One of the challenges advisors face when preparing and managing a client’s retirement plan is to reduce the risk of the client running out of money during their retirement years. Some of the questions advisors often grapple with are:
- What if the client lives longer than the typical life expectancy?
- What if the client retires during a great financial crisis or a pandemic?
- How much growth assets and offshore exposure should the portfolio hold?
- How do you manage market risk in the portfolio?
These are just some of the questions our research has focused on over the last few years. The aim was to have an evidence-based framework to help advisors navigate the difficulty and dilemma of investing during a client’s retirement years.
Our research focused on developing strategies to address two key considerations when managing a portfolio for retirement:
Sequence risk
While sequence risk is not as important in the accumulation phase of a client’s investment journey, it can make or break them financially, and emotionally, during the decumulation phase. Clients retiring at the start of a bull market often have a much better investment experience than those starting their retirement journey just before a major market correction or an adverse event like the COVID-19 pandemic.
But what can you, as a financial advisor, do to reduce sequence risk? Our research shows that appropriate asset allocation, based not only on long-term returns but also on incorporating different risk criteria, is critical in constructing a decumulation portfolio. Secondly, continuously applying tactical asset allocation based on the valuation of asset classes is one of the best strategies to mitigate sequence risk. However, implementing this requires a portfolio mandate specifically developed and managed for retirement investing. That’s why we believe an outcomes-based investment strategy implemented through building blocks is appropriate for this purpose.
Ruin probability
The second consideration is longevity. In 2022, South Africa had the largest elderly population in its history. Living longer may be wonderful, but it also means your retirement portfolio needs to last longer. Therefore, when constructing a portfolio for retirement, the ruin probability should be considered. Ruin probability refers to the likelihood of a retirement portfolio being unable to provide the income required for the specified investment horizon. Our research found that ruin probability can be reduced through appropriate asset allocation. However, the optimal mix of growth assets and offshore exposure is affected by the portfolio withdrawal rate.
| 6% initial withdrawal, 5%escalation, 30-year investment horizon | 7%% initial withdrawal, 5% escalation, 30-year investment horizon | |
| Growth assets | 40%-60% | 80%-90% |
| Defensive assets | 40%-60% | 10%-20% |
| Local assets | 70%-80% | 65%-70% |
| Foreign assets | 20%-30% | 30%-35% |
| Ruin Probability | 12% or Less | 33% or Less |
Our research found that at a 5% withdrawal rate, the ruin probability can be reduced to less than 5%. It is also interesting to note that at this withdrawal rate, the ideal portfolio requires fewer growth assets and less offshore exposure – the main drivers of risk in a portfolio – than expected. As indicated in the table above, the exposure to growth and offshore assets increases as the withdrawal rate increases. However, increasing these assets does not mitigate the ruin probability. At a 7% withdrawal rate, a client has a 33% probability of running out of money before the 30-year investment horizon.
Findings like these indicate that constructing a retirement portfolio entails more than selecting the right funds; it requires portfolio design based on defined financial and behavioural outcomes.
