Coronavirus – Financial Planning Challenges

For those near retirement this year’s global pandemic has thrown up new challenges for them and their Financial Advisor.

Early retirement due to losing a job, the running down of emergency funds, and a low interest rate environment are new challenges facing those about to retire.

Events this year are likely to have significant repercussions for how individuals conduct their financial planning.  Specifically, how they approach spending and saving goals.

The pandemic will likely have lasting implications for how people think about creating their financial and investment plans, and therefore raises new challenges for the Advisors who assist them.

These are the key issues and conclusions outlined by Christine Benz, director of personal finance for Morningstar, in her article, What the Coronavirus Means for the Future of Financial Planning.

In relation to the key issues identified above, Benz writes “All of these trends have implications for the way households—and the advisors who assist them—manage their finances. While the COVID-19 crisis has brought these topics to the forefront, their importance is likely to persist post-pandemic as well.”

Although the article is US centric, there are some key learnings, which are covered below.

How the Pandemic Has Impacted Financial Planning for Emergencies

The Pandemic has highlighted the importance of emergency funds as part of a sound financial plan and the difficulties that many individuals and households face in amassing these “rainy-day funds.”

Lower income families are more at-risk during times of financial emergencies.  Research in the US found that only 23% of lower-income households had emergency funds sufficient to see them through three months of unemployment.  This rises to 52% for middle income households.

It is advisable to have emergency funds outside of super.

The Morningstar article highlights “Withdrawing from retirement accounts is suboptimal because those withdrawn funds can’t benefit from market appreciation—imagine, for example, the worker who liquidated stocks from a retirement account in late March 2020, only to miss the subsequent recovery.”

An emergency fund helps boost peace of mind and provides a buffer and the confidence to maintain longer-term retirement goals.

Financial Advisors can assist clients in setting saving goals to amass an emergency fund, which is specific to their employment situation, and how best to invest these funds so they are there for a rainy day.

From an industry and Policymaker perspective, and reflecting many households struggle to accumulate emergency reserves, Morningstar raised the prospect of “sidecar” funds as potentially part of the solution.

Sidecars “would be for employees to contribute aftertax dollars automatically to an emergency fund. Once cash builds up to the employee’s own target, he could direct future pretax contributions to long-term retirement savings. Automating these contributions through payroll deductions may make it easier for individuals to save than when they’re saving on a purely discretionary basis.”

The concept of sidecar funds has recently been discussed in New Zealand.

Financial Planning for Early Retirement

The prospect of premature retirement will pose an urgent challenge for some clients. 

Although those newly unemployed will consider looking for a new job some may also consider whether early retirement is an option.

The US experience, to date, has been that those workers 55 and older have been one of groups most impacted by job losses.

Morningstar highlight that early retirement is not always in an individual’s best interest, actually, working a few years longer than age 65 can be “hugely beneficial to the health of a retirement plan,”….

They note the following challenges in early retirement:

  • Lost opportunity of additional retirement fund contributions and potential for further compound returns; and
  • Earlier withdrawals could result in a lower withdrawal rate or reduce the probability the funds lasting through the retirement period. 

Financial Advisors can help clients understand the trade-offs associated with early retirement and the impacts on their financial plans.  Often the decision to retire is about more than money.

Individual circumstances in relation to access to benefits, pensions, health insurance, and tax need to be taken into consideration.  Given this, a tailored financial plan, including the modelling of retirement cashflows on a year-to-year basis would be of considerable value.

Accommodating Low Yields in a Financial Plan

The low interest rate (yield) environment is a challenge for all investors. 

Nevertheless, for those in retirement or nearing retirement is it a more immediate challenge.

Return expectations from fixed income securities (longer dated (maturity) securities) are very low.  Amongst the best predictor of future returns from longer dated fixed income securities, such as a 10-year Government Bonds, is the current yield.

In the US, the current yield on the US Government 10-year Treasury Bond is not much over 1%, in New Zealand the 10-Year Government Bond yields less than 1%.  Expected returns on higher quality corporate bonds are not that much more enticing.

