Any retirement plan has to make a number of assumptions. One of those is the long-term return you can expect from your investments.
As people are living longer, and generally not saving enough, the returns they need to earn on their money are also quite high. This means that most investors, both before and after retirement, need to keep a large exposure to the stock market. That is, after all, where the best long-term returns can be earned.
This does, however, introduce a problem: the stock market is inherently volatile in the short-term, and returns from equities don’t come in a straight line. This means plans that assume a certain yearly return can be disrupted if periods of particularly poor returns happen at inopportune times. This is true both before and after retirement.
It’s all in the timing
The graph below illustrates what happens in the case of two investors, both of whom save 10% of their salary for 40 years, with increases of 3% per annum. For investor A, there is a big market drop ten years after they start. For investor B, the same drop happens ten years before retirement.
The difference is substantial. The large drawdown shortly before retirement has a much bigger impact.
“If something bad happens in those last ten years before someone retires, the chances are they are not going to have enough time to make up that difference,” explains Lesley-Ann Morgan, head of multi-asset strategy at Schroders.
A similar problem presents itself after retirement. A large loss early on can have a lasting impact.
The graph below shows how three investors, each starting with $100 000 and drawing $9 000 per year, see their money depleting at different rates because of the sequence in which their returns are generated. In all three cases, the average return is 7% per year, but having a large drawdown before a large increase means the capital depletes far more quickly than if the sequence is reversed.
The problem this poses, of course, is that investors have no control over the stock market. They also have no way of accurately predicting future returns. So how can they manage this risk?
The importance of diversification
“Having a wider variety of asset classes in your portfolio helps,” says Morgan.
“Equities are not always the hero or the villain. There are different asset classes you can invest in to protect a portfolio or get growth.”
This diversification is crucial in any portfolio. Both before and after retirement, investors must have exposure to growth assets like stocks, but they need to manage the risk by also considering all of the tools available to them, including bonds, listed property, cash, preference shares and commodities.
Just diversifying into different asset classes is not, however, sufficient on its own. This is because when there is a serious dip in the market, it can happen that all asset classes fall, leaving investors essentially unprotected.
“A problem with multi-asset funds is that when you have a market event like Nenegate [the firing of former finance minister Nhlanhla Nene, which could have pushed South Africa over the edge], the correlation of all assets tends to spike,” explains Len Jordaan, head of ETF (exchange traded fund) distribution at Absa. “Those kinds of portfolios may provide you with very poor diversification when you need it the most.”
This highlights the need for alternative strategies. One option is hedge funds, which have the benefit of being able to take short positions on the market. This means that if prices go down, they can actually benefit, and therefore lower the risk on the downside.
Another is structured products that provide some degree of capital protection. These allow investors to enjoy exposure to the performance of the stock market, but at much lower risk.
A third option is targeted volatility funds, which mainly hold stocks, but will switch to cash when market volatility increases beyond a certain limit.
“There is a 90% correlation between spikes in volatility and equity drawdowns,” explains Jordaan. “So these products capture most of the upside of the equity market, but protect you by moving into cash when that volatility kicks in and you would be realising losses.”
These different strategies will suit different individuals, depending on their requirements. Investors should therefore fully apprise themselves of how they work, what they are trying to achieve and the outcomes that they can expect.
“Finding the right solution for the right market is part of the answer, but as an individual you also need to make sure that you understand what you have bought,” says Morgan.
“You also need to appreciate that having hard downside protection is an insurance policy and, like any insurance policy, you have to pay a premium. So you need to understand the impact on the return.”