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Why retirees need re-risking and a cushion

Wade Matterson
As low interest rates push aging retail investors to retain exposure to growth assets, portfolio risk management has become increasingly important, according to Wade Matterson, practice leader in Australia for global actuarial firm Milliman.
Matterson said retail investors – particularly those in or near retirement – are faced with a difficult choice in an era of increased longevity and low interest rates.
“You either accept the concept that people have to de-risk their portfolios as they get closer to retirement, which means accepting the lower rates of return on conservative assets,” he said. “Or you take the view that [retirees etc] need to take on more exposure to growth assets – and if so, how do they deal with market volatility?”
Retirees, who generally have larger account balances than early-to-mid career individuals, are particularly vulnerable to market swings as they “magnify both gains and losses”.
“It’s a risk paradox,” he said.
Matterson, who will be presenting his views at the ‘Perfecting Investment Portfolios’ conference in Auckland next week, said investment risk strategies have diverged into two separate streams: active management targeting risk factors as a source of return, or; insurance-style portfolio overlays that retain exposure to growth asset returns but offer some protection against major market downturns.
“For example, we’ve seen the risk of boutique investment firms that say they will trade volatility as an asset class,” he said. “This is still the remnant of the long-only world where managers are selling people on their intelligence and ability to make good decisions.”
And while such active approaches are legitimate – akin to absolute return strategies – Matterson said an alternative method seeks to bake risk management into the portfolio rather than include it in the icing.
“The other path is more systematic,” he said. “It’s not presented in the context of a good investment decision – it’s more of an insurance angle. And you don’t want insurance to pay you every year – you just want it to be predictable, robust and reliable.”
According to Matterson, building insurance into retail investment products can be achieved with minimal cost using derivatives “in some form or another”.
“These strategies are not unfamiliar at the institutional level but retail investors may not have had much exposure to them,” he said.
However, Matterson said the benefits and risks of protected products do need to be communicated effectively.
“There’s an art to making sure investors have the information they need to understand the product without overwhelming them with detail,” he said. “For example, providers use concepts like ‘smoothing’ or ‘cushioning’ to help investors understand how the products work.”
Matterson said the products essentially aim to keep investors exposed to at least some market growth while putting a floor on downside risks.
“The reality is there is an insurance cost associated with getting protection,” he said. “And that cost might see investment returns lag as the market rises – it’s an opportunity cost – that will be somewhat proportional to how far markets are up.”
While some providers refer to ratios – like 75 per cent of the upside and 25 per cent of the downside – Matterson said these should not be seen as guarantees.
“They’re useful rules of thumb,” he said.
Milliman advises on about $60 billion of insurance-protected investments globally, including a swag of Australian products. The group also provides the risk overlay for New Zealand’s Retirement Income Group about-to-be-released annuity product.
– David Chaplin, Investment News NZ

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