If you thought building a retirement portfolio with interest rates at 1% was challenging enough, brace yourself for a new gauntlet being thrown down by our Canberra legislators.
In a move that’s likely to change the way retirement portfolios are designed, the Federal Government is introducing a retirement income covenant that will require superannuation trustees to seek to maximise a retiree’s income for remaining life, not just life expectancy.
That change of wording will have a big impact, as it recognises that those fortunate to live longer than expectancy (84 for males and 87 for females) simply need a longer lasting portfolio. That will potentially require planning for a 35-year portfolio duration (rather than 22 for life expectancy) because under a remaining life principle, you need to provision for the chance you’ll live to 100, even if you don’t.
From a public policy perspective – you can see the merit in the covenant. Having a burgeoning post-retirement population with portfolios designed for expectancy isn’t going to be entirely useful if half of the folk live beyond it.
But bear in mind there’s no extra dollars to help retirees increase their portfolio mileage. The same dollars will simply need to last a third longer – and remember that’s in a world where rates not expected to tip above 1% anytime soon.
You don’t need to be Einstein to see a looming challenge ahead.
As there is an implementation period before the covenant commences in July 2020, action can be taken now. A possible first step may be to reassess how the portfolio is invested and whether it can last 13 more years on the same tank of fuel.
This is where expert personalised financial advice or consulting can really prove its value, because the change will probably force a change in portfolio design and drawdown profile.
The change in the investment mix could be profound, because chances are a 35-year portfolio will need more in higher income generating or capital growth assets than a 22-year portfolio, for a given drawdown sequence. And with that, higher risk.
But here is one of the greatest paradoxes in retirement portfolio construction.
Increasing the exposure to a riskier asset class like shares, can lower portfolio risk long term – we’ll get to the reason later. And that exposure to riskier shares can be moderated by investing in low-risk equity strategy. Like a lot of things, it’s the execution of the principal that matters.
That’s because the level of risk of investing in Australian shares is not homogenous – it depends on the equity strategy employed. For example, holding a traditional equity fund aiming to maximise capital growth is a whole different ball game than investing in an equity income fund focusing on capital preservation. Both are equity investments – granted – but are chalk and cheese when it comes to risk levels.
Can lower equity risk extend portfolio life?
It can be shown, at least in theory, that extending the longevity of a retirement portfolio may be possible by switching exposure towards low risk equities – particularly if it’s low risk against the equity market.
Because we are comparing risk against a sharemarket index, an effective measurement tool is Beta, which compares the volatility of a fund to the volatility of the sharemarket. It tells you the degree to which a fund is sensitive to sharemarket movements.
For example, a low Beta of 0.5 means the fund has half the sensitivity of the market. A Beta of 1 implies the fund has the same sensitivity – just as volatile.
Beta casts no judgement on whether the volatility leads to better or worse performance – it just measures relative volatility.
The chart below shows how long a nest egg is expected to last under two different approaches in lowing risk for retirees. A common strategy called the bucket approach (grey line) blends 50% cash and 50% equities (either an index fund or possibly more akin to an equity accumulation fund). An alternative approach is to invest in an equity income fund with a beta of 0.5.
Both portfolios start with $614,000, with an assumed 10% per annum return on shares over the long term, cash return of 1.5%, annual living costs of $43,255 (based on ASFA comfortable retirement), and CPI of 2%. Given where markets are poised, we have also assumed equity markets suffer a 20% decline in year one of retirement.
Given that both retirement portfolios have a beta of 0.5, it minimises the impact of the equity market correction in year one. Big tick. However, the retiree investing in the Beta 0.5 equity income portfolio (gold line) will in theory, have a 35-year portfolio that includes income earned on the equity portfolio, plus a gradual drawdown on the capital base, until all funds are exhausted at age 100.
But look what happens to the lifespan of the bucket approach. It is halved, and only lasts 17 years, to age 82.
So to put it another way, switching to a low-risk (low Beta) may double the theoretical lifespan of a retirement income portfolio.
How does this happen?
While the cash/equities blend will reduce risk, over the long term the very low returns from cash will result in running out of money faster. You can blame low rates for this. It simply forces the retiree to draw down on other assets that would otherwise generate higher income.
It’s ironic that the very thing that many retirees have relied on for safety – cash – may do the exact opposite when rates are low and more years are needed.
Of course, if rates rise, then the outcomes will change, but the basic principle still applies.
The key point here is that lowering equity Beta may extend the lifespan of a retirement portfolio, without needing more money upfront. And we’re not talking just a few extra years. In this scenario the lifespan is doubled. That’s a massive difference in a retiree’s living standards.
It’s worth considering a low Beta fund, if you want to reduce the risk sensitivity of your retirement portfolio.
At the end of the day, you can’t go back in time and increase a retirement nest egg. But you can act today and change the way it’s invested and potentially the extra distance it now needs to go.
So how can you lower portfolio Beta?
If you are seeking to reduce portfolio Beta, the first consideration is to look beyond the marketing of equity income funds and compare the Beta results.
Our research indicates the Vertium Equity Income Fund has the lowest level of Beta compared to other equity income funds in the Australian market, when assessed from its inception in April 2017. Lower beta means lower volatility of returns and hence less chance of negative surprises. The chart below compares the results.
Vertium seeks to deliver a low-risk experience for equity income investors by its focus on low portfolio risk first, stock selection, and deployment of cash as a key risk management tool. A low Beta is not specifically targeted, but proof of the process.
Speak to Copia today (Vertium’s distribution partner) to discuss how Vertium may lower your market risk exposure and potentially expend the life of a retirement portfolio.
Past performance is not a reliable indicator of future performance. This document is for general information purposes only and does not take into account the specific investment objectives, financial situation or particular needs of any specific reader. As such, before acting on any information contained in this document, readers should consider whether the investment is suitable for their needs. This may involve seeking advice from a qualified financial adviser.
Copia Investment Partners Ltd (AFSL 229316, ABN 22 092 872 056) (Copia) is the issuer of Vertium Equity Income Fund. To invest, contact Copia on 1800 442 129 or email firstname.lastname@example.org or visit vertium.com.au. Any opinions or recommendations contained in this document are subject to change without notice and Copia is under no obligation to update or keep any information in this video current.