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Advice focus needs to shift to goals in retirement

Financial planners are adopting new frameworks as they deepen their understanding of client goals in retirement and implement more targeted investment strategies both pre- and post-retirement. While this trend has been in place for some time, largely driven by changing customer attitudes, interest in new approaches has accelerated in the aftermath of the global financial crisis.

There are two major competing frameworks used by advisers:

  • The traditional approach is characterised by an investment portfolio, specified by its strategic asset allocation, judged to have a high probability of delivering returns to meet a client’s overall needs.
  • An asset-liability management (ALM) approach, which starts by focussing on the various goals of a client, segments the goals according to importance or priority and then identifies portfolio strategies whose cash flows and risk characteristics are appropriate for each goal and its priority.

The traditional approaches

While the traditional approach remains dominant in practice, there is growing interest in the ALM approach as it is more client-centred and arguably leads to a better experience for both financial planning businesses and their clients. Using the traditional approach, an advice business may find over time that it has delivered to the needs of 85% of clients while the unlucky 15% of its client base has potentially fallen well short. And even among the clients whose needs have been met, many will have experienced extended periods where they lacked confidence that they would be OK. By contrast, the ALM framework holds out the possibility of all clients largely, or entirely, meeting their goals with greater confidence.

Maximising wealth is the central objective in the traditional approach. Fund managers build a series of high quality portfolios along the ’efficient frontier‘, with strategic asset allocations that reflect long-term risk and return forecasts implemented through sector portfolios designed to deliver returns above sector benchmarks. An adviser will then work with their client to select the product with the optimal risk profile given the client’s risk tolerance, arguably a concept few people find particularly intuitive. The portfolio strategy employed to build up adequate wealth pre-retirement is often the same one used to draw down cash flow in retirement.

In practice, advisers wrap additional behavioural-based strategies around the portfolio to help clients deal with market volatility and resist the temptation to make poor choices at bad times. A popular strategy, which seeks to insulate clients from short-term volatility, is based on allocating capital into three sub-portfolios: a cash portfolio of a size that covers spending needs for the subsequent three years, a capital stable portfolio to cover the next two years and a balanced portfolio for the remaining capital. Clients draw capital from the cash portfolio, which is replenished from the capital stable and balanced portfolios through a re-balancing program. While this approach has behavioural benefits it cannot protect clients from a protracted decline in markets, conditions which often provoke poor decision-making that increases the chance of failure.

There has also been considerable innovation in recent years among investment managers as they develop products to mitigate sequencing risk, which arises when a client experiences a bad run of returns just when portfolio value is at its maximum level near retirement. These products rely upon the increasing exposure to diversifying assets classes that reduce the reliance on equity markets as well as more dynamic management of asset allocations. Most of the dynamic approaches utilise short or medium term return forecasts to position for good volatility while trying to avoid bad volatility. Other approaches focus on shorter term forecasts of market volatility and adjust allocations to stabilise the volatility experience of portfolio returns. However, none of these strategies places a hard floor under portfolio outcomes.

The ALM framework focusses on setting goals

In the ALM framework, things are done in a different order. It starts with a conversation between adviser and client around needs and goals in retirement. These goals can loosely be considered as liabilities on the client’s household balance sheet. Critically, the various goals can be prioritised. This helps establish the capacity to take risk in pursuing each goal.

The goals with the highest priority centre on the capacity for clients to deal with emergencies and to meet essential living expenses on an ongoing basis, for example food, shelter and transport. The goals with moderate priority can be termed ’discretionary expenses’ such as overseas holidays and new cars. The lowest priority goals might be characterised as ’aspirational’ such as leaving a legacy for subsequent generations. While there is considerable scope to take on short-term investment risk in pursuing low priority goals, there is little capacity to do so for the high priority goals. A key advantage of the ALM approach is that separate strategies can be employed to match different goals.

For the goals identified as high priority, clients want to be confident they will receive a regular income, ideally one that rises with the costs of living over time. Multi-asset income-focussed funds come within a strategy that has been developed to meet this goal. While they carry no guarantees, the strategies, properly communicated, can promote confidence among clients that their income expectations will be met. For those looking for guarantees, insurance products such as annuities, especially if they are inflation protected, and variable annuities with a guaranteed income stream for life are also relevant products to meet essential needs in retirement.

For goals with moderate priority, resilient growth strategies that seek to increase wealth progressively while limiting the extent of temporary setbacks appear appropriate. The new multi-asset strategies described earlier are well-positioned to support the attainment of these goals. And for low priority goals, it is appropriate to focus on long horizon strategies, which can include illiquid assets, aimed at generating real long-term compound growth. Provided the client is confident in the strategy, they do not need to worry about its short-term risk profile.

Under this framework, clients work with their advisers to determine how much to allocate to accounts supporting each goal and then select strategies for each account.

New technique is more intuitive

I believe the ALM approach will progressively become the framework of choice for advisers looking to improve the confidence of their clients that they are on track to meet their goals. The approach is more intuitive. It facilitates more effective discussion around risk by framing it in terms of failure to achieve a high priority goal.

There are also important investment implications around the demand for securities and strategies generating sustainable real cash flows. The difference between the traditional approach and the ALM approach is most apparent when real interest rates are unusually low. In the traditional approach, there would be little appetite for inflation-linked bonds and similar securities on account of their low return prospects while the appetite would remain strong in the ALM approach if these securities were considered suitable for the achievement of high priority goals.

It should be acknowledged that existing advice tools and compliance frameworks have been designed to support the traditional approach. Revised versions of these tools and frameworks are required to facilitate the development of the ALM approach. That is still a work in progress.


Jeff Rogers is Chief Investment Officer at ipac Securities.


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