As Morningstar note, “These low yields constrain the return potential of portfolios that have an allocation to bonds and cash, at least for the next decade.“

The low yield and return environment have implications as to the sustainability of investment portfolios to support clients throughout their retirement.

The impact of low interest rates on “withdrawal rates” is highlighted in the graph below, which was provided by Morningstar in a separate article, The Math for Retirement Income Keeps Getting Worse, Revisiting the 4% withdrawal rule

The 4% withdrawal rate equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.

For illustrative purposes, the Morningstar article compares a 100% fixed income portfolio from 2013 and 2020 to reflect the impact of changes in interest rates on the sustainability of investment portfolios assuming a 4% withdrawal rate. 

As Morningstar note, since 2013 investment conditions have changed dramatically. When they published a study in 2013 the 30-year Treasury yield was 3.61% and expected inflation was 2.32%. Investors therefore received a real expected payout of 1.29%.

When they refreshed the study in 2020, those figures are 1.42% and 1.76%, respectively.  This implies a negative expected return after inflation.

The graph below tracks the projected value of $1 million dollars invested in 2013 and 2020.  The prevailing 30-year Treasury yields for July 2013 and October 2020, as outlined above, are used to estimate income for each portfolio, respectively, over time.  A “real” 4% withdrawal rate is assumed i.e. the first years $40k withdrawal grows with the inflation rates outlined above.

As can be seen, the 2013 Portfolio lasts up to 30 years, the 2020 Portfolio only 24 years, highlighting the impact of lower interest rates on the sustainability of an investment portfolio.

Financial Advisors can help in determining the appropriate withdrawal rates from an investment portfolio and the trade-offs involved.  They may also be able to suggest different investment strategies to maintain a higher withdrawal rate and the risks associated with this.

This may also include the purchase of annuities, to manage longevity risk (the risk of running out of money in retirement) rather than from the perspective of boosting current portfolio income.

Morningstar suggests that new retirees “should be conservative on the withdrawal rate front, especially because the much-cited “4% guideline” for portfolio withdrawal rates is based on market history that has never featured the current combination of low yields and not-inexpensive equity valuations.”

The 4% withdrawal rate is an industry “rule of thumb”.  Further discussion on the sustainability of the 4% withdrawal rate can be found here.

I have posted extensively about the low expected return environment and the challenges this creates for the Traditional Portfolio of 60% Equities and 40% Fixed Income.

The following Post on what investors should consider doing in the current market environment may be of interest. This Post outlines some investment strategies which may help in maintaining a higher withdrawal rate from an investment portfolio.

Likewise, this Post on how greater customisation of the client’s invest solution is required and who would benefit most from targeted investment advice may also be of interest.

Lastly, Wealth Management.com covers Benz’ article in Retirement Planning in a Pandemic.

Please read my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Who would benefit most from targeted investment advice?

Those in the Retirement Risk Zone would benefit most from targeted investment advice.

The Retirement Risk Zone is the 10-year period before and after retirement (assumed to retire at age 65 years).

It is the 20-year period when the greatest amount of retirement savings is in play, and subsequently, risk is at its highest.  It is a very important period for retirement planning.

The Retirement Risk Zone is the worst possible time to experience a large negative return.  How much you lose during a bear market (20% or more fall in value of sharemarkets) may not be anywhere near as important as the timing of that loss.

Therefore, the value of good advice and a well-constructed portfolio aligned with one’s investment objectives is of most value during the Retirement Risk Zone.

Impact on timing of market losses

If a large loss occurs during the Retirement Risk Zone it will result in less money in retirement and raise longevity risk (the risk of running out of money in retirement).

The risk that the order of investment returns is unfavourable is referred to as sequencing risk. 

Sequencing risk can be viewed as the interaction of market volatility and cashflows. The timing of returns and cashflows matters during both the accumulation of retirement savings and in retirement.

Once an investor needs to take capital or income from a portfolio volatility of equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives.

