Goals-Based Investing

Rethinking the investment approach in post-retirement

By Darren Beesley
Sydney, Australia

The common way of doing something becomes so engrained in us that it can often cloud our ability to solve new problems. As a species we have a strong primal tendency to stick to the status quo and not challenge established ways of thinking. Yet as the problem we are trying to solve evolves, with new problems emerging or new technology changing the landscape, we need to reconsider whether what we’ve accepted to be true may no longer be relevant.

In the Australian superannuation industry there’s an opportunity to challenge the established ways of thinking.

Our industry and its approach to investing was built for the wealth accumulator. The design aspects of most funds including the investment objective, definition of risk, performance measurement and portfolio attributes are appropriate for the younger, working individual who is growing their superannuation wealth.

The investment approach the industry has developed over the years serves younger investors (those accumulating superannuation) well. However, news ways of thinking could bring about more bespoke investment approaches for those who are retired and are drawing down on capital.

New ways of thinking in post-retirement

In accumulation the investment objective is simple - most aim to maximise accumulated wealth (given an individual’s risk tolerance). This means that within each growth allocation category (conservative, balanced growth, high growth, etc) - total return is most important. This also explains why there is such a focus on comparison tables of the funds within each category. For example, you probably know how your favourite balanced fund ranks amongst its competitors.

Yet in retirement the investment objective is not simple nor common across all retirees.

An individual’s mixed priorities between consumption and bequests, income and capital growth, a different tax environment, varying liquidity needs and the elevation of certain risks such as sequencing risk and inflation risk make investing for post-retirement very challenging. It’s no longer just about total returns within a growth/defensive bucket.

This fundamental difference means that some investment practices used in the super accumulation phase don’t necessarily apply to the retiree phase. Here’s five examples:

  • Defining risk by the “growth/defensive split”

What defines risk to a retiree? It can be a hard question to answer but for most retirees their “growth/defensive split” means little to them intuitively nor aligns with the key risks they face.

One of the most significant risks introduced in retirement is ‘sequencing risk’, which is the risk of a large GFC-style loss at the start of retirement which causes irreversible damage to future spending plans. Continuing to draw down on capital at suppressed asset prices can crystallise losses and take away the chance for those assets to participate in a recovery.

We believe a “potential loss” risk measure is both more intuitive and improves alignment in managing sequencing risk.

  • Underutilising tax trade-offs

Retirees typically invest in an account-based pension structure with a zero tax rate up to $1.6 million . With no tax payable, any franking credits received by zero tax payers are effectively convertible to cash . With every dollar of franking credits on Australian equity income equating to a dollar in the retiree’s pocket, the investment trade-off between income, realised capital gains and deferred capital gains changes. 

Most funds however set their investment objective irrespective of tax implications. We believe a more effective fund objective for retirement incorporates the benefit of franking credits. This then incentivises the fund manager to make aligned decisions between franked income and unfranked income, and franked income vs capital gains/losses (such as what is available in off-market buybacks).

  • Holding a static asset allocation

A static “buy and hold” mentality to asset allocation has some merit over a very long horizon (20+ year) – long enough to wait out cycles in asset class pricing. The tolerance for shorter-term losses is lower in retirement, and a more flexible/responsible approach to asset allocation is required to allow the fund to avoid expensive asset classes and dampen volatility.

  • Less focus on inflation risk

Inflation is not a significant risk for young accumulators. An unexpected risk in inflation will damage asset prices, particularly fixed income assets such as corporate and government bonds, but over the longer term the effect on equities may become positive. Further to this the salaries of younger people in work will have a link to inflation therefore their future super contributions could be expected to be higher in an inflationary environment.

As rising inflation is a benefit for the accumulator in many ways, superannuation funds tend to give less focus to hedging inflation risk. But when retirees’ assets are invested in a traditional ‘balanced fund’ that was designed for an accumulator, as is often the case, does this make sense?

Retirees have no future salaries or contributions that may be linked to inflation, so their assets are the only inflation hedge they have. Yet on the defensive side of their fund (which is usually higher in retirement) they hold mostly bonds which are actually the most negative correlated asset to rising inflation of any. On the growth side, they don’t have the investment horizon to see out the long-term positive impact inflation can have on equities and are more likely to feel more of the negative short-term impact rising inflation can have.

Given this, it makes sense to have an investment approach in post-retirement that is more considerate of potential negative impacts of short-term inflation.

  • Thinking “defensive” assets are actually defensive

The most prominent change to a retiree’s investment strategy under the status quo will be to lower risk. As discussed in the first example, this means reducing the “growth/defensive split”. This may mean for a conservative investor holding 70 per cent defensive assets mostly comprising bonds and cash. Yet bonds are currently at incredibly expensive levels and carry heightened risk of capital loss. This loss is likely to materialise on any signs of reflation which triggers accelerated downward pressure on bond prices.

Labelling these assets defensive and giving less focus to valuations and inflation risk makes less sense for a post-retirement investor.

What we’re doing differently for retirees

Below is a list of adjustments we believe need to be made to the investment approach when moving from accumulation to decumulation:

Rethinking Retirement

At AMP Capital, we’ve taken a unique approach to our post-retirement solutions. We believe it is prudent that retirees’ portfolios have the following attributes designed to address specific risks and needs in retirement:

  • Defining risk by what could be lost in a stressed environment
  • Hedging against large losses using tactical tail risk hedging instruments such as options
  • Factoring in the tax implication of franking credits
  • Applying dynamic asset allocation to avoid expensive asset classes and protect capital
  • Explicitly thinking about the risk of inflation to the retiree and holding inflation hedges
  • Skewing the portfolio toward income when reasonable, but not at any price

As the amount of assets entering retirement continues to grow, we believe the industry will invest differently for those in retirement. Risk needs to be defined differently, tax needs to be accounted for, and the stability of return needs greater focus. A question to ask yourself is - Is your post-retirement fund making similar adjustments?

  • Goals-Based Investing
  • Goals-Based Investing Update
  • Income
  • Retirement

Important notes

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.

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