By Jayson Forrest
Building portfolios for retirees that can withstand market volatility in a fluid market environment, is one of the great challenges facing advisers. Victor Huang (Milliman) and Tim Cook (Russell Investments) discuss their approaches to retirement portfolios.
As wealth decumulators, retirees face many unique challenges — longevity risk, sequencing risk, and market risk. For advisers, managing market risk for retirees, whilst balancing their retirement needs, can be demanding when building portfolios for this cohort of investors.
According to Victor Huang — Principal and Head of Investment Solutions Asia-Pacific at Milliman — the biggest challenge in creating a portfolio (or strategy) for retirees is the need to balance different types of financial objectives, such as: maximising income, stability of income, and access to capital.
Durand Oliver
Milliman
Tim Cook
Russell Investments
Victor Huang
Milliman
There are many studies that show retirees fear loss five times as much as they value a gain. That’s because from a financial perspective, retirees have a lot more to lose financially and a lot less time to recover from a significant loss in the markets
Speaking at the 2024 IMAP Independent Thought Conference on building retirement portfolios, Victor says considering these key objectives in a portfolio can be a delicate balance between the use of growth assets and defensive assets.
“Retirees are living longer than ever before, which means they need to maximise their income. They can do this with an exposure to growth assets and lifetime income streams,” says Victor. “However, both pre-retirees and retirees tend to be more risk-averse and are definitely exposed to sequencing risk. That’s why they also need exposure to defensive assets or risk management solutions.
“Retirees also typically want access to capital, which can be achieved through account-based pensions. So, when building portfolios for these investors it’s important to understand their objectives and needs, in order to help them navigate the products and strategies available. There is definitely a need for products that help balance the different financial objectives of retirees.”
This fear of loss can drive retirees to de-risk their portfolio to defensive assets, like cash, just after market drawdowns. De-risking combined with drawing down their portfolios in retirement can exacerbate the impact of sequencing risk
Investing for retirees
Another challenge of building retirement portfolios is the uncertainty of investment returns, which can have a considerable impact on the financial outcomes of both pre-retirees and retirees. And that’s where behavioural and sequencing risk both kick-in.
“There are many studies that show retirees fear loss five times as much as they value a gain. That’s because from a financial perspective, retirees have a lot more to lose financially and a lot less time to recover from a significant loss in the markets,” says Victor. “This fear can drive retirees to de-risk their portfolio to defensive assets, like cash, just after market drawdowns. De-risking combined with drawing down their portfolios in retirement can exacerbate the impact of sequencing risk.”
According to Victor, investors who are close to retirement or in early retirement are most impacted by sequencing risk as a result of large market corrections. For example, a 30 per cent market shock at age 65 can take away 13 years of retirement income from a retiree’s portfolio. However, if the same shock happened to a 30-year-old, only five years of retirement income is lost.
“As a result of the behavioural and sequencing risk faced by retirees, managing market risk becomes a significant factor for advisers to consider for their clients. By doing so, advisers can reduce the chance of clients getting ‘spooked’ by market shocks or drawdowns, which may lead to de-risking at the wrong time and suffering a significant drawdown early in their retirement, which can make it difficult for them to recover from.”
During market downturns, retirees can leave assets in their growth bucket and dip into their spending bucket for income. This bucketing approach helps to protect clients from downturns, meaning they don’t have to de-risk their portfolios or liquidate assets when the market is down
Managing behavioural risk
Tim Cook — Head of Client Strategy and Implemented Consulting at Russell Investments — agrees that managing behavioural risk and keeping pre-retirees and retirees invested in the market, is one of the key challenges advisers face, especially in the current market environment.
Russell Investments takes a multi-tier approach to tackling this challenge with its portfolios. This includes selectively using active management in portfolios to help minimise the risk retirees face.
“We have also designed an offering that clients feel comfortable about using,” says Tim. “We use tools like a personalised glide path (the way the asset mix of a client’s portfolio changes over time) and our GoalTracker program. GoalTracker enables clients to calculate how much income they’ll need to fund the lifestyle they want in retirement, see how they’re tracking to their income goal, and making a plan to help them get there. Tools like these provide clients with confidence, clarity and control over their financial future.”
Russell is also an advocate of the bucketing approach to investing, which provides clients with different pools of assets/income from which to draw on. A bucket strategy categorises assets into separate ‘buckets’, which generally covers short-term income needs, intermediate requirements and long-term necessities. Assets within each bucket is normally invested in different ways, depending on when the money will need to be accessed.
As part of this approach, Tim believes it’s essential to include a growth bucket as part of any retiree’s strategy, “because retirees still need to have investment growth in retirement”.
“This means that during market downturns, retirees can leave assets in their growth bucket and dip into their spending bucket for income. This bucketing approach helps to protect clients from downturns, meaning they don’t have to de-risk their portfolios or liquidate assets when the market is down,” he says.
Milliman manages this behavioural risk by using a systematic risk management strategy within its portfolios.
