Four tips for constructing a Goals Based retirement portfolio

A goals based fund might have a clear goal of drawing down capital to fund an investor’s retirement.

But how do you then construct the fund’s portfolio to actually deliver that goal in the current environment?

By stepping through our current portfolio, we can provide four key strategic and tactical tips that will help investors manage their own SMSF or client’s retirement portfolio.

1. Franking focus

Looking first at Australian equities, when it comes to tax, most retired Australians’ assets sit within an account-based pension.

Therefore, at the margin, we tend to prefer franked income to capital gains as a source of return. For retirees on a 0% tax rate, they will be able to receive an uplift of up to 43 per cent on each dollar of fully franked dividend. (For every 70 cents of dividends, investors can receive a tax credit of up to 30 cents, which equates to 43 cents per dollar of dividends).

In our retirement goals based funds we do two things to boost our after-tax returns.

We outsource to Australian equity fund managers who have a clear mandate to generate high levels of franked income. And we increase our exposure to Australian equities beyond what we would like in terms of risk.

Based on risk, we would hold 10% to 15% of our portfolio in Australian equities. But for our goals based funds we increase that up to 25% to get more franking credits. We then hedge out some of that risk using futures to get our desired amount of equity risk.

2. Stable and growing income

In terms of global equities, we aim to align risk with the needs of retirees. That means being dynamic, but also risk averse. We are aware of downside risk but also try to move out of overpriced assets.

Within global equities, we tilt towards listed infrastructure and in most environments listed property because those asset classes have previously shown stable and growing revenues that nicely align to the typical income and inflation protection needs of retirees.

At this point in time, however, we are tilted into listed infrastructure but out of listed property because we feel that there are certain headwinds, including the move to online shopping and other factors, that could drive listed property prices lower going forward, although this is never a certainty.

3. Inflation-linked bond ballast

When it comes to the defensive side of the portfolio, investors should consider whether their retirement portfolio has bonds that are inflation-linked or nominal.

The majority of bonds are nominal, so they pay a fixed amount that isn’t adjusted for inflation. When inflation starts to pick up and expectations rise, nominal bonds tend to underperform.

By contrast, inflation-linked bonds 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, providing protection.

So it’s quite prudent for retirement portfolios to tilt towards inflation-linked bonds.

While inflation linked bonds are a better risk match, they may also deliver a higher return than nominal bonds if realised inflation turns out to be greater than “breakeven inflation”. The current breakeven inflation rates for 10-year bonds in Australian are just 1.53%, which in our opinion, presents a good opportunity to enter an inflation hedging asset at a reasonable level.

4. Caution around credit and duration

In terms of fixed income, a retirement portfolio may also include exposure to credit risk and duration.

Right now, we feel that credit exposure such as US corporate high-grade bonds are expensive given the risks they represent. These bonds currently offer around 1.2% above government bonds on average. However, we are late in the economic cycle and leverage is extended, suggesting to us the additional return does not sufficiently compensate the risk of default. We currently have very low exposure to corporate credit risk.

We also feel ‘duration’ is becoming expensive. Longer-term government bonds (those with higher duration such as 10-year bonds) have moved strongly higher since November 2018 when the US Federal Reserve indicated it would slow its cash rate hiking path. Following the strong rally, we are now taking profit and lowering the duration of the portfolio in response to the lower yields on offer.

Delivering outcomes

When an investor has a clear goal of generating a retirement outcome, they should consider constructing a portfolio that delivers a number of things including downside protection, income, inflation protection and liquidity.

The four tips above – seeking franking credits, tilting to inflation-linked bonds, tilting to listed infrastructure, and managing credit and duration exposure – will potentially enhance an investor’s prospect of delivering that outcome in the current environment.