There are proven solutions and that employ managed risk strategies and are available to Australian financial advisers to assist their clients with achieving their retirement.
Retirement signals one of the most important periods in an individual’s lifetime – once their work-life cycle begins, it is for many people a significant life-stage on the horizon.
Even though it could be many years away, retirement planning requires careful consideration when it comes to their finances. For many, it presents the picture of a time to relax after years of hard work, time to travel and to enjoy their nest-egg, yet there is a very serious side to it. Managing one’s finances and planning for this important life-stage is therefore one of the most challenging tasks in financial planning.
As highlighted in another recent article by Milliman, Building portfolios to keep retirees invested, requires moving a client’s mindset from simply growing a pot of savings in accumulation to managing the longevity, as well as behavioural and sequencing risks associated with decumulation.
It’s an extremely important part of the advice conversation and in the current high-inflationary and uncertain market environment, the outlook for retirees has never been more challenging.
At the end of the day, it all boils down to two key (not so simple) questions:
- How much income can I take in retirement? And following that:
- How can I improve it?
Traditionally, the approach used to answer this question was tackled by setting an asset allocation coupled with an assumed withdrawal rate (e.g. 4%) and then modelling this along various paths of a single return stream (i.e. historical market returns at different points in history).
We know from historical events that this rudimentary approach is indeed not fail-safe; as history has taught us, it has significant flaws that haven’t accounted for some of the most significant market crashes in the past 20 years.
If we therefore tackle these questions with a stochastic lens across the retirement income challenge, we get some very interesting results.
Rather than setting a withdrawal rate and testing it for success, a stochastic approach enables us to optimise the level of income using thousands of projected scenarios that are based on a probability of success, while also factoring in unexpected tail events. In doing so, it enables the consideration of a much-wider spectrum of potential outcomes including multiple cases of severe market corrections and continual portfolio withdrawals, which together may significantly impact the sustainability of any retirement portfolio.
Jack, 67 with $1m invested in a Balanced portfolio, is retiring and has a question for his adviser
How much retirement income can he comfortably draw down each year, from his portfolio, to carry him through retirement?
To answer this, we have first projected 5,000 sets of real-world market scenarios[1], including projected inflation rates. Income is assumed to increase in line with the projected inflation rates at each scenario and time step and is then assumed to be withdrawn from Jack’s balance at the end of each year across the planning horizon.
The planning horizon, or really the question of ‘how long will Jack live for?’ is another unknown that adds a whole new dimension to the retirement challenge (and one which we won’t delve into in this article). For the purpose of this analysis however, we will make the assumption that the planning horizon is 20-years, i.e. the life expectancy of a 67-year old male[2].
For each of the 5,000 scenarios, we can measure if Jack is able to maintain the level of withdrawal without running out of money at the end of the 20-years. Based on this, a probability of success is obtained. Whilst this probability of success is an important and easily understood measure, it is a binary measure (for each single return path) and doesn’t provide any information around how ‘bad’ the outcomes can be.
As such, we also look at the ‘conditional tail event’ – answering the question “in the event things do go bad, how bad can it go?” This is determined by looking at the average shortfall in the worst 1 out of 10 scenarios.
In this analysis, the following constraints are placed to determine the sustainable withdrawal rate:
- At least 90% probability of success; meaning he won’t run out of money throughout retirement in 9 out of 10 scenarios
- Potential shortfall of no greater than 5 years in the worst 1 out of 10 scenarios; meaning that in the event where he does run out of money, he can expect to not be short for more than 5 years.
For Jack, our 67-year-old male with $1m retirement balance, this approach leads to a sustainable retirement income when invested in a Balanced portfolio of $45k per year (real income). This is based on an average compounded annual growth rate (CAGR) of the Balanced portfolio over 20 years of 7.2% (pre fees) in the scenarios used.
Whilst calculating the sustainable withdrawal rate is useful, what’s more important for advisers is being able to improve it reliably for their clients
Traditionally, this has been done by shifting allocations between equity and fixed income assets. And whilst this approach was generally successful in the 1980s and 1990s, today’s market conditions with lower real yields, high levels of market volatility and soaring inflation have made it much more difficult for many retirees to generate (real) income, without taking on too much risk.
The challenge in the traditional planning methods lies in the trade-off of risks between allocation to equities and fixed income assets. Too much in equities may mean too much market risk, whilst too much in fixed income may equate to a lack of growth. In some ways, it is a zero-sum game. This can be quantified by examining the effects of allocating into 100% equities, and 100% fixed income, respectively.
Table 1 below indicates the attainable sustainable withdrawal rate, average CAGR as well as the standard deviation of returns for each of the Balanced, all equities and all fixed income portfolios we examine.
The effect of allocating to 100% equities is a sustainable withdrawal rate of $40k per year, $5k lower than the withdrawal rate obtained when invested in the Balanced portfolio.
