital in conservative investments, we risk their retirement savings run out well before their life expectancy.
SmartShield allows advisers to build portfolios with a higher allocation to growth assets while knowing that extra risk is actively managed.
The High Growth portfolio launched in February 2020, was tested through the COVID-19 crisis and as per the chart above, has already proven to provide a smoother ride for investors.
While markets have now recovered, this approach can provide some peace of mind for investors with significant economic uncertainty still ahead.
As history shows economic downturns tend to occur about once every decade, it's crucial that retirees protect their investments against these re-occurring risks without missing opportunities for return. This will help retirees pave the way for a smoother road through to retirement.
2Milliman. SmartShield Simulator. Assumes a retiree is withdrawing $12,000 per year (CPI adjusted) from $200,000 invested in a typical growth fund based on 5,000 scenarios. Retrieved from https://smartshield.millimandigital.com/Identity/Account/Register.
3Milliman. SmartShield Simulator. Assumes a retiree is withdrawing $12,000 per year (CPI adjusted) from $200,000 invested in a typical growth fund based on 5,000 scenarios. Superannuation balance and annual salary for a 30-year-old is assumed to be $35,000 and $58,000 respectively. Retrieved from https://smartshield.millimandigital.com/Identity/Account/Register.
4Dissanayake, N. & Shahroozi, N. (2020, 29 January). Re-thinking Risk Management in an Ultra-Low Yield Environment. Retrieved from https://uk.milliman.com/en-gb/insight/Re-thinking-Risk-Management-in-an-UltraLow-Yield-Environment.
Milliman SmartShield range of Managed Accounts’, are designed to provide direct protection against market downturns.
For more information go to: https://advice.milliman.com.