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Spotting signs of trouble in a retirement portfolio

Everyone has 20/20 vision in hindsight – and sometimes, even the most obvious risks to a portfolio are more common than you may think. On the flipside, there are income opportunities on the horizon this year, if you know where to look.

Two potential areas of trouble in a retirement portfolio in the current climate are concentration of risk around Australian property trades and accelerated draw-down of retirement assets due to low yields on offer on fixed income.

Property exposure

One particular area where we often notice concentrated risk in retirement portfolios is in residential property, both specifically within self-managed super funds and also as a large component of the total assets of many people entering retirement.

Currently, yields in domestic residential property are very low, and valuations are very high. With most investors having a direct stake in the asset class, and also considering ancillary trades around that, such as investments through banks and some of the REIT providers, it’s a stacked bet on one very expensive trade.

That approach has worked well over the last two decades or so, but in recent years we received a warning shot across the bow in the form of a small market correction. Although investors with a long horizon can take this kind of correction in stride, retirement investors should be very cautious about the sequencing risk associated with this kind of market event.

Low cash and fixed incomes yields

Another point of concern is the effect of a low-yield world on retirement incomes. The cash rate in Australia currently stands at 0.75%, with further cuts expected early this year, and fixed income assets are returning yields at record lows. Retirees are having to draw down on their asset base in order to generate income from these asset classes. This is a particular risk inherent to some fixed allocations in the current economic climate and we think it needs to be taken into consideration, given the likelihood that the current low-yield rate will continue for some time to come.

Similarly, cash exposure must be carefully managed to ensure inflation and financial repression don't eat into your asset base. One way investors can manage this risk is to tactically allocate to higher yield asset classes such as Australian equities. With the benefits of franking, Australian equities have been able to achieve over 6% income over the past decade since 2009 and has also delivered some capital growth.

There’s also the issue of longevity risk to consider. You should plan to live long and better while also managing your assets to cover that eventuality that you do live until a very old age. Retirement investors don’t want to outlive the value of their portfolio. Investing in equities makes sense if investors can look through the short-term volatility.

Key considerations: retirement versus accumulation

There are several key differences to consider between investing during the retirement phase as opposed to the accumulation phase – the two have distinct needs and profiles. It’s important to understand the different needs and goals of each phase.

In accumulation, the investor is typically contributing towards their superannuation and at the same time making other investments outside that portfolio. The principal goal is growth, with the aim of reaching retirement with the largest possible portfolio of assets.

In retirement, investors will need to think a little differently.

The first consideration is their tax situation. In retirement, investors will likely be in a lower tax bracket than they were through the accumulation phase, and with that comes a number of advantages. In retirement phase, franking credits are worth much more. Every dollar of franked income is worth $1.43 in retirement, and that has the potential to generate a very large income from the Australian equities and hybrid components of a retiree’s portfolio.

Secondly, investors must consider longevity and the risk of outliving their asset pool. Portfolios in the retirement phase are typically more exposed to fixed income, and potentially cash and more conservative assets. The income from many of these asset classes is currently quite low, and expected to stay low for some time.

In order to prepare for the possibility of living a long life – or leaving a corpus for family members or benefactors, investors might need to consider their allocation between more conservative asset classes and other defensive positions in assets that have the potential to generate higher income in the current climate. This may help investors to retain sufficient equity in their portfolios so that over time they can draw down on their asset base as well as invest for the future and generate some capital returns in their retirement.

Finally, investors should keep a close eye on valuations, and how they relate to yields across different asset classes, and be prepared to adjust their allocation over time in accordance with changes in these relationships.

 

Dermot Ryan is Co-portfolio manager of the AMP Capital Australian Equity Income Generator Fund. AMP Capital is a sponsor of Firstlinks. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs.

For more articles and papers from AMP Capital, click here.

 

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