“We like the idea of understanding what the distribution of returns are in a particular market and/or portfolio under certain conditions, which can be achieved by using a systematic risk management strategy. For example, you can work out the probability of a fund returning 10 per cent or more, or 10 per cent and less, or negative 15 per cent. You can calculate that and calibrate a strategy to try and minimise (or maximise) the probability of those types of events happening,” says Victor.
He adds such an approach is particularly important when considering behavioural risk, as it helps an adviser to identify what type of market environments and scenarios are going to impact the behaviour of clients.
“It doesn’t matter so much if the markets are up 6 per cent and your portfolio is up 5 per cent, because your clients are unlikely to do anything. But if the markets are down 15-20 per cent and your portfolio is also down by the same amount, then that’s when it can be detrimental to clients if they decide to de-risk their portfolio.
“However, on the flip side, when markets are significantly up, clients want to be participating in that run. Therefore, it’s important to ensure your portfolio still has the right exposure to growth assets, in order to be able to deliver strong returns in bull markets.”
Not surprisingly, Victor believes it’s extremely important for advisers to have a dynamic approach to managing risk when participating in the market. He says such an approach also provides clients with the confidence to stay invested throughout market cycles.
Whether your client is a wealth accumulator or a retiree, they generally have a fairly long investment horizon. So, it’s important to ensure they have a sufficient amount of growth exposure to participate in the market upside
Moving through the advice journey
The needs of wealth accumulators are much different to those of retirees, which means that as clients transition through their advice journey, so too must an adviser re-evaluate and readjust their clients’ investment strategies and portfolios. However, at Milliman, its investment philosophy for investors, regardless of their wealth stage, doesn’t really change.
“Whether your client is a wealth accumulator or a retiree, they generally have a fairly long investment horizon. So, it’s important to ensure they have a sufficient amount of growth exposure to participate in the market upside,” says Victor. “The question is about how much growth and defensive exposure they take on. This depends on their risk appetite and how much market downturn and volatility they can handle, before they feel the need to de-risk or move into cash.”
From Milliman’s perspective, wealth accumulators should be in high growth for their entire accumulation period — up until pre-retiree stage. However, he concedes that this ideal growth exposure is not suitable for every accumulator client, with some clients remaining risk-averse.
For these clients, Milliman offers a growth portfolio that does include a scaled down version of risk management. It has been designed specifically for those accumulators who should really be in high growth but who are not comfortable taking on that amount of risk. These clients are looking for some buffer when markets take a hit.
“This approach is a good way to encourage advisers to get their risk-averse clients into growth portfolios by essentially using an offering that manages some of the downside risk,” says Victor.
Advisers need to clearly articulate to clients the reasons why they have set up this approach with their portfolios. It’s a learning journey for clients, which needs to be explained as simply as possible. Clients need to know that this strategy will help them to withstand any downturn, while enabling them to rebuild their assets during the market recovery
Adapting to different market environments
Tim acknowledges that with retirees living longer these days, there’s real concern with older Australians about whether they can maintain their lifestyle in a market environment that is constantly changing. He believes given the volatility of markets, managers need to be focused on their respective investment philosophies and strategies when adapting to different market conditions.
He says fluid market environments require adaptive investing, which aims to deliver consistent returns by adjusting to ever-changing market conditions.
Russell takes a two-pronged approach to this. Firstly, there is the active management component that sits within its portfolios. Russell’s managed accounts have a unique dynamic core, which allows portfolio managers to use active management to adapt the portfolios in real-time, taking advantage of market opportunities and reducing unnecessary changes at a platform level.
This dynamic core alleviates many of the problems of having to trade in or out of this structure. That’s because the core allows the manager to put derivatives in place, which can protect on the downside, while enabling portfolios to remain dynamic and active.
And secondly, Russell encourages the bucket approach to investing, which includes a spending bucket for clients to draw on when required. Tim believes that a combination of both approaches is ideal for allowing clients to remain invested during different market environments.
“Advisers need to clearly articulate to clients the reasons why they have set up this approach with their portfolios. It’s a learning journey for clients, which needs to be explained as simply as possible. Clients need to know that this strategy will help them to withstand any downturn, while enabling them to rebuild their assets during the market recovery.”
Victor agrees: “The market environment is always changing. One of the things we focus on within our portfolios is to ensure that the returns clients are receiving are relatively consistent over time, even as market environments change.
“We seek to manage and stabilise volatility within our SmartShield portfolios. We do that through a managed futures approach, where we forecast short-term volatility and trade in and out of derivatives to essentially stabilise the volatility in the portfolio,” he says.
“An approach like this not only provides investors with confidence to remain invested in the market over the long-term, which is important, but also provides clients with considerable comfort in the investment strategy they’ve chosen.”
About
Victor Huang is Principal and Head of Investment Solutions Asia-Pacific at Milliman; and
Tim Cook is Head of Client Strategy and Implemented Consulting at Russell Investments.
They were part of a panel discussion on ‘How we build retirement portfolios’ at the 2024 IMAP Independent Thought Conference in Melbourne.
The session was moderated by Durand Oliver — Head of Distribution at Milliman.