CPD: Building portfolios to keep retirees invested


What are the key risks facing retirees in the current economic climate?

Building portfolios for retirees is one of the toughest tasks in finance. Retirees in typical defined contribution superannuation funds must transition from the mindset of simply growing a pot of savings to having to manage the now very real risk of outliving their savings (longevity risk). Additionally there is the risk of making poor investment decisions (behavioural risk) and finally, the risk of large market corrections hitting their retirement savings at the worst possible time (sequencing risk).

This is a difficult set of risks to manage at the best of times. However, with inflation rocketing to its highest level in recent times, Australians living longer than ever before along with the threat of a global recession, the outlook for retirees has never been more challenging.

This article will tackle each of the risks faced by retirees and walk through some of the solutions and strategies that can be employed to tackle them.

Longevity risk

According to the latest Australian Bureau of Statistics study on our population, the number of people aged 85 and over has more than doubled in the last 20 years (an increase of 110 per cent). 

Figures from the United Nations are projecting a dramatic increase in people aged 65 or older. By the end of the 21st century, 22 per cent of the global population will be in this age group. That’s more than double the proportion of 9.3 per cent reported in 2020.

What does it mean for your clients? A 67-year-old now has a life expectancy of age 87 (for men) and age 89 (for women). This represents an increase of 5 years  for men and 3 years for women compared to the life expectancy of a 67-year-old just 20 years ago. Actuaries will then come along and spoil the party, with the fact that a retiring couple aged 67 have a joint life expectancy of age 92, which is distinctively not the average of 87 and 89[1].

However, it’s important to keep in mind that even if you plan for your income to last this long, then there is a 1 in 2 chance (or a flip of a coin) of actually living past life expectancy.

If the same couple want to be 90% sure they don’t outlive their savings, then they need to be planning an income that lasts till age 99[1]. That is a required retirement income of more than 30 years.

How should this impact your clients’ investment strategy?

From an investment lens, this means a typical pot of retirement savings for a 67-year old should reflect an investment horizon of 20-32 years. Based on a typical superannuation fund’s fact sheet[2], the minimum investment horizon across their investment options range from 7 years for their conservative fund, to 12 years for their high growth fund. This implies, a typical 67-year-old actually has a long enough investment horizon in retirement to justify being in investment options with higher growth allocations.

In fact, in most standard deterministic retirement calculators, we’d see that the investment option leading to the highest longevity, or most amount of expected income in retirement, is a portfolio invested in 100% Australian equities.

We all know this is a flawed argument. The drive to deliver higher returns needed to combat inflation and longevity risk needs to be delicately balanced by the risk taken to achieve this.

Behavioural risk

As a result of the market impacts of COVID-19, a typical Balanced fund[3] would have fallen -10.4% in the first 3 months of 2020.

For an accumulator, a market shock like this can be viewed as an opportunity to contribute at cheaper levels. However, for a retiree who is no longer contributing, they could be facing a substantial reduction in their retirement income for the rest of their life.

At this point, it is natural for them to look at averting further losses. Unfortunately, it is exactly this ‘loss aversion’, that leads to one of the most common and detrimental behavioural biases for investing.

According to a 2007 study[4] by AARP and the American Council of Life Insurers, the average person feels pain from a loss twice as much as the pleasure they feel, from a financial gain. From an emotional perspective, this means that the pain from losing $100, is just as strong as the pleasure from gaining $200.

The same study then shows that Retirees are actually FIVE times more sensitive to these losses. That is, losing $100 for a retiree is as painful as the pleasure they experience, from gaining $500.

This type of a bias is a key reason investors de-risk or ‘cash out’ of their investments at the worst possible time.

How can bucket strategies help?

Fortunately, advisers can play a big role in giving their clients that confidence to stay invested throughout these market cycles.

Common approaches such as using bucket strategies can also play a big part in keeping retirees invested; by segregating their investments into designated long-term buckets for their investments and short-term buckets for their spending.

These strategies can be very effective in giving investors the confidence that they have enough cash to support their income needs for a few years, irrespective of where markets are headed and helps tackle the tendency for investors to sell out at the bottom of a market cycle.

However, when viewed from an investment perspective these strategies don’t actually manage the underlying risk in the portfolio, meaning that these cash reserves can still run-out in a sustained market downturn and overall the outcomes for investors are therefore unlikely to improve materially.

Market/Sequencing risk

The elevated loss aversion as we approach retirement can be justified by our increased exposure to sequencing risk in the few years before retirement and also in the early years of retirement. Sequencing risk is a function of the sequence of returns year on year, for an investor who is drawing down on their assets.

The chart[5] below illustrates this by showing the number of years of retirement income lost from the same 30% shock, applied at different ages.

It is clear for investors within plus or minus 10 years from their retirement, that the impact of the 30% shock is at its highest. This is because within this period, their savings are at their highest, so they have more to lose and there is also little, if any, in the way of further contributions (nor time!), to help them recover from a severe market shock.

With this dynamic at play, it is clear that reducing the likelihood and severity of large market corrections for investors in this zone, is particularly important to improve their risk adjusted outcomes.

How does de-risking address market risk?

The most common approach to managing market risk as members approach retirement is de-risking. That is, reducing allocation to risk assets (typically equities) and allocating it to ‘defensive’ assets (typically fixed income). The theory behind this approach is that defensive assets such as fixed income can help lower the market risk of a portfolio through diversification benefits as well as simply being a lower risk asset class. The trade-off is of course, lower expected returns in the long run.

