By Sam Morris, CFA, Investment Specialist, Fidante Partners (Reproduced and modified with permission)
While growth assets are widely accepted in asset allocation decisions during the accumulation phase, many investors overlook the benefit allocating to shares can provide in the way of growing tax-effective income in the post-retirement phase. This paper discusses the differences between pre- and post-retirement asset allocation and how investors can use an equity income strategy to improve income and returns with less risk.
During our working lives, investment strategies are typically aimed at accumulating wealth and are less concerned with year-to-year return fluctuations. During this accumulation phase it usually makes sense to skew portfolios towards growth assets such as shares in order to maximise the final value of the portfolio. While annual returns from such strategies can be quite volatile, over longer time periods the volatility is less pronounced, particularly when inflation is taken into account.
Needs of retirees compared to workers
Accumulation investors generally do not need to rely on their portfolio returns or withdrawals of capital to support their lifestyle and are purely investing to maximise their wealth, subject to their risk tolerance.
In retirement, investors have a very different risk profile and appetite and should think about risk and return differently.
According to National Seniors Australia1, over 90 percent of seniors rate the following factors as very important when addressing retirement spending (in order of importance):
- Meeting the rising cost of healthcare
- Ensuring their money lasts a lifetime
- Having regular income to cover the essentials
- Income that adjusts for inflation
- Ensuring their savings are not adversely impacted by market falls
- Having access to their savings instantly when needed
Thus, for retirees cash-flow matters and the pathway of returns matters. Retirees will be reliant on the income from their portfolio to live on. The higher the income, the higher the cash available to fund day-to-day expenses without the need to sell the capital assets that produce the income.
Furthermore, the month-to-month fluctuations in returns – both capital and income – of those assets matter. Investors in the accumulation phase can endure market declines because they have time to recover their losses and also can contribute more funds to buy assets at lower prices.
1 National Seniors Australia / Challenger, “Retirees’ Needs and Their (In)Tolerance for Risk” March 2013.
The two key investment considerations for retirees
1. Sequencing risk
Retirees do not have the luxuries afforded to accumulation investors. Not only do they not have a steady income from their workplace skills – their human capital – to supplement their financial capital, but if they have to sell their financial capital to fund their living expenses during periods of lower prices, their retirement savings are not likely to last as long.
This is known as sequencing risk, because it is higher at the early stages of retirement when the retirement portfolio is largest but needs to last the longest – hence the sequence of either good or bad returns is very important. Retirees can mitigate sequencing risk by investing in low-risk assets that have less capital value volatility, but this comes with another trade-off, known as longevity risk.
2. Longevity risk
Longevity risk is essentially the risk of outliving one’s money. Investing in low risk assets minimises sequencing risk, but it comes with the trade-off of potentially not generating sufficient returns to meet desired spending over the retirement timeframe. In the current low-yield environment, traditional retirement asset allocations heavy on fixed income, term deposits and cash simply do not provide the same future expected returns that they used to.
A key component of longevity risk is inflation – which erodes the purchasing power of savings. This is why it is important to ensure both your income and your capital value keeps up with the rising cost of living. Whilst inflation has moderated in recent years, the fact remains that the cost of living for retirees is actually rising faster than the broader population, in part due to healthcare costs.
Why traditional thinking on asset allocation in retirement needs to change
Traditional retirement allocations are heavy on fixed income…
In making this trade-off, a typical retiree portfolio would skew them away from growth assets such as shares, towards less volatile assets, such as bonds and cash.
The traditional way of dealing with some of the risks in retirement portfolios is through asset allocation – shifting the mix of assets into less volatile asset classes such a bonds and cash. This is generally a conscious decision to trade more longevity risk for less sequencing risk: a higher risk portfolio has higher future return potential – reducing longevity risk – but at the expense of sequencing risk if a large market crash takes place early.
This traditional allocation towards fixed income has been supported by a favourable return environment for fixed income securities over the last 30 years as long-term interest rates have fallen, which coincides with much of the development of the retirement savings and funds management industry.
…yet fixed income may not be able to deliver the same absolute returns going forward
Fixed income still remains an effective portfolio diversification tool as its returns are generally negatively correlated to equities over the cycle. However, future returns are likely to be lower and more volatile. In addition, fixed-rate bonds (which comprise the majority of traditional benchmark fixed income allocations) are a poor inflation hedge – interest by definition is fixed and does not grow, nor do investors benefit from tax-effective franking credits.
