new direction / sefa ozel

As clients transition into retirement, their portfolio needs change. Switching from deposits to withdrawals can be complex. Clients also must consider their needs and whether to focus on preserving capital or growing their nest egg to pass on to future generations.

In the accumulation phase, the primary focus should be on long-term goals, diversification and growth. In this stage, a client’s portfolio can take on more risk to drive long-term returns. Furthermore, dollar-cost averaging can benefit investors as they invest at regular intervals (through both up- and downmarkets).

When a client is ready to retire, their portfolio should be reconstructed to meet their changing needs and mitigate key risks such as sequence of returns, longevity and inflation. In retirement, market volatility can become problematic when clients must withdraw from their portfolios. In addition to generating income, longevity becomes a critical issue, as their portfolio must last and outpace inflation.

A retiree’s portfolio must also be well-diversified and provide cash flow (for income needs), generate growth (for longevity) and offer stability (capital preservation).

As part of this portfolio reconstruction, advisors should aim to understand each client’s needs and goals in retirement:

  1. Are they seeking to increase wealth to build a larger estate value? This client would require a portfolio that generates returns beyond their income needs.
  2. Are they looking to preserve their nest egg? This client would need a portfolio return to match their spending.
  3. Are they willing to deplete their portfolio over time by accessing both investment return and the principal? This client is not looking to have a residual estate value and therefore does not require returns beyond their income needs.

Each of these outcomes requires a different asset mix and should vary based on individual client circumstances and risk tolerance.

The new reality of declining defined-benefit pension plans and people living longer means that retirees are responsible for making their incomes last for their lifetime. According to a recent Pollara survey, 66% of retirees aren’t confident about where their retirement income will come from. Given this, it’s important for clients to have a retirement income plan and revisit it regularly.

Aligning various dependable income sources with regular retirement spending and matching those with outcome-oriented solutions to last throughout retirement is complex and should be tailored to each individual. For example, getting the right order of asset withdrawal can be complicated, but it’s crucial as retirees seek to maximize their income and minimize tax. The difference between an optimal and suboptimal income withdrawal strategy can be significant.

In addition to considering and balancing the goals of preserving capital, growing their nest egg or spending, an approach to reconstructing the portfolio might include matching the asset mix to the needed time horizon, known as a bucket strategy.

Near-term needs (up to 24 months) are funded with a cash wedge, while medium-term needs (two to 10 years) are funded from a balanced mix of income-oriented equities, bonds and alternatives. Finally, longer-term needs (more than 10 years) are structured with a more growth-oriented portfolio with higher exposure to equities and alternatives while maintaining some exposure to fixed income to maintain proper diversification.

From a retirement income perspective, one important consideration in transitioning portfolios from accumulation to decumulation in a lower interest rate environment is that, to get the same expected return today versus 30 years ago, investors must take on three times the volatility. It requires investing in riskier asset classes, and income needs to come from not only fixed income but also dividends and capital gains to outpace inflation and address longevity. Given this and the above-identified threat of sequence of returns, it is vital to manage risk for better risk-adjusted returns.

One way to address key retirement risks, such as sequence of returns and longevity, is to invest in a fund that focuses on downside protection through the use of derivatives. It’s necessary to invest in a fund that has various risk mitigation strategies, such as implicit and explicit risk management, to reduce large losses in the portfolio as well as smooth out long-term performance. Markets are vulnerable to sharp declines, and it is essential to mitigate this downside risk when drawing income to prevent locking in those losses, which lead to less capital to recapture upside movements. This can be done through puts, calls and collar strategies to cushion the impact on the fund’s net asset value. This strategy involves mitigating downside risk relative to the market by locking in the selling price (through puts) and selling the upside performance to another investor (through calls). Using this put and call strategy together is called a collar strategy.

Without the ability to use derivatives to provide explicit downside protection at the portfolio level, volatility can still be managed through a thoughtful and disciplined approach. The process begins with the appropriate asset mix using product solutions that provide diversification benefits. The primary principle is that diversification across asset classes, including equities, fixed income, alternatives, geographies and investment styles, is at the core of delivering higher risk-adjusted returns.

While investing in retirement requires long-term considerations due to the possibility of outliving one’s money, and growth is needed to outpace inflation, we are seeing in portfolio reviews that many portfolios are taking too much undue risk. Unlike in the accumulation phase, investors are increasingly put at sequence of returns risk if their portfolios aren’t reconstructed for retirement.

On the other side of the spectrum, we also see portfolios that are too conservative, meaning investors will not achieve their income needs. A balanced approach that is focused on growth, downside risk mitigation and income is the key to successful investing in retirement.

New retirement realities call for thinking differently about client retirement investment strategies. Because of this, downside mitigation becomes increasingly important as well as ensuring the portfolio remains well-diversified to deliver on the client’s goals and objectives in retirement.

Luc Lafleur is associate vice-president of portfolio construction with Mackenzie Investments.