The following chart illustrates the average returns and volatility expected from typical investment options ranging from High Growth to Conservative[5]:

Based on this, de-risking from a typical Growth fund to a Balanced fund is expected to reduce volatility by 2.8% but also lower average returns by 1.2%. For a typical retiree aged 65, this has a cumulative impact of reducing the longevity of their portfolio by 3 years[5][6].

In practice, de-risking hasn’t been as straightforward. Last year, it was no surprise that as rates rose, bond prices fell. The Bloomberg Global-Aggregate Total Return Index (AUD Hedged) has a duration of approximately 6.8 years, so it has fallen -12.3% in 2022, whilst the Bloomberg AusBond Composite 0+ Index with a duration of 5.2 fell about -9.7% in 2022. This is one of the largest corrections in bond markets in recent history and what’s made it worse for investors looking to de-risk is that it has happened in a year where equities have sold off as well.

Instead of providing a buffer for equity markets, fixed income has actually contributed to the losses of these diversified multi-asset portfolios. The end result is that for many multi-asset portfolios, the lower risk portfolios with higher fixed income allocations have actually suffered just as much if not greater losses compared to more aggressive investment options.

Diversification is ultimately a tool that relies on correlations which are inherently an unstable relationship. For the purposes of managing market risk, diversification should be paired with more explicit and robust risk management strategies.

How do managed risk strategies address sequencing risk?

There are now managed account portfolios that have been designed specifically to address sequencing risk for retirees. These portfolios incorporate a ‘managed risk’ strategy to systematically target two objectives:

  • stabilise the volatility of the portfolio
  • minimise the impact and likelihood of large market drawdowns.

The two objectives combined, aim to create a strategy that helps improve the expected outcomes for retirees.

Stablising the volatility of the portfolio

The realised volatility of a typical balanced investment option has averaged 5.8% over the past 10 years. However, in 2020, and 2022, this would have spiked to 12%, and 7.2% respectively. This creates uncertainty and nervousness for investors.

Fortunately, market volatility exhibits a level of ‘stickiness’, that allows short-term market volatility to be forecasted. This can be done through short-term statistical forecasts and market based measures based on option pricing.
Within these new managed account portfolios, if the forecast volatility exceeds a certain level, it will actually generate a progressive increase in hedge levels and if the forecast volatility is low, it can very quickly remove the entire hedge position, to enable maximum participation in any market upside.

In the long-run, this approach is expected to keep volatility of each portfolio within a significantly narrower band, delivering a more predictable outcome and true to label risk profiles.

Minimise the impact and likelihood of large market drawdowns

Large market drawdowns happen more often than you think. The All Ordinaries had six 20%+ falls since the 80s. In fact, the likelihood of a 20%+ fall happening in equities markets over a typical 30 year retirement is 1 in 7.

It is these types of market drawdowns that can trigger the wealth destroying behavioural risks outlined earlier, and disproportionately impact retirees as a result of sequencing risk.

There are financial instruments such as put options that can be structured to contractually provide a payoff in the event of a market drawdown. However, because these instruments provide what is effectively a guarantee, persistent options-based strategies can be expensive, especially when you need them the most, in volatile markets.

Managed risk strategies instead, use a technique to replicate/manufacture a long dated put option using futures contracts. This is the same approach taken by large insurance companies and investment banks to manage the risk on their own balance sheets. The objective is to simply reduce the likelihood and severity of large market drawdowns.

The following chart illustrates the likelihood of experiencing a large market drawdown within typical portfolios compared to these Managed Account portfolios with a built in managed risk strategy:


As this article discusses, when it comes to building strong retirement portfolios, moving a client’s mindset from simply growing a pot of savings in accumulation to managing the longevity, behavioural and sequencing risks associated with decumulation is a challenging but extremely important part of the financial advice conversation.

What makes the building of retirement portfolios especially challenging is the need to balance growth assets with the risk averting tendencies of retirees and their elevated exposure to sequencing risk.

Fortunately, techniques that have traditionally been used by institutional investors to manage market risks and have successfully saved billions of dollars during the Global Financial Crisis, have been made available to Australian financial advisers and their clients.

The portfolios with these ‘managed risk’ strategies have been designed to deliver a smoother ride and can provide a cushion in market downturns, giving pre-retirees and retirees that confidence to stay invested in growth assets, to achieve their retirement goals.


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[1] Based on Australian Life Table 2015-17 with the 25-year improvement factor. Statistics from 20 years ago is based on Australian Life Table 2000-02
[2] Based on Investment options from Australian Super
[3] Based on the Morningstar Australia Fund Multi-sector Balanced Index
[4] http://assets.aarp.org/rgcenter/econ/guaranteed_income_1.pdf
[5] Assuming a starting annual contribution of $5,000 (in today’s dollar terms) that grows at a CPI + 1% wage growth annually and capital growing at CPI + 4% annually, retirement is assumed to occur at age 65 with an yearly withdrawal of $40,000 (in today’s dollar terms).
[6] Calculated based on the output from 5,000 1-year stochastic market scenarios, calibrated using Milliman’s economics scenarios generator
[7]  Based on retirement balance of $500k and $30k annual retirement income
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