Investments such as cash and term deposits provide respite during periods of volatility, but the current low level of interest rates means these investments have quite limited attraction in terms of their total return, especially after taking account of inflation. Importantly, we believe the low level of interest rates will persist for a number of years. It is therefore likely that too large an allocation to these investments will mean that client outcomes fall short of achievable long-term financial goals.
The risk of being too defensive
As people enter retirement they may intuitively have an increased preference for defensive assets such as term deposits. Historically, a sizeable commitment to defensive assets did produce reasonable total return outcomes because interest rates were on average well above the inflation rate for protracted periods. So the strategy did support an adequate level of retirement spending over time without generating anxiety about wealth ‘going backwards’.
It does make sense to be somewhat more defensive at retirement because that is when you have the largest account balance and there is reduced capacity to work longer and save more. However, in the prevailing environment where the cash rate barely exceeds the inflation rate, clients are increasingly vulnerable to specific types of risk: inflation risk and retirement adequacy risk.
This risk arises because spending power erodes over time due to a rising cost of living. For long-term savings, it is important to assess rates of return after inflation has been accounted for. (This is often called the real rate of return.) For instance, currently the real rate of return on term deposits is barely positive. Almost all of the income from the term deposit needs to be reinvested – allowing little for spending – if the investment is to maintain its purchasing power. By contrast, many growth investments such as property, infrastructure and share investments have dividends that are likely to rise with inflation over time. These investments help to guard against inflation risk over the medium term but come with the discomfort of higher short-term volatility.
Retirement adequacy risk
Retirement adequacy risk refers to the problem of transforming financial assets at retirement into a cash flow stream that allows a retiree to fund an adequate retirement lifestyle. The average life expectancy for Australians is increasing and retirement savings need to adequately provide cash flow for 30 years or more. Given the asset balance of a typical retiree today, allocating too large a portion of savings to low-yielding defensive assets could result in cash flow running out prematurely.
Time vs. risk – striking a balance
Choices around investment strategy are influenced by an investor’s timeframe and the importance of their various goals. Retirees face a long horizon investment problem. A key financial goal is to receive a high and stable cash flow from their portfolio throughout retirement. This is not the same as requiring ongoing stability of returns on a short-term basis. Investment strategies that strike the right balance between defensive and growth assets are more likely to support retirees’ cash flow goals.
Benefits of diversification and risk management
Investing across a number of assets – and in a number of different strategies within each asset class – can help to reduce portfolio volatility as different asset classes generally perform better at different times. Factors including market conditions, interest rates and currency markets can affect investment outcomes. Risk management involves the application of specific strategies to mitigate downside risk. For example, in the past few years, exposure to foreign currency served to reduce the portfolio impact of periodic sharemarket weakness. Diversification and risk management help reduce the risk of retirees abandoning their long-term strategy during phases of temporary pain.
Combining defensive and growth assets
When choosing the investment strategy best suited to meet a client’s needs, it is important to consider the economic characteristics of their goals as well as the expected returns from various asset classes over the medium to long term.
It makes sense that clients approaching retirement adopt a higher allocation to defensive assets than when they were accumulating wealth. These defensive assets can provide confidence that spending goals early in retirement are well covered by safe assets. However, it is also important to hold some growth assets that have the potential to support higher cash flows on a medium-term and long-term horizon.
Finally, it is important for retirees to be able to adjust the cash flows they access through retirement as circumstances change or as living expenses vary. Liquidity is important for retirees.
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.