Asset allocation for retirement income

Historically, if an adviser was presented with a client approaching retirement at the age of 60, the period in which they are in decumulaion could plausibly be 15 years, and the asset mix in the portfolio can be created with this in mind.

But a client entering the decumulation phase today may be doing so with a 30 rather than 10 or 15-year time horizon. 

This could mean a portfolio that needs to produce some growth alongