The nuclear brinkmanship between North Korean president Kim Jong-un and US President Donald Trump highlights the significant risks markets face right now. A major market meltdown is almost certain if a nuclear conflict escalates.
Any number of other risks, including European political instability, overvalued markets, the China credit bubble, or even the emergence of an unforeseeable event (a black swan), could trigger a global crisis, putting retirees’ assets at risk at one of the most vulnerable times in their lives.
As we saw in the GFC, there is a significant danger that retirees abandon investment plans during market dislocations because they lack confidence in their investment strategy.
It’s vital for advisers and investors to perform a risk assessment of investment strategies to ensure a retirees’ assets are being managed to protect them against the major risks they face in retirement - not just volatility risk for major market events, but also longevity and inflation risk.
When clients know their interests are being protected they will have the confidence to stay the course during difficult times and to ultimately reach their important goals during retirement.
How long will you live?
Retirees face many unique risks. One commonly highlighted is longevity risk – the possibility of outliving your retirement savings and facing a sharp drop in living standards. Longevity risk is increasing given our rising lifespans. Australians are living longer.
It’s important to consider funds that provide greater clarity around how long a retiree’s money will last.
In this article we will, however, primarily focus on two other risks -- the possibility of a major market correction and the prospect of lifestyle-damaging inflation.
What happens if markets crash?
If, hypothetically, the risk of a nuclear clash between North Korea and the US escalated, or some other severe risk materialised, and markets did have a sustained crash, who would be most affected?
For young people in accumulation, they can weather the fall; eventually, markets bounce back. Indeed, young accumulators could take advantage of lower prices to buy at cheap valuations and they have superannuation contributions in the future which effectively average in over time to market prices, softening the impact of market falls.
But a market crash is a potentially devastating event for those in retirement or on the cusp of retirement. Retirees have no future contributions; they would be forced to sell assets at low prices to fund retirement; and they don’t have the luxury of time to wait for markets to recover.
A portfolio that has shed one-third of its value requires a significantly larger gain – 50 per cent – just to recover prior losses.
This is called sequencing risk – the risk of a large loss just before or after a client retires, which can lead to a significant cut in their standard of living.
A retirement fund needs to be aware of how large negative returns could be in any single stress event. And they need to be actively managing that downside risk, particularly at the start of retirement.
When performing a goals-based retirement risk assessment to assess the preparedness for a market crash, consider the following points. Does your investment or fund:
- Diversify across asset classes, regions, fund manager styles, and risk factors
- Have a tail risk management program
- Use options and currency flexibly and in a cost-effective manner to manage downside risk
- Think about maximum loss in stress even as a guide to how much risk and how much hedging they should have at any given time
A return of rampant inflation?
The election of Donald Trump as US President late last year triggered a significant sell-off in bonds. Investors fretted that Trump’s policies would create rising inflation – an increase in the cost of goods and services.
Since then, inflation worries have eased. But the bond sell-off highlighted the damage an unexpected spike in inflation could have on portfolios.
For those still working and in accumulation, inflation right now may not be a big risk. Their salaries, and therefore their contributions, would have a link to inflation. They effectively have an unknown ‘inflation asset’ in their pockets – future salary-linked contributions.
But it’s a different story for retirees. They don’t have inflation-linked assets in terms of salary and future contributions. They have all their inflation exposure in their assets.
If there was an inflation spike, their basic costs of living, such as groceries and utilities, would rise. Their retirement goal in the form of future cash flow needs would increase.
To protect against inflation, retirees need their assets to rise to offset increased costs. Yet most retirees’ assets in status quo advice arrangements are invested in conservative funds or moderately conservative funds. Those funds have large exposure to government bonds and duration. (Duration is the cash flow weighted time to maturity. The longer the bond’s maturity, the greater its value tends to fall when inflation emerges.)
Government bonds and duration perform badly when inflation spikes, exactly the time when retirees need their assets to rise.
Retirees need to be sure that their investments are managed with inflation risk in mind. That means some form of tilt towards assets with a negative correlation to inflation, such as inflation-linked bonds which increase both the principal (the amount you get back when the bond matures) and the coupon (the amount you’re paid) in line with inflation.
When performing a goals-based retirement risk assessment for preparedness for a spike in inflation, consider the following points. Does your investment or fund:
- Have flexibility to manage inflation risk through dynamic asset allocation
- Manage exposure to nominal government bonds
- Manage portfolio duration to limit possible inflation damage
- Use inflation-linked bonds to hedge against inflation
- Have exposure to assets such as infrastructure and listed property that can increase revenues in line with inflation
Increasing retiree confidence through goals-based investing
Goals-based investing is an inherently optimistic and future-focused approach to advice and investment. Its focus is on reaching deeply important personal goals.
But when we define a goal for retirement – paying our grandchildren’s school fees or funding our dream European trip – we face a set of risks that, if they come to pass, could derail our achievement of that goal.
Because goals-based funds are geared specifically to deliver an outcome for retirees, they are deeply aware of the risks that could prevent the achievement of those goals, such as sequencing, longevity and inflation risks.
Retirees have significantly more confidence in the strategies that prudently manage retirement risk with their goals at the forefront. They know the fund has planned for difficult times. And retirees will be much more likely to stay the course when those times eventuate.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.