Whilst falling interest rates have supported historical fixed income returns, it means that current yields – the ‘price of safety’– are at record lows.
For retirees with capital within account based pension structures, with minimum annual draw-downs exceeding 4% and rising to over 7% during the peak spending periods of retirement, current yields on the fixed income asset classes mean that they must spend capital to meet their minimum drawdown requirements.
If investors need to draw down capital to meet spending, this means that the capital remaining is less likely to last as long. It is unlikely that the yields on the above instruments will go back to the levels that existed before the GFC in the foreseeable future given global macro-economic headwinds.
How equity income strategies address the key investment considerations for retirees
Investment in equities has the potential to add considerable value to the issues detailed above. Equity income strategies attempt to build upon the inherent income production strengths of equities whilst reducing the risk of capital loss.
• Use of equity income strategies to lower longevity risk
Australian equity yields have remained attractive compared with pre-GFC levels. Unlike foreign equities, which often have yields below 3% and no franking credits (plus extra volatility on this income stream by virtue of foreign exchange risk), Australian equities deliver cash-flows to end investors that are the envy of the world.
Importantly, dividend income streams are much less risky than many investors would assume. Over the past five years from October 2011, the return on the ASX200 price-only index has averaged 6.3% p.a. with risk of 12.6% p.a. Yet the same index, but with dividends and franking credits included and reinvested, has returned 12.9% p.a. with risk of 12.1% p.a. – much more return with slightly less risk.
The returns from dividends inclusive of franking credits on the ASX200 have been consistently around 6% p.a. over the past 15 years with around 1.5% annual volatility – a testament to the steadying influence of dividends on overall returns.
Furthermore, within an Australian context, retirees also benefit from the tax treatment of fully franked dividends relative to bank deposits and bonds. For retirees, franking credits are as valuable as cash dividends or interest received, and can reliably add an extra 1.5% to 2.0% in annual returns.
In short, shares can provide rates of return from dividends alone that can exceed minimum drawdown amounts on pension accounts.
Shares also deliver capital returns that ensure portfolio values keep up with inflation. Companies with good competitive positioning within their respective industries have what is called ‘pricing power’, meaning that they are able to pass on increases in the cost of their inputs to their end customers, or they benefit from economies of scale that enable them to grow revenue whilst keeping their costs relatively static. Both of these factors mean that investments in well run, strongly positioned companies should benefit from cash flow streams that comfortably exceed inflation over time.
Furthermore, the average dividend yields on the market have remained very consistent through time, yet the capital value on the share market has increased. This means that the actual cash flows received from the stock market have increased in line with the capital value appreciation, growing at a much faster rate than inflation.
So shares have the potential to deliver a rising capital value and a rising cash flow stream that protect against losses of purchasing power.
• Use of equity income strategies to lower sequencing risk
Despite the income advantages of Australian shares, retirees are left with higher price risk then other asset classes. A way to reduce this risk is to use derivatives that remove a large part of the price risk associated with a traditional share portfolio, while at the same time retaining the significant tax benefits – the access to franking credits.
This approach partially hedges share exposures by selling call options and using proceeds to purchase put options. The call options reduce returns in stronger markets but, importantly, the put options protect capital in weaker markets.
The net effect is that volatility is reduced, leading to less sequencing risk. Because hedged share portfolios are less risky than traditional share portfolios, a greater allocation is justifiable for a given level of overall risk, lowering longevity risk whilst ensuring that the contribution of the share allocation to sequencing risk remains flat or declines.
Unlike accumulation investors, retirees face different challenges to maintaining an income stream sufficient to deliver the lifestyle they have been saving all their working lives for.
Investing in shares allows retirees to access the strong fundamental cash flow generating capabilities of well-run companies which have the potential to generate dividend streams and capital returns which can maintain a portfolio’s spending power.
Equity income strategies such as Merlon’s can then overlay a volatility reduction strategy that can substantially lower the risk of the portfolio running out of money early. Combined with a fundamental research process that invests in companies that are undervalued and likely to generate sustainable cash-flows creates an equity solution perfectly suited for retirees.