Apr 16

Retirement Income Portfolios – poorly understood

One of the debates in the financial services media has been around the investment strategy of superannuation funds and whether they are holding too many equities. In the camp of too many equities is former Head of Treasury, Ken Henry, nd former Chairman of the Future Fund, David Murray; and opposing views have typically been valuation focused, which is not necessarily a bad thing, by fund managers. Whilst I believe this is a healthy debate and one that should have occurred many many years ago, one of the rarely spoken debates has been regarding retirement income portfolios. Unfortunately many retirees carry their ‘default’ super fund with them into retirement without any understanding of the potential inappropriateness of that portfolio. Some of the retirement income issues that need to be debated include…

  • Risks
  • Asset Allocation requirements
  • Product innovation


As opposed to accumulation stage, there are two major risks that are potentially far more damaging to the retirement income portfolio than an accumulation portfolio…

  1. Sequencing or timing risks
  2. Inflation risk

One of the world’s leading thinkers in retirement income portfolio construction is Moshe Milevsky who in his book, “Pensionise your Nest Egg”, is of the belief that the first 7 years of retirement is the most crucial period to determining whether portfolio lasts a lifetime. A sequence of negative returns can result in a dramatically changed lifestyle.

My own simulation studies also show the potential portfolio failure of a 5% drawdown growing at 3%pa has a probability of 20% of running out of money inside 25years given relatively aggressive return and conservative volatility expectations of a balanced portfolio. The sort of figures that I’m sure not too many believe or are aware of.

Inflation risk is a multidimensional one for retirees. Firstly higher inflation means higher drawdown….which is not good. Secondly, an inflation spike typically means higher bond yields and therefore lower bond prices…which is not good. Thirdly, an inflation spike in the past has also resulted in lower equity prices…which is not good. So an inflation spike can result in a portfolio destroying triple whammy on the retirement income portfolio…whilst this is not a good result in accumulation stage at least there isn’t the impact of the drawdown hit.

Asset Allocation Thoughts

The two risks above strongly suggest a need for a lower level of equities in the portfolio. Sequencing risks can be reduced with lower risk assets and they aren’t exactly a hedge for an inflation spike. So what to do? In the Global Returns Yearbook 2012, Dimson, Staunton, and Marsh examined 17 markets over the last 112 years in terms o inflation hedging asset classes and the best hedges came from inflation linked bonds, and the real assets gold, and property. Unfortunately the real assets are prone to sequencing risks and the only significant issue with inflation linked bonds are their current valuations (i.e. some inflation linked bonds are actually paying a negative real yield…bummer). Whilst there’s no silver bullet for the construction of any portfolio, if reducing sequencing risks and inflation risks is important then inflation linked bonds are a worthy inclusion.

So how much should be in inflation linked bonds? Of course. like any asset allocation decision it depends on the amount of risk one wants to reduce and the return goals of the portfolio. Some time ago, I discovered an approach to retirement income from a financial planner in the US, Mitch Anthony, who uses a Maslow’s Hierarchy of Needs for designing the portfolio…and its quite useful for determining the potential amount in inflation linked bonds. For example, if someone wants to spend $50,000 in today’s dollars each year in retirement, that may for a good lifestyle, but the question Mitch asks is…how much is the absolute minimum  that you must spend? That figure may be $30,000 and is for the base necessities of Maslow’s hierarchy of needs (food, shelter etc)…this annual income must not be placed at risk…and it is this income which potentially could be secured with an inflation linked income. The remaining income could be acquired with the portfolio of cash, bonds, and equities etc. This is obviosuly just one example but is hopefully some food for thought.

One risk with inflationlinked products is that they are linked to a general inflation indicator which is typcally diferent to the inflation level of the retired…studies in both the US and Australia have shown that in recent years inflation for the retired has been higher than for the average population so even inflation linked bonds may not keep up.

tere are other asset allcoation thoughts but in the consideration of article length I’ll leave it at that for the moment.

Product Innovation

There is one product category that has failed to lift off in Australia but has been very popular in the US and that is Variable Annuities. The kind I am specifically referring to are Variable annuities whereby the investor invests in a diversified portfolio of assets (bonds, cash, equities) and an income of 5%pa, give or take, is drawn each year and a fee is paid such that should the portfoio decline, the income is protected for life. OnePath (previously ING) have a product called Money for Life that recently closed and AXA North is another. The problem with the Australian versions of these products are that they are ridiculously expensive. For the AXA North product, last time I checked, the costs of protection were around 3 to 4  times the cost of equivalent products in the US…clearly not a good deal so its no wonder these products haven’t been popular.

From a portfolio perspective, given the goals are largely about the provision of income, these variable annuities have a lot going for them…the ability to take on risk whilst insuring an ongoing income sounds like a good concept to me. If we could see some better priced products I do believe these products have great deal of potential.

Another products that has been spoken of is the deferred annuity. Asteron life had one of these products some time ago, and basically it was an investment today that would pay income, a substantial income as I’ve been led to believe, should you survive beyond your ‘life expectancy’. The problem was, that if you didn’t survive, your invested dollar was not returned to the estate and Asteron kept it for themselves. A second problem was that adviser didn’t believe in the product so didn’t sell it…the product died. There is however, potential for deferred annuities that aren’t as strict with greater liquidity but the life companies are awaiting for government incentives before issuing.

There are many more issues to discuss but my post has gone on too long already. Its obvious the focus of the financial services industry has been on the accumulation stage but the more challenging area is in retiremnet income. The debate needs to start asap on retirement income and more education, better default solutions, and more innovation needs to occur asap. Any person who retired before 2008 with a significant account based pension has seen their lifestyle slashed and our industry must be prepared for the next crash as our age pension is slowly getting worse and the success of our superannuation system is essential.

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