It is untrue to say that volatility does not matter for the long term when cashflows are involved.  For further discussion on this issue see this Post, Could Buffett be wrong?

Longevity Risk

The portfolio size effect and sequencing risk have a direct relationship to longevity risk.

For individuals, longevity risk is the risk of outliving ones’ assets, resulting in a lower standard of living, reduced care, or a return to employment.

One-way longevity risk manifests itself is when an investor’s superannuation savings is subject to a major negative market event within the Retirement Risk Zone.

Materiality of Market Volatility in Retirement Risk Zone

Research by Griffith University finds “that sequencing risk can deplete terminal wealth by almost a quarter, at the same time increasing the probability of portfolio ruin at age 85 from a probability of one-in three, to one-in-two.“

Based on their extensive modelling, investors have a 33.3% chance of not having enough money to last to aged 85, this raises to a 50% chance due to a large negative return during the Retirement Risk Zone.

They also note “It is our conjecture that, for someone in their 20s, the impact of sequencing risk is minimal: younger investors have small account balances, and plenty of time to recover …… However, for someone in their late 50s/early 60s, the interplay between portfolio size and sequencing risk can cause a potentially catastrophic financial loss that has serious consequences for individuals, families and broader society.”

This is consistent with other international studies.

Managing Sequencing Risk

Sequencing risk is largely a retirement planning issue. Albeit a robust portfolio and a suitably appropriate investment approach to investing will help mitigate the impact of sequencing risk.

Two key areas from an investment perspective to focus on in managing sequencing risk include:

The Retirement Goal is Income

The OECD’s Core Principles of Private Pension Regulation emphasis that the objective is to generate retirement income.  This is different to the focus on accumulated value.  A key learning from the Australian Superannuation industry is that there has been too greater focus on the size of the accumulated balance and that the purpose of superannuation should be about income in retirement.

An important point to consider, without a greater focus on generating income in retirement during the accumulation phase the variation of income in retirement will likely be higher.

Therefore, it is important to have coherency between the accumulation and pay-out phase of retirement as recommended by the OECD.

The OECD recommends the greater use of asset-liability matching (LDI) investment techniques.   

This is not just about increasing the cash and fixed income allocations within the portfolio but implementing more advanced funds management techniques to position the portfolio to deliver a more stable and secure level of income in retirement.

This is aligned with a Goals Based Investment approach.

A greater focus on reducing downside risk in a portfolio (Capital Preservation)

This is beyond just reducing the equity allocation within the retirement portfolio on approaching retirement, albeit this is fundamentally important in most cases.

A robust portfolio must display true portfolio diversification, that helps manage downside risk i.e. reduce degree of losses within a portfolio.

This may include the inclusion of alternative investments, tail risk hedging, and low volatility equities may also be option.

The current ultra-low interest rate environment presents a challenging environment for preserving portfolio capital, historically the role of Fixed Income.  Further discussion on this issue can be found in this Post, which includes a discussion on Tail Risk Hedging.

This article in smstrusteenews highlights the growing issue of capital preservation within the Australian Self-Managed Super Fund (SMSF) space given the current investment environment.

Meanwhile, this article from Forbes is on managing sequence of returns in retirement, and recommends amongst other things in having some flexibility around spending, maintaining reserve assets so you don’t have to sell assets after they fall in value, and the use of Annuities.

Many argue that sequencing risk can be managed by Product use alone. 

My preference is for a robust portfolio, truly diversified that is based on the principles of Goals-Based Investing.  Longevity annuities could be used to complement the Goals-Based approach, to manage longevity risk.

This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.

Further Reading 

For a more technical read please see the following papers:

  1. Griffith University = The Retirement Risk Zone: A Baseline Study poorly-timed negative return event
  2. Retirement income and the sequence of-returns By: Moshe A. Milevsky, Ph.D., and Anna Abaimova, for MetLife

The case for a greater focus on generating retirement income is provided in this Post, summarising an article by Nobel Laureate Professor Robert Merton.  He argues strongly we should move away from the goal of amassing a lump sum at the time of retirement to one of achieving a retirement income for life.

