The sharp decline in asset prices since January 2008 has badly affected one class of investors — the retirees.
Those who did not plan their retirement portfolio well may live to regret it; for the asset price decline could affect their post-retirement lifestyle.
Given this, it was not surprising when one investor asked us this question: How should the retirement portfolio be structured so as to protect pre-retirement lifestyle?
This article discusses retirement portfolios within this investment objective.
It mentions the risks associated with traditional portfolios and shows how target-date funds are good introductory investment products in the retirement space.
Traditionally, a retirement portfolio simply consisted of stocks, bonds and cash-equivalents.
A 40-year old investor had lower equity allocation than a 30-year old investor.
A strategy was to primarily allocate equity by rule of thumb- 100 less the investor’s age.
The investor had to evolve an asset allocation strategy if she wanted to reduce her equity exposure as she aged. This was tax-inefficient because cutting equity exposure meant selling shares. And that attracted capital-gains tax.
Besides, the portfolio was subject to high market risk at the target date (retirement date).
What if asset prices declined in the retirement year? The portfolio would not have enough money to fund investors’ post-retirement consumption.
These issues led to the introduction of target-date funds.
Target-date funds, also called life-cycle funds, were built on the concept that asset allocation policy had to change over the individual’s lifetime.
Such funds are typically fund-of-funds that invest in stocks, bonds and cash-equivalents.
As the investor ages, the allocation to stocks automatically reduces and exposure to bonds goes up.
Such allocation is not a linear function of age. It is instead a function of human capital, which is the present value of the future income.
Investors need such portfolios because employee retirement plans will not be enough to protect retirees’ lifetime consumption.
But it is not as if target-date funds can ensure comfortable post-retirement lifestyle.
There are risks associated with such investments, as with traditional portfolios.
The risk that the investment may not support pre-retirement lifestyle arises due to three reasons.
One, the retirement portfolio will run out of capital before the retiree dies (longevity risk).
Two, the portfolio does not have enough assets on retirement to support the required lifestyle (shortfall risk).
And three, cash flows are not enough to support lifestyle because of the general increase in price levels (inflation risk).
The longevity risk is increasingly becoming a problem because advances in healthcare has extended life span and spiralling price levels have led to low purchasing power.
The retirement portfolio is, therefore, required to generate higher income to survive through retiree’s lifetime. This necessitates exposure to equity even during the retirement phase, which subjects the portfolio continually to equity price risk.
As for inflation risk, exposure to inflation-protection bonds can help investors reduce this risk. Unfortunately, such bonds are not available in India. So, retirees’ only hedge against inflation is equity.
What about shortfall risk? A retirement portfolio will be immensely benefited if the stock market is up during an investor’s midlife, which is between 45 and 60 years.
This is because the investor can save more during this phase.
A higher return on higher asset base will enable the portfolio meet its retirement goals. Portfolio managers can also delta-hedge the equity portfolio as it nears the target date to protect the downside risk.
Target-date funds are gaining in popularity in the US. Yet, some issues need to be addressed. For one, such funds do not have appropriate benchmark to measure the performance of the portfolio manager.
For another, such funds may not be suitable for risk-averse investors who prefer zero equity allocation.
Consider the performance measurement issue. Target-date funds, like traditional portfolios, benchmark their performance to an appropriate market index.
This is, however, inappropriate because the objective of the portfolio is to protect lifetime consumption of goods, not beat a market index.
An appropriate measure may be to fix the required return that would enable a class of investors to meet their lifestyle objectives and compare the actual returns to this benchmark.
Consider next, the problem of the risk-averse investors. Their alternative investment avenue could be inflation-indexed annuities.
The Indian market is yet to offer such high-end products to suit the risk-return preferences of investors.
Worse still, target-date funds are not yet popular in India. Franklin Templeton offers a life-cycle fund but the responsibility of changing equity allocation through time is on the investor.
The investors have to be content with traditional portfolios and its associated risks till the Indian market offers more innovative investment products in the retirement space.
Protecting pre-retirement lifestyle till then may be difficult for the working class.
B. Venkatesh
(The author is an investment strategist. He can be reached at enhancek@gmail.com)
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