This is largely due to the impact of adverse market environments and the sequence of returns risk associated with the equity markets. That is, due to the higher risks (volatility) associated with equity markets, there are more scenarios where the return paths lead to the retiree running out of assets by the end of the planning horizon, despite the all-equities portfolio having a higher average CAGR of 9.2%
The sustainable real retirement income of the 100% fixed income portfolio is $38k per year, $7k lower than the sustainable withdrawal rate obtained when invested in the Balanced portfolio.
It is evident that whilst the risk is much lower on the fixed income portfolio, there’s much less growth potential as well given the average CAGR of 4.6% over 20 years. As a result, in an environment with insufficient yield, or when excess risk must be taken to achieve the sufficient yield, investing in fixed income provides some protection around market risk, at the cost of greatly reducing the retirees’ withdrawal rate.
What makes the building of retirement portfolios especially challenging is the need to find a delicate balance between the exposure to growth assets with the risk averting tendencies of retirees and their elevated exposure to sequencing risk. Nothing could be worse than taking money out at the bottom of the market only to put them into something with much less growth potential in the future.
We delved into this topic in more detail in our recent CPD accredited piece Building portfolios to keep retirees invested.
Managed Risk strategies
Fortunately, there are now Managed Account solutions available to Australian financial advisers and their clients, that employ managed risk to provide clients with a cushion in market downturns.
These solutions employ strategies that dynamically hedge the portfolio against volatility and extended market downturns.
It is all done systematically, with the level of hedging being adjusted daily based on the market environment and implemented in real-time using futures contracts throughout the day. This is a similar strategy used by large insurers and institutional investors over many years to hedge their long-term liabilities and have successfully saved them billions of dollars during the Global Financial Crisis
The result for investors being that it helps to lower and stabiles volatility, whilst also reducing the impact of large market drawdowns giving investors that confidence to stay invested in growth assets to achieve their retirement income goals. By not providing a ‘hard guarantee’, the cost for these strategies can be efficiently managed.
For the adviser it can help solve the retiree conundrum that is all too familiar: ‘Recommend a more aggressive portfolio to generate healthier returns and risk taking the heat when a market downturn devastates the client’s retirement savings. Alternatively, if we keep retirees’ capital in conservative investments, we risk their retirement savings run out well before their life expectancy.’
The table below illustrates the same metrics explored above, for a Balanced portfolio with the inclusion of a managed risk strategy.
Here we note there’s a $2k improvement in the sustainable withdrawal rate with the managed risk strategy included, coupled with a marginal reduction in the volatility of returns albeit with a slight reduction to the average CAGR as well.
By utilising managed risk strategies to address issues such as market shocks and sequence of returns risks, there is more room for Jack to potentially reduce his overall exposure to fixed income assets and participate in growth assets to a greater degree, which can also help to improve his sustainable withdrawal rate.
Now, Jack has another question for you – what happens if a market correction like the ‘GFC’ happened today, right when he was about to retire?
Given the volatile markets we’re experiencing, where we seem to have lived through a couple of ‘1 in 100 years events’ in less than 20 years – with the Global Financial Crisis (GFC), 2015 market sell-off, Covid-19 market crash in 2020 and most recently the impact of unwinding over a decade worth of monetary policy, it is not a surprise that market corrections are at the very top of retirees’ minds.
To proxy this, we observed the actual performance of different asset classes during the GFC[3]. The results show that the benchmark Balanced portfolio dropped 24.45% in value over the period. However, an equivalent fund with the managed risk strategy in place fell only 6.74%.
Jack’s retirement balance ($1m) was then reduced accordingly based on the reduction level observed and we performed the same calculation to determine his sustainable withdrawal rate.
As can be seen in the charts below, the resulting sustainable income in retirement drops to $33,500 per year for the Balanced fund. This indicates a 25% reduction in the standard of living in retirement for Jack. However, with the managed risk strategy alongside, it drops by just under 7.5% to $43,500 per year, enabling Jack to safely maintain his retirement lifestyle.
Conclusion
For decades, conventional wisdom has said “When the market goes down, ride out the storm. Eventually the damage to your portfolio will be corrected” or “Wait it out; and batten down the hatches”. Unfortunately, for many – especially those closest to retirement who do not have the benefit of time in the market to recover – this advice has not proven the best and they have been left significantly short of their retirement income goals, from their portfolio.
Traditional methods used within financial planning for calculating a ‘reliable’ income stream and shifting asset allocations between growth and fixed income asset classes have unfortunately fallen short and for many retirees, that can have a huge detrimental effect upon their retirement income. As we have noted here, real income for retirees in the current market environment: investing in equities may mean too much risk; whilst investing in fixed income typically results in lack of growth.
We have explored the concept of turning a large pot of money (retirement balance) into a number that is more relatable for retirees – a level of sustainable income that enables them to live their desired retirement lifestyle.
The real value-add that advisers are able to bring to their clients, is the ability to either reliably increase a client’s sustainable income; or maintain it during times of high market volatility.
Today, there are proven solutions that employ managed risk strategies and are available to Australian financial advisers to assist their clients with achieving their retirement, particularly in the current and ongoing volatile environment.
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