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OBJECTIVE

“The design and depletion of retirement portfolios” is eligible for CE credits. See Accreditation details for more information.

Summary: Graham Westmacott, portfolio manager at PWL Capital, and Susan Daley, investment advisor at PWL Capital, show how retail advisors can use a pension-style approach to optimize clients’ drawdown portfolios.

Introduction

The facts that are indisputable are that we are living longer and returns from income generating securities such as bonds have fallen to historic lows. This results in an increased focus on making retirement portfolios more efficient at generating income. Retirees must grapple with two uncertainties: future market returns and how long they will live. Remove these uncertainties and it would be straightforward to project a future consumption pattern that uses all the retirement savings while they are alive. We would consider this an efficient depletion strategy.

Our goal is to introduce tools and ideas that have been in the research literature for some years but not readily accessible to retail investors. The focus is pragmatic and uses widely available investment products that are liquid, low-cost and transparent. When retirement constraints are removed, the portfolios should revert to a well-diversified accumulation portfolio.

The real retirement crisis

The concern expressed most often about retirees is whether they are saving enough.  Sun Life’s Canadian Health Index 2014 found 45% of Canadians are worried about outliving their retirement savings. The good news is that most Canadians in, or soon to be in, retirement are well provided for, although younger savers face more of an uphill struggle.

Of more concern is that many investors lack a workable strategy for converting assets into income. The decline of defined-benefit pension plans has shifted responsibility for managing retirement to the individual through defined-contribution pensions (which aren’t really pensions but savings schemes), RRSPs, TFSAs and taxable savings. The individual saver is left to figure out how much to save, which investment vehicles to use, how to invest, how to convert assets into income and how much to spend.

These are difficult questions to answer. Our goal in this course is to show how some of the tools developed by researchers and used by the pension industry can be applied to better design retirement portfolios for individual investors.

Why are retirement portfolios different?

Consider the situation of Alan and Betsy, both aged 60, who have invested $1 million in a diversified Canadian equity portfolio. Over the past 20 years, such a portfolio has averaged 8.4% annually, so they consider it prudent to withdraw $60,000 per year (6% of the initial investment). Unfortunately, they do not realize that two out every five investors who pursue this strategy are going to run out of money by age 90 and that the likelihood of one of them living beyond 90 is almost 50%.

Alan and Betsy have encountered two problems specific to retirement portfolios. The first is that withdrawing a fixed amount from a portfolio that fluctuates in value can make the portfolio vulnerable to an irreversible decline if it experiences a market downturn. Second, there is uncertainty about how long they will live and for how long the investments have to provide income. In industry jargon, Alan and Betsy are vulnerable to withdrawal risk (spending too much) and longevity risk (outliving their money).

Both these risks relate to income, so addressing them requires a fundamental shift from a capital appreciation perspective to an income perspective. The conventional view of portfolio performance is that investment decisions are focused on the value of the assets, progress is measured by portfolio returns and risk is measured by the volatility of those returns. The trouble is that these are the wrong measures if the goal is to obtain a reliable future income.

Consider the idealized situation of an initial portfolio value of $100,000 and a constant return of 5% annually. The volatility of the portfolio is zero.  Does this mean the portfolio risk is zero?  For a retiree who wants to withdrawal $5,000 annually, or less, the risk of running out of money is indeed zero, no matter how long they live.  For the retiree who needs more than $5,000 the portfolio will, with certainty, run out of money.

Conversely, the investor may seek to reduce the risk of running out of money by buying an annuity that guarantees a lifetime of income. Longevity risk and liquidity are both zero and so is the potential for outperformance: in this case all potential for capital growth is traded for income security. For the income investor, the riskless investment is not cash but an inflation-adjusted annuity free of default risk.

Funded status

Let’s get to know a bit more about Alan and Betsy. Say Alan employs a gardener who is paid $50 in cash before he leaves for the day. But one morning Alan looks in his wallet and sees he has only $40.

Another way to put it would be to say that Alan has a future liability of $50 but only $40 of assets to match this liability. Alan’s funded status is $40/$50 = 0.8. Ideally, Alan needs to have a funded status of 1 or more.

We can apply the same concept to retirement planning. A person’s funded status is the ratio of two numbers: today’s value of all their assets, and today’s value of all their liabilities. In this instance, assets include everything someone intends to use to fund retirement. This would include today’s value of current savings, future savings, and employer and government pensions. Liabilities include today’s value of all the future expenditures in retirement.

Let’s dig deeper into Alan and Betsy’s situation. Alan has $600,000 in investments and is on the point of retirement. Betsy’s government and company pensions are worth an additional $400,000 at today’s value, meaning they have total assets of $1,000,000. They plan to consume $40,000 each year in retirement. In other words they have a liability of a series of annual payments of $40,000 for as long as they live.  We calculate that the present value of this total retirement liability is $893,830 and so their funded status is 1.12 ($1,000,000 divided by $893,830). We would expect Alan and Betsy to have just sufficient funds for their retirement because their funded status is slightly greater than 1.0. Their situation is illustrated below.

Source: PWL Capital

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