Daring to take the plunge

Mike Morrison discusses the role of risk in the development of a retirement planning portfolio

The word ‘risk' comes from the early Italian word ‘risicare' meaning ‘to dare'. This seems to suggest that risk is perhaps a matter of choice rather than one purely of fate and, in this way, perhaps it is possible to control or manage.

In a retirement planning portfolio there are a number of risks that need to be addressed, some it would appear we can control and others that we perhaps cannot.

Investment risk

This is perhaps the easiest one to attempt to address, at least in theory anyway. There are a number of questionnaires and computer programmes that, through a number of questions, seek to ascertain an individual's attitude to risk. These often address perception of risk but also an attitude to loss.

We have moved on from the days when you would just ‘risk rate' an individual on a scale of one to 10, with one being totally risk averse, 10 being speculative, and most people would come out as a five!

Although not a perfect science, it should be possible to construct an investment portfolio that should perform in line with the client's profile, as long as a degree of investment expertise exists to assist in that construction.

More and more financial advisers need to understand investments and portfolio construction or to be able to delegate this function to a specialist.

Portfolio construction needs to consider the range of asset classes and their correlation. At its most complex there will also need to be an understanding of issues such as volatility, and indicators such as alpha, beta, and the Sharpe Ratio*, as well as other portfolio measurement tools.

Managing a retirement portfolio will invariably involve a number of distinct phases - at its simplest, an accumulation phase and a decumulation phase, and for each of these the investment problem might be different, perhaps maximum returns in accumulation and maintenance of capital in decumulation.

The other important thing is that the portfolio is regularly reviewed and, if required, adjusted to take account of changes in circumstances. This would have been particularly relevant over the last year with the volatility in investment markets.

Longevity risk

We are all living longer than anticipated and there can be a real risk that we will live longer than our retirement assets. The life expectancy for a 65 year old man in 2009 is an additional 21 years, and for a 65 year old woman is an extra 23 years and, as far as we can see, this is continuing to increase.

An annuity will pay a stream of income for life and therefore is an effective insurance against longevity. However, annuities are criticised for other factors, particularly the inability to pass capital on down the generations and the fact that that they are perceived as a poor investment.

Mortality cross subsidy is an important feature of annuities with the annuitants that die before their life expectancy, enhancing the benefit of those that live longer than their life expectancy.

A way of ‘de-risking' an investment portfolio may well be a gradual conversion to annuities over a period of time, particularly at older ages when the return is enhanced by the mortality gain.

Inflation risk

Another area of risk that can affect a retirement portfolio is inflation, particularly when linked to the increase of longevity. It is entirely possible for retirement to last in excess of 30 years and during this time we could endure a whole range of inflation cycles. At an inflation rate of 3% per annum for 20 years an individual would need £27,000 a year to maintain the same purchasing power as a starting income of £15,000 per annum.

It is important that the rate of investment return on the portfolio exceeds the ongoing rate of inflation to enjoy real growth. This might mean having to change the risk profile of a portfolio in times of high inflation or to use index-linked investments.

In today's pensions world, with the breadth of possible investments allowed and the choice between annuity purchase and unsecured pension, plus the option of phasing, the management of risk can be vital. The move from defined benefit to defined contribution has fairly and squarely put risk back onto the individual and management of that risk can mean the difference between a comfortable retirement or not.

Mike Morrison is head of pensions development at AXA/Winterthur Wealth Management

* http://www.investopedia.com/articles/mutualfund/112002.asp?viewed=1