In this article we will be looking at the alternatives for protecting you retirement nest-egg against short-term market down-turns. In this context it should be appreciated that normally a retiree must apply two-thirds of his retirement capital to purchase a pension, while only one-third may be paid out in cash.
As far as the two-thirds portion of the retirement capital is concerned, a prospective retiree need not be concerned about any short-term down turn in the market. This is so because this capital will be returned to him with investment returns over his remaining life, usually anything from 15 years upwards, a long period during which the market should have recovered again. The down turn will only impact the level of post retirement income while the down turn prevails and this should be for a short term.
As far as the one-third cash portion is concerned, a fund member will obviously be worried about the impacted of any down turn in the markets in which the capital is invested. His retirement planning may be dependent on realising a certain amount in respect of the one-third pay-out, say for paying off the balance on his home loan or on the loan arranged to purchase that last new Benz before heading into retirement. If the N$ 2 million the retiree had hoped for turns out to be only N$ 1.7 million, the shortfall of N$ 0.3 million will mean that a portion of his post retirement income will now have to be applied to pay off the balance on the outstanding debt. How ‘mission critical’ the one-third pay-out is to the retiree, should inform his decision how this portion of the retirement capital is to be invested. How long before retirement a decision has to be taken and what options are typically offered in the market will be examined further on.
Retirement capital is generally invested in the same asset classes no matter what retirement product one is looking at, namely equity, bonds, cash and property. The difference between the most common retirement products lies in the manner in which the returns on the investment in these asset classes are passed on to the prospective retiree. Returns are either allocated directly to the retiree or are allocated by way of a mechanism that resembles the principle of a ‘funnel’. The difference is that in the former method, the return flows ebb and flood while in the latter method a regulated flow passes through the funnel no matter a what rate returns are pouring into the funnel. Of course the funnel serves no purpose anymore should returns dry up totally or flow out as fast as they trickle in and in such event the retiree will experience exactly the same returns under both methods. In the retirement funds industry former method of investing is referred to as market linked investing while latter method of investing is referred to as smooth growth investing or return smoothing.
The following graphs depict the performance of the worst performing prudential balanced portfolio on the Benchmark Retirement Fund platform over the period January 2002 to August 2016, the best performing prudential balanced portfolio and the Benchmark Default Portfolio that are all market linked portfolios and the most popular alternative, the Old Mutual AGP portfolio with a 50% guarantee.
Let’s look at the Graph 1 which depicts rolling 12 month returns. Firstly, it shows that the AGP portfolio commenced in January 2008 when the market was on a steep downward slope and just before its trough in consequence of the financial crisis. One may argue that the first 12 months’ or performance to January 2009, probably even longer, are not representative of the characteristics of the smooth growth portfolio compared to the market linked portfolio. The graph shows that at the worst of times, in January 2009, the worst performing market linked portfolio had a one year return of minus 22%, the Benchmark Default market linked portfolio had a one year return of around minus 8% while the best performing portfolio had a one year return of around minus 3%. At the same time the smooth growth portfolio had a one year return of 10%. As depicted by Graph 1 above, markets have recovered rapidly from this trough as the result of the quantitative easing program.
One can conclude from this graph that the smooth growth portfolio has outperformed some of the market linked portfolios over 1 year periods at times by around 5% and underperformed at other times by up to 20%. The smooth growth portfolio has thus protected the prospective retiree’s one-third by around 30% over a one year period if compared to the worst performing market linked portfolio, by around 20% compared to the Benchmark Default Portfolio and by around 15% compared to the best performing market linked portfolio.
If we now look at the same portfolios but over rolling 5 year periods as depicted by the Graph 2. This graph shows that the smooth growth portfolio outperformed the market linked portfolios from commencement to late 2013 and underperformed since then. To what extent the initial outperformance was the result of perfect timing of the introduction of this portfolio, history will show. Going by the principles and assuming Old Mutual will be able to produce average returns over the long-term one should expect this portfolio to underperform the average manager because of the cost of the guarantee it offers.
Graph 3 depicts the cumulative return of the smooth growth portfolio and the market linked portfolios since 1 January 2009
Conclusion
From these graphs the smooth growth portfolio relative to any prudential balanced portfolio can add value over the short term (+/- 12 months) if the main concern is to avoid negative returns on the commutation. Tracking the worst performing market linked portfolio’s performance over rolling 12 months, it underperformed the smooth growth portfolio by 30%, with a performance of – 22%, when the bottom fell out of the market but outperformed smooth growth portfolio by 25% when the market recovered soon afterwards. Given that most members would have to arrange a pension with two-thirds of their retirement capital their highest underperformance risk based on the statistics of the worst performing prudential balanced portfolio is then 10% (30% *1/3) while they risk losing outperformance at the same time of 8.3% (25%*1/3), at times of extreme volatility.
Given that a fund member invests in the investment management skills of the provider of the smooth growth portfolio only, sacrifices returns of 0.2% p.a. to pay for the guarantee and sacrifices the flexibility of moving between asset managers to improve performance, a member may prefer to retain greater flexibility. This would however require the member managing the risk against short term negative returns differently. Within most funds a member should normally know 12 months ahead of time that he intends to go on retirement. The member can then move to the cash portfolio 12 months before retirement at times of high market volatility in respect of the one-third retirement commutation. Through preservation, the prospective retiree should also be able to defer retirement to ride out any trough in the market in respect of his one-third commutation at the time of planned retirement.
Important notice and disclaimer
This article summarises the understanding, observation and notes of the author and lays no claim on accuracy, correctness or completeness. Retirement Fund Solutions Namibia (Pty) Ltd does not accept any liability for the content of this contribution and no decision should be taken on the basis of the information contained herein before having confirmed the detail with the relevant party. Any views expressed herein are those of the author and not necessarily those of Retirement Fund Solutions.