[su_note note_color=”#d2d2d2″ radius=”0″]Over previous weeks, this series of articles has looked at two broad issues, specifically longevity and later life investment strategies, that planners need to consider when assisting clients with their retirement income plans.
The final part looks at portfolio construction and whether conventional wisdom meets the needs of retirees in decumulation.
The articles are based on a research paper commissioned by Sanlam Private Wealth authored by Dr Paul Cox of Birmingham University[/su_note]
I recently watched an excellent video produced by the Financial Conduct Authority (FCA) regarding its expectations of how risk profiling fits into the financial planning and portfolio construction process.
What was clear to anyone watching this was that the profiling process should only be the start of the investment discussion, especially in decumulation where investment consideration can be very different to accumulation.
The FCA’s 2015/16 Business Plan makes absolutely clear that client advice processes and outcomes in the decumulation arena are absolutely at the top of their agenda. This article, I hope, will give you some assistance in making sure that your processes are in tip-top shape.
Building a profile
As mentioned already, for most portfolio managers and advisers the starting point in building a portfolio is to assess the views of clients when it comes to accepting investment risk.
But in retirement, risk becomes multi-faceted – it is not simply about day to day volatility of the portfolio, or likelihood and extent of a drawdown. Clients in retirement have to contend with a need for income, certainty of its delivery and potential longevity of the fund.
The thing is, not all risk profilers are capable of assessing the risk to income because they pay insufficient attention to the timing of expected cash-flows out of the portfolio. Similarly, they model portfolios on a total return basis, whereas in retirement a client and their adviser may logically separate the concept of yield and capital return.
So, understand that risk profiling is a measure of investor responses to risk scenarios, usually stated in isolation from their income needs. Risk
Risk profilers attempt to give an appropriate distribution of scoring linked to an idealised, long-term, stochastically modelled set of asset class returns. They do not claim to fill the final mile between the risk profiling exercise and suitability.
The second step is usually to think about diversification across asset classes to reduce (capital) risk.
This is fine provided that (a) you believe that modern portfolio theory is correct and applicable to decumulation investing (b) you take history as a guide to the future and (c) you do not believe that asset classes can change their levels of inherent risk and correlation over time.
The reality is, of course, somewhat more complex. Assets that are considered “safe” by many have demonstrated long losing streaks in the past. Between 1963 and 1970, Gilts suffered an eight-year sequence of losses (in capital terms) and the current economic climate may again make diversifying into such assets a very
Between 1963 and 1970, Gilts suffered an eight-year sequence of losses (in capital terms) and the current economic climate may again make diversifying into such assets a very high-risk proposition.
And avoiding losing streaks is important. The modelling we undertook in the search for ideal investment solutions emphasised the need, at all costs, to avoid being a forced seller (at a loss) in the early years of a portfolio’s life. Similarly, we know from the outset that not all the capital in the pension fund will be invested for at least five years, there will be outflows to contend with.
Similarly, we know from the outset that not all the capital in the pension fund will be invested for at least five years, there will be outflows to contend with.
Our modelling also led us to conclude that because of the near infinite variability of time horizon and size of cash-flow out of portfolios in retirement there is probably no single ideal portfolio (fund) that will become a default solution for investors. Drawdown really does have to be tailored to the individual.
A layered process?
So with these factors in mind, might a better process be to build a portfolio of more than one part? Instead of trying to achieve a compromise that may meet all needs, how about a more distinctly segmented portfolio?
Having this “layered” discussion instead of describing one, overarching portfolio, may help the client to better compartmentalise their portfolio so that they better understand the need to take risk to achieve their longer term goals. They may be more confident in taking risk because they can see how shorter term needs will be met, irrespective of volatility that affects the longer term portfolio.
Short-term and medium-term portfolios
So how do you build the short-term portfolio? I think that any adviser will agree that for capital allocated to very short-term income requirements the trustee bank account is probably the right place. Minimal return but no fees charged.
Liability matching is a great concept for the second tier of the portfolio but buying individual lines of stock or funds that exactly match the payment due dates may not be possible due to the practicalities of working through a funds only platform or even minimum deal size and liquidity. Short dated bond exchange traded funds (ETFs) are a welcome addition to the investment armoury.
Structured products have a place too, provided they are “vanilla” and offer a good way of producing cash+ returns with a reasonable degree of security.
The growth portfolio – yield and quality
We have to show our cards here. We like yield.
Yields on the assets typically held within managed portfolios (equities and corporate bonds) generally show a narrow range of variability.
Provided the portfolio manager is not asleep at the wheel and finds himself/herself holding stocks where yields are being cut or coupon payments defaulted on, this return is going to be delivered, regardless of market volatility.
Quality of stock is important too. In the equity space there are plenty of well-run companies that carry little leverage, generate significant cash and return a lot of that cash to investors, if not through dividend payments then by share repurchases.
It is a frustration that so many investors focus on the short term without giving due consideration to the longer term, which in the drawdown case may mean trying to make a fund last for 30 years in retirement.
Consider the chart below (Dividend Aristocrats) which demonstrates the ability of companies focused on consistency of value and dividend growth to outperform over the type of timescale applicable to retirement.
But coming back to the concept of diversification, if we deliberately target sectors that deliver yield and have these ‘high quality’ characteristics then are we not undermining the concept of diversification? Very possibly but when did diversification for the sake of it take precedence over constructing a portfolio that actually meets the clients needs?
We looked at the MCSI All Country total (see chart) and this suggested that focusing in certain sectors may not deliver an outcome different from a more diversified portfolio.
What would be more worrying would be ill-considered diversification into stocks or funds that are more cyclical in nature.
Our research suggested that while there may be periods where the additional return from cyclical stocks are meaningful, the additional volatility and downside that they also carry should be an amber (if not red) light to a post-retirement investor.
There will probably never be a panacea ‘at-retirement’ product. Sure, there will be lots of clever ‘solutions’ but most likely they will be over-engineered, expensive and ultimately flawed.
The real answer is to use old wisdom to deliver new solutions and to treat clients as the individuals that they are.
Suitability can never be driven by process alone but a considered framework applied to each situation, once properly assessed, stands a good chance of delivering what the client expects, as well as an outcome judged as ‘good’.
This is a huge opportunity for the adviser community and properly explored gives the chance to build successful and long-lived relationships and businesses.
Ian Porter, head of business development and marketing, Sanlam Private Wealth