The concepts in Merton’s article are consistent with the work by the EDHEC Risk Institute in building more robust retirement income solutions.

Lastly, a recent Kiwi Investor Blog Post, The Traditional Diversified Fund is outdated – greater customisation of the client’s investment solution is required, provides a framework for generating greater tailoring of investment solutions for clients.

Please read my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Monthly Financial Markets Commentary – October 2020

We have a winner – Maybe!

  • Markets appear to have moved on from the US election result, reflected in the 7.3% gain in the US S&P 500 index last week (its best week since April).
  • The US sharemarket declined 2.7% over October.  Global equities fell 2.4% and Oil 11.0% on rising COVID-19 cases internationally and US election uncertainty.  Europe led markets lower, falling -5.6%. Emerging markets rose 2.1%, driven higher by Chinese stocks.
  • The “Blue wave” failed to materialise. Although Biden won the US Presidency and the Democrats retained their majority in the House, control of the Senate will be decided in runoff elections in Georgia in January.  It was not the resounding win predicted by the “Polls”.
  • With a divided government, regulatory risks decline for some sectors, and government spending is likely to be less robust relative to a Blue wave outcome.  A $1 trillion dollar US Government stimulus package is now expected, less than half of what was previously anticipated. 
  • Global interest rates are expected to remain lower for longer given the US election outcome. 
  • The result is also slightly positive for emerging markets due to lower interest rates for longer and an expected friendlier global trade environment under a Biden Presidency.
  • October witnessed a rise in COVID-19 cases across Europe and in the US, resulting in fresh lockdown announcements in Europe and the UK.
  • In view of the above outcomes, economists are trimming their economic growth forecasts for the US and Europe.  Albeit the “V” shaped global economic recovery remains on track.
  • In more positive economic news, the US Labour market is rebounding more quickly than anticipated, largely due to a rehiring of temporarily laid off workers.  Measures of global manufacturing activity have also improved more than forecasted.
  • The US economy grew at a 33% annualised rate in the third quarter of 2020 but remains 2.9% lower compared to a year ago.  In the US retail sales, manufacturing, CAPEX, and the housing market underpin the bounce back in economic activity.
  • The Chinese economy continues to recover, economic activity is 4.9% higher compared to a year ago, driven by industrial production, rising retail sales, and strengthening exports.

The Red Wave

  • In a red wave New Zealand’s Labour Party (which is more aligned with the US Democratic Party) claimed a decisive victory in the General Election.
  • Like the rest of world, New Zealand is expected to see a sharp rebound in economic activity over the second quarter (the economic growth data is not available yet).  Consistent with this, Business confidence has rebounded sharply to be above pre-pandemic levels, according to the NZIER Survey of Business Opinions.
  • New Zealand’s unemployment rate rose by 1.3% to 5.3% in the third quarter’s Employment Report.  Workers covered under the Government’s wage subsidy programme are counted as employed in the official data.  Accordingly, the unemployment rate is expected to rise further.
  • The New Zealand Sharemarket continues to perform strongly in absolute terms and relative to the rest of the world.  The strong performance of F&P Healthcare and the electricity generating sector helped push the market 2.9% higher over the month.
  • The Australian sharemarket also outperformed, returning 1.9%, on an improving economy and expectations the Reserve Bank of Australia (RBA) would reduce interest rates further, which they delivered in early November by reducing the cash rate to 0.1% from 0.25%.
  • Australia and New Zealand remain relatively well placed for 2021 as the global economy transitions into a recovery phase. 
  • Australia is expected to benefit from a pickup in global economic activity, particularly if a vaccine becomes available.
  • A COVID-19 vaccine is anticipated to become available by January 2021.  If so, global economic growth is expected to pick up strongly over the second quarter of 2021.   
  • Global equities are likely to perform strongly in this scenario.

Please read my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

The value of Emerging Markets within a Robust Portfolio – The Attraction of Emerging Markets

Canada’s largest Pension Funds plan to increase their investments into emerging markets over the following years.  Asia, particularly India and China, are set to benefit.

