Preparing for the journey

Graham Bentley goes through the different issues affecting asset allocation during retirement

After years of slaving, nose-to-the-grindstone sweat and toil, retirees should look forward to a stress-free retirement. They may also expect that the work on their pension will have ceased. All the ups and downs of the accumulation phase are over, so now there’s just 20 to 30 years of worry-free withdrawals. However, retirement could be described as a journey, not a destination.

During the drawdown phase of retirement the dynamics don’t change. Asset allocation of investment funds in retirement is even more important. There are two variables that affect the ‘decumulation’ phase – lifestyle, e.g. potential spending habits, and the combination of capital performance and income generation required to fund that lifestyle.

The first principles of investing for retirement are about shortfall and the risk of ruin – will the client run out of money before they run out of life? Typically advisers’ default position is to assume that retirees’ spending will be around 70% of pre-retirement spending. This can be hopelessly wide of the mark in terms of what modern retirees actually end up spending.

A client who hopes to spend his retirement enjoying the view from his garden will demand a very different approach from a client who hopes to enjoy the view from each of the Seven Wonders of the World. Research¹ indicates that spending patterns may decline, rise (over inflation) or be stochastic (i.e. random), depending on the psychological profile of the investor. Meanwhile, one study² suggested that there were five behaviour retiree-profiles that would together categorise the vast majority of clients:

Socialite. Modest spending with more time for patronage and community with a constant spending pattern.

Gardener. The stereotype – stay at home more, food intake decreases, declining real consumption.

Uninsured. Retires early due to poor health, with a slow debilitation (e.g. arthritis, non catastrophic e.g. stroke). Retiree has a potentially increasing pattern of consumption.

Explorer. Pre-retirement this retiree would have saved a lot and spent little. Post-retirement, they will expand their horizons, particularly by travelling and eating out. There will be higher consumption initially but this will settle back to another pattern when the novelty wears off.

Victim. Disaster in retirement, e.g. serious illness or accident. This is a low probability but high impact event and should be viewed as an insurance issue, not an investment risk.

Over 10 years ago The Trinity Study³ determined that a spending pattern is the most important factor affecting sustainability of retirement funds, and that 4-6% of initial capital seemed to be optimum withdrawal rate, depending on asset allocation.

The authors of the study suggested that the optimal asset allocation was 75% equities and 25% long-term corporate bonds; however equity-dominated portfolios using a 3-4% withdrawal rate may create rich heirs at the expense of the retiree’s current standard of living.

Advisers need to pay attention to retirees’ behaviour profiles and the asset allocation required to fund those aspirations while reflecting a dynamic appetite for risk. This needs to be monitored and fine tuned over the life of the retired investor, e.g. over a likely minimum 20 years. Further, the asset allocation needs to balance spending requirements with appetite for risk.

There is a habit of funding the first few years of income from cash. This skews the expected volatility and therefore the return of the portfolio, but worse, traps the investor in an increasingly risky portfolio as the proportion of cash falls as it is withdrawn. Cash funding income from a retirement portfolio is a tacit bet on a bear market.

In summary, advisers should assess both risk and behaviour profiles and focus on short and longer term retirement goals. Are the expected returns sufficient, and are the withdrawals sustainable? This requires quite complex modelling, both from an investment and financial planning viewpoint. It is also probably the pinnacle of the art of financial planning

¹Social Science Research Network, York University Toronto – Atkinson School of Administrative Study
²Robinson, Chris and Tahani, Nabil, Sustainable Retirement Income for the Socialite, the Gardener and the Uninsured (October 25, 2007)
³Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable, by Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz. AAII Journal, February 1998.

Graham Bentley is head of investment marketing at Skandia