As interest rates hover near the zero bound retirees must drive faster, on narrower roads or face a higher probability of never reaching their destination. However, forced to take on ever-increasing levels of risk just to stay on pace, traditional retirement investment approaches now pose a serious danger.
Even before the COVID-19 crisis further dampened global growth prospects and squeezed interest rates closer to zero, the level of additional risk required to match returns had at least tripled over two decades.
According to a September 2016 study by US investment research house Callan Institute, in 1995 investors would have earned 7.5 per cent on a portfolio consisting entirely of low-risk bonds – a pretty compelling investment proposition for retirees.
“… by 2015 to achieve comparable returns that fixed income portion was down to just 12%, with growth assets – stocks and private equity making up around three-quarters of the portfolio,” the Callan study says.
“Return-seeking portfolios are now more complex and expensive than ever.”
Financial advisers, then, can no longer simply cushion portfolios with a higher proportion of fixed income securities, to achieve target returns of this magnitude, as clients move closer to retirement.
Inevitably, retirement income portfolios will have to fuel up on growth assets such as equities to sustain returns over the longer term.
Out of order
Adding more equities to the mix certainly improves the theoretical retiree investment outcomes and expected returns over time.
For example, a 2014 paper by noted Australian academic Michael Drew (and others) found that investing more in growth assets over time is “the equivalent of a 3% increase in superannuation contribution”.
While the Drew study focuses primarily on portfolio construction for those still working, it also highlights one of the biggest issues inherent to holding a greater exposure to equities as retirement looms: sequencing risk – or the risk that the order and timing of investment returns are unfavourable, resulting in less money in retirement.
“Sequencing risk is highly relevant to the issue of retirement adequacy because a large market downturn occurring close to retirement could deplete a worker’s retirement nest-egg to the point where it may never recover,” the Drew paper says.
Australian investment research house and consulting firm, Lonsec, further elaborates on sequencing risk in its May 2020 analysis of the Allianz Retire + ‘Future Safe’ retirement income product.
Lonsec labels the years of 55-75 as especially prone to sequencing risk as individuals prepare to maximise retirement savings and then look to sustain a certain level of income.
Foot on the accelerator (and the brake)
While many retirees may not grasp the technical details of sequencing risk, they do appear to have an intuitive understanding of it.
The Lonsec report, for instance, notes the now well-accepted concept of ‘loss aversion risk’ – a notion based on behavioural finance research that shows in general people feel the pain of a loss twice as much as the joy that is felt from a gain.
“Interestingly, and perhaps not surprisingly, this ratio increases as people approach retirement,” the Lonsec report says. “What is surprising is that the magnitude of this increase; retirees fear losses 10 times as much… (a 10:1 margin)”.
“In practical terms, this means many retirees are willing to reduce the probability of negative returns at the expense of upside potential.”
Caught between the need to take more risk to generate returns and a strong psychological desire to play it safe, retirees rely on financial advisers to help them navigate this challenge.
Safer travelling: why investors want seatbelts and airbags
Interestingly, research commissioned by Allianz Retire+ this May found that only half of Australian retirees said their financial adviser presented investment options that made them feel safe.
Of course, advisers are obliged to point out investment risks but the study reveals that a significant proportion of retirees are interested in products that offer some insurance from market downturns, like Future Safe by Allianz Retire+.
With features that enable retirees to set a limit on their exposure to market losses while still providing the potential to earn the upside gains of growth assets, Future Safe is one of the few retirement income vehicles designed for the risky road ahead.