The increased exposures are expected to be achieved by increasing portfolio target allocations to emerging markets, partnering on new deals, and boosting staff with expertise to the area.

The expected growth in the share of global economic activity in the years ahead and current attractive sharemarket valuations underpin the case for considering a higher weighting to emerging markets within portfolios.  Particularly considering the low interest rate environment and stretched valuation of the US sharemarket.  This dynamic is very evident in the market return forecasts provided below.

Additionally, emerging markets bring the benefits of diversification into different geographies and asset classes for investors, including both public and private markets.

Increasing allocations to Emerging Markets

As covered in this Pension & Investment ((P&I) online article emerging markets are set to become a large share of Canadian Pension Plan’s portfolios. 

As outlined in the P&I article, the Ontario Teachers’ Pension Plan (C$201.4 billion) is investing significantly into emerging markets, particularly Asia.  Their exposure to emerging markets fluctuates between 10% and 20% of the total Portfolio.

The Fund’s investments across the emerging markets includes fixed income, infrastructure, and public and private equities.  They plan to double the number of investment staff in Asia over the next few years, they already have an office in Hong Kong. 

The Canada Pension Plan Investment Board (CPPIB) (C$400.6 billion) anticipates up to one-third of their fund to be invested in emerging markets by 2025.

CPPIB sees opportunities in both equity and debt.  Investments in India are expected to grow, along with China.

The Attraction of Emerging Markets

The case for investing into emerging markets is well documented: rising share of global economic activity, under-representation in global market indices, and currently very attractive sharemarket valuations.

Although the current global economic and pandemic uncertainty provides pause for concern, the longer-term prospects for emerging market are encouraging.

From the P&I article “CPPIB estimates the share of global gross domestic product represented by emerging markets will reach 47% by 2025 and surpass the GDP of developed economies by 2029”.

Based on the expected growth outlook CPPIB “feel there are attractive returns available over the long term to those investors who take the time to study the characteristics and fundamentals of these markets and are able to identify trends and opportunities in those markets,”…..

CPPIB also highlight the benefit of diversification into different geographies and asset classes for the Fund.

Lastly, the valuations within emerging market sharemarkets are attractive. 

This is highlighted in the following Table from GMO, which provides their latest (Sept 2020) Forecasts Annual Real Returns over the next 7 years (after inflation).

As can be seen, emerging market is one of only two asset classes that provides a positive return forecast.  Emerging market value offers the prospect of the highest returns over the next 7 years.  As GMO highlight, the forecasts are subject to numerous assumptions, risks and uncertainties.  Actual results may differ from those forecasted.

Nevertheless, GMO provided the following brief commentary in this LinkedIn Post “From an absolute perspective, broad markets in the US are frighteningly bad; non-US developed markets, however, are not as bad, but that is faint praise, as our official forecast for this basket is also in negative territory. “Safe” bond forecasts are not much better. With yields this low, the very foundational justification for holding bonds — as providers of income and/or as anti-correlated money makers when equities decline — has been shaken to its core. The traditional 60/40 portfolio, consisting of heavy doses of US and International stocks and Government Bonds, is poised for a miserable and prolonged period.”

GMO Annual Real Returns over 7 years

In February 2020, GMO advised that it was time to move away from the Balanced Portfolio, as outlined in this Kiwi Investor Blog Post. GMO provide a historical performance of the traditional Balanced Portfolio (60% equities and 40% fixed income).  Overall, the Balanced Fund is riskier than people think.

In the LinkedIn Post mentioned above, GMO comment that “Our Asset Allocation team believes this is the best opportunity set we’ve seen since 1999 in terms of looking as different as possible from a traditional benchmarked portfolio.”  Where the traditional benchmarked portfolio is the Balanced Portfolio of 60% equities and 40% fixed income.

Why the Balanced Portfolio is expected to underperform and potential solutions to enhancing future portfolio returns is covered in this Post.

Please read my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.