Unconventional solution needed to fund longer retirements

Today's pre-retirees faces a different landscape.

Today’s pre-retirees faces a different landscape.

With the investment world getting more and more complex, ‘vanilla’ solutions are unlikely to help investors achieve their aims – particularly those approaching retirement, says Chad Padowitz, chief investment officer at Wingate Asset Management.

“Today’s pre-retirees are faced with a reality that is quite different to any operating environment in the last two or three decades.

“For example, following a 30 year bull market in fixed income, coupled with the zero interest rate policies adopted by major central banks, the risk versus return dynamic on bonds is now decidedly negative.

“Therefore investment strategies trying to include the three aims of low risk, maintaining living standards, and dealing with longevity, are blending incompatible aims.

“The reality is that in retirement risk must be maintained or even increased. This may sound concerning for many retirees, however the risk of an underfunded pension should be more alarming.

Mr Padowitz said equity markets are amongst the most suitable asset class to achieve these objectives.

“Against the backdrop of lower interest rates, equities remain one of the few asset classes that can generally provide the returns required.”

He pointed to several reasons for this:

· Capitalism works – return on equity is a long term proven model
· Dividend yields now often exceed long bond rates – an historically rare occurrence i.e. selling equities to buy bonds actuallyreduces expected cash returns
· Quantitative easing and low interest rates support equity prices, albeit this support is declining
· Corporate share buybacks and dividends support returns in the absence of earnings growth
· Cash and fixed income rates are supressed by deleveraging and central banks
· Many other asset classes suffer from liquidity issues, making them incompatible with a decumulation phase.

“However given equity markets’ inherent volatility, sources of return that are not based purely on capital growth – such as option premiums and dividends – should be considered.

“Such strategies can reduce the volatility of returns and thus reduce sequencing risk.

“For investors that are close to retirement, the trade-off between reducing risk and generating returns needs to be carefully managed; nonetheless, in the current environment of low interest rates, this equation has moved decidedly in favour of taking more equity risk.

“In a low growth environment and a fairly valued market, relying purely on capital growth to achieve returns may be somewhat optimistic over the medium term, so adding additional sources of return like dividends and option premium are appropriate considerations.

“For example, the equity market allows investors to collect option premiums, similar to an insurance premium, for agreeing to buy shares. These premiums can serve as very useful sources of return.

“Like any insurance policy, option premiums are determined by risk of loss and the volatility of that risk. For this reason the relatively high volatility of equity markets is well suited to generating outsized option premiums.

“However, this strategy is only suitable if the major risks are removed, principally removing all leverage, but also by applying certain mitigants such as only selling put options on shares you want to own at a price you want to own them.

“Investors therefore need to keep in mind that in a world that is not “vanilla”, the solutions can’t be either,” Mr Padowitz said.

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