Wealth Management

Jenny Williams
Senior Servicing Consultant

 

 

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Considerations of a long-term well-structured retirement portfolio – Part 2

What is the appropriate construction of an investor’s retirement portfolio – and debunking some common investment myths

Last quarter we covered the structuring of retirement portfolios as the first in a three-part series.  This quarter sees us analysing the difference between pre – and post – retirement portfolio construction.  We also analyse some investment errors we see fairly consistently.  

Considerations and pitfalls of portfolio construction within a retirement portfolio which may still be many years from retirement

When considering assets related to retirement savings, many investors, regardless of their age, immediately revert to an orientation of preserving capital at all costs, favouring this conservatism over a bumpier investment ride up to, and into retirement.  Ironically, this primary decision often undermines the fundamental objectives of long-term planning, which is the cornerstone of creating retirement income requirements.

By being unduly focussed (because there is the luxury of time) on not losing money – with the subsequent requirement for a conservative investment approach – misguided investors are unable to focus on long-term total return objectives.  These investors destine their investments to a progression of short-term risk-free time horizons, at the expense of realistic long-term growth which is based on time-honoured and proven investment strategies. 

Rather than focus on this ‘fear of loss’ (as is a common human behavioural trait), GTC would recommend that one consider specific short-term objectives and goals (i.e., schooling, home maintenance, and holidays) outside of one’s retirement portfolio, and plan for these accordingly, not diluting or tainting one’s longer-term retirement investment strategy.  One’s appetite for risk and volatility must certainly be considered in this construction, though it should never be the singular focus of an investment portfolio. 

Another common investment error – and this is not solely in the domain of individual investors, but also trustees and actuaries – is adopting retirement age as a specific investment target date.  Whilst the responsibility of a trustee for the appropriate construction of a retirement investment portfolio may cease once a member reaches nominated retirement date, the portfolio needs to continue delivering for many years thereafter.  Age (say) 65 should be seen as approximately two-thirds of one’s life expectancy and not an end date in itself. 

While we are de-bunking investment myths and highlighting flawed strategies, we might as well tackle another elephant in the room…

Life-stage portfolio modelling has been a popular and commonly used methodology for constructing and managing retirement investment portfolios for many years.  As the name implies, an investor’s particular stage in life (age, earnings, assumed lifestyle choices, home ownership, number of children, etc.) affects a pre-determined composition of a specific investment strategy.  Life-stage investing automatically sees a portfolio being progressively de-risked as an investor nears retirement age. 

In a world of ever-increasing technology and data assimilation, the simplicity of life-stage investing could be seen to be superficial and generic.  Portfolio construction assumptions based on accurate specific data are now possible, rather than relying on the simplistic lifestyle categories devised many years before this data analysis was ever possible. 

An investment strategy that automatically assumes it is appropriate to progressively reduce risk as one approaches retirement age is simplistic at best and sometimes glaringly flawed. 

Typically, in the latter years of employment, a retirement fund member’s highest levels of income are earned. 

 

Applying an overly conservative life-stage strategy (which often prevails for several years) to assets within a retirement fund during this phase of employment, can significantly undermine investment performance.

Common financial advisory practice within GTC is to contact a retirement fund member ahead of retirement.  This engagement often establishes that a member is invested in a portfolio focussed on preserving capital.  GTC, adopting the retirement planning responsibility for this member is then required to reconstruct their portfolio for it to have any possible chance of providing the required income that an investor requires for the next (say) 20 years.  

This same investment portfolio may well have met a retirement fund trustee’s and an asset consultant’s obligations to deliver a required value at a specific date without any danger of a depressed end value.  Just as surely, this portfolio is likely to be inappropriately positioned for the long-term post-retirement period of many years.  As already noted, a retirement date should be but an interim point in the tenure of this investment strategy.    

Interest rates can cause a distorted and compromised investment perspective.  Investors often make the error of de-risking equity-based portfolios in favour of perceived higher interest income portfolios.  Equally, it is true that money market and bond portfolios can be useful for short-term tactical strategies and for providing short-term financial goals, which cannot afford market volatility as compared with long-term investment objectives (which can withstand and indeed benefit from this same volatility), and should be used accordingly.  These same capital preserving strategies can result in significantly reduced returns over the longer period, impacting the income potential on a post-retirement portfolio.  

It is important that an investor understands the tax consequences of holding cash, before and after retirement, in compulsory and discretionary investments.  Government regulates the asset composition of retirement portfolios through Regulation 28.  You can watch our video on this subject here. 

This subject has been covered in previous Trendline articles.  The complexity of taxation highlights the need for seeking professional financial advice. 

Though we are critical of the inappropriate use of overly conservative portfolios, particularly in the construction of long-term retirement savings, there are many occasions when conservative asset allocation strategies should be applied. 

If a retiree were intending to use their retirement savings to purchase a fixed annuity with their working career’s investment proceeds, any capital loss at the time of the transaction would be very compromising.  Equally, once the portfolio is required to provide drawdowns (i.e., either regular or ad hoc income withdrawals) it will be financially damaging to be forced to sell an investment at a suppressed value.

Electing the appropriate investment horizon for each stage of one’s life, while running multiple investment objectives concurrently, is the cornerstone of sound financial planning.  This could perhaps be seen as personalised and sophisticated life-stage modelling. 

After retirement date, the same portfolio that was used to accumulate funds for a member (who is now a retiree) must be restructured so as to provide income in the short-term, investment capital for income in the medium term, and longer-term appreciation to meet income goals 15 or 20 years away.  

Next quarter we will discuss the appropriate revision of a retirement portfolio once its objective is to provide (some degree of) income rather than its capital appreciation objection whilst the member is working.