Insights

Episode 2 - The importance of fund selection in retirement

30 July 2018

Episode 2 - The importance of fund selection in retirement

The information included in this recording is general advice only and has been prepared without taking account of your objectives, financial situation or needs. Please refer to the full disclaimer at the bottom of this page.

Welcome to the second in a four-part podcast from Bennelong Funds Management. Today we will be speaking with Stuart Fechner, Account Director of Research Relationships about the importance of fund selection for those in retirement.

So Stuart, why do you say individual funds can play a more important role for investors in retirement as opposed to when they are in the superannuation environment?

Firstly, it’s important to understand the fundamental differences between the two (super and retirement) as this goes a long way to providing perspective as to why.

It also helps to understand the different challenges at hand within the retirement phase.

Can you outline some of those differences?

Retirement is much more ‘now’ and very immediate and current for every investor. Someone has worked for many years, contributed to their superannuation and built this pool of savings to support them in retirement. Until now they have not been able to access this money, but now in the pension phase, they can and in fact must draw down on it.

It goes from being a future based asset to a true current day asset. The changes in account balance or size of the account are no longer just a change in the number on a superannuation statement. They now have a potential real impact on the living standards and activities someone can or cannot afford to do.

Upon retirement, this savings nest egg has hopefully never been any larger nor more important, as it now represents a key asset in determining to a large extent the quality of someone’s retirement.

Effectively, as retirees draw down on these savings and are no longer being paid as an employee, it represents their new income or new wage.

What are some of the challenges in retirement?

There are three key items or risks that come to mind:

  1. Sequencing risk
  2. Longevity risk
  3. Inflation risk

Part of the overall challenge is that a couple of these risks, sequencing risk and longevity risk, are largely opposed to each other. That is, what is often a standard solution for one, may negatively impact the ability to solve the other.

Can you explain those three risks a little further? Let’s start with sequencing risk.

Sequencing risk is the risk of experiencing a negative return at various or certain stages of your retirement. Importantly, the stage of retirement when a negative return occurs can and does have a varying impact on a person’s account balance.

The key risk here is the negative investment return being experienced right at the start or very early on in a person’s retirement. That is because their nest egg/account balance is typically at or near its largest point.

So a negative investment return at this point in time will have a greater dollar impact compared to if it happened later in retirement, where after several years of drawdown the account balance is likely to be less.

If you think of a ‘sequence’ of anything, in this instance it’s really about the sequence or order in which returns occur – and in particular, the negative returns that clearly have a negative impact.

What about longevity risk?

Put simply, longevity risk is the risk that you outlive your retirement savings.

It may be that you simply don’t have a sizeable enough nest egg to last you through your retirement, or that you do have a reasonably sized retirement account but you live longer than the average and effectively outlive your money.

In 2017, the Australian Bureau of Statistics released a paper stating that a child born in Australia in 2016 has a life expectancy of 84.6 years for females and 80.4 years for males. On a combined basis, this ranks Australia third on a global scale, behind Japan and Switzerland, for average life expectancy.

And finally, inflation risk.

This is the risk that the level of inflation, reflective in a broad sense of the cost of goods and services, increases faster than your income or the level of earnings from your income.

If this occurs in ‘real terms’ – that is, after taking inflation into account – your money or the value of it is worthless.

Can you explain what you meant when you said these risks oppose each other?

It’s essentially related to the challenge of managing for both longevity risk and sequencing risk.

To minimise the risk associated with longevity risk, one of the key elements is to invest in growth assets (such as shares), as over the long term (such as a 10-year timeframe) they are expected to outperform most other asset classes.

However, growth assets like shares also have a higher probability of delivering a negative return over a shorter-term timeframe, such as one year.

Herein lies the challenge – aiming to achieve sufficient growth for your nest egg to last the test of time, but at the same time avoiding or minimising potential short term negative returns that have an adverse impact in relation to sequencing risk.

What can be done to help manage this challenge?

This is where I believe that identifying and selecting the appropriate investment strategy or fund really comes to the fore.

It’s not to say that a certain fund is good and that another with a different strategy or objective is bad, it’s simply a matter of clearly understanding what the need or challenge is for an investor and then identifying a fund that can play a relevant role in achieving this.

I often think of it as ‘funds for a purpose’.

So what type of funds come to mind?

Actively managed funds are the first port of call and those that have a degree of flexibility within their active investment mandate is important.

In this instance, it’s also not as simple as such a fund being a long only share fund that can be a relatively small overweight or underweight stock size or sector allocations versus the index – but more so strategies that have a good degree of flexibility within their investment mandate.

It could, for example, be as simple as a long only fund that has the flexibility to invest a significant portion of its investments in cash if they are worried about the markets, or cannot identify enough suitable stocks in which to invest.

Other types of funds that can play a role include:

  • Variable beta funds

These are funds that actively allocate between being invested in the share market and being invested in cash.

This allows and provides the flexibility to protect capital and hence to allocate to cash with the view to avoiding or minimising the impact of a negative market return.

  • Absolute return or alternative funds

While investing the majority of the fund in growth assets, such funds may often employ and use options or derivatives.

One of the key aims in doing so can be to manage tail risk – effectively this is a strategy employed to deliberately minimise the impact of negative market returns.

These strategies sound interesting. Is there anything else that needs to be considered here?

A couple of things come to mind.

One is fees. Not always, but typically, funds implementing these strategies may have an associated management fee that is higher than the average for a traditional long only share fund.

But while we’re talking about investment funds as a ‘product’ I like to think of a parallel to other products – this could be a computer, a caravan or a mix master.

The greater the degree of flexibility or elements that a product has, typically the higher the cost. But it makes sense that a higher fee or cost can be justified, because they can play arguably a more important, tailored or flexible role than the standard vanilla edition.

The other point to note is that such strategies may not always perform as well as the more traditional vanilla benchmark aware funds during times of very strong market performance.

It’s not to say that in absolute terms their performance is weak, but it can be somewhat of a trade off in missing out on the very high end of a strongly performing market to ensure a strategy is managed – so that when the opposite happens and the market delivers a negative return, this negative impact is minimised for investors.

Does this have any link to behavioural psychology?

I think it does.

In retirement, I believe that the shape or type of returns that are achieved are more important to people than they are in the superannuation environment.

It really relates to people wanting to worry less about their hard-earned savings in retirement – sometimes referred to as the ‘sleep at night factor’. They can go to sleep at night knowing that should market returns be negative, for example, it’s not going to have a huge detrimental impact on their retirement.

What do you mean by the ‘shape of returns’?

If you look at the income someone receives from their retirement savings, this is effectively their new wage or salary. Everyone is accustomed to having their salary paid regularly and consistently – such as every fortnight or month.

This is exactly the same in retirement, with payments or income from retirement savings. It’s perhaps even more important, as remember unlike superannuation we’re not making any further contributions to ‘top things up’ and there is a reduced time horizon on these investments when compared to superannuation as well.

Some people I think are far more conscious in retirement of avoiding or minimising a big negative or drawdown should equity markets crash.

As far as the ‘shape of returns’, I think many people are happy to potentially give up a small bit of the upside when returns are very strong, if it helps to then protect them on the downside, minimise the losses and ensure they can sleep at night.

In effect, it’s the desire for a greater consistency of returns.

And is this why you say the use of actively managed funds is important?

That’s right.

If you invest in an index or passively managed fund, you will get whatever the market delivers – there is no room or scope to move or adjust anything.

Actively managed funds can be thought of as having the ability to be flexible or to adapt if deemed appropriate to market moves or changes; or having a more tailored or deliberate investment approach to achieve a certain type of outcome or characteristic of return.

In the first instance, this may be the ability to invest more in cash and be more defensive if it’s deemed that the investment outlook is unfavourable.

Or it may be a more tailored or specific outcome that is aiming to be achieved, such as an increased level of income or dividends compared to the broader market, or perhaps a strategy that focuses on protecting the downside when markets are negative.

There is a broad range and scope of actively managed funds available, and at the least it allows investors the opportunity to somewhat tailor their investments to be better positioned to achieve a certain type of outcome, designed to meet their specific and individual needs.

That brings us to a close for today – we’ll talk more about the difference between active and passive investing in our next episode. We hope you enjoyed this podcast, and encourage you to visit bennelongfunds.com for more insights from the team.

 

This recording is provided by Bennelong Funds Management Ltd (ABN 39 111 214 085, AFSL 296806) (BFML). The information provided is general information only. It does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Information Memorandum (IM) and or Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388 (AU) or 0800 442 304 (NZ). BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current IM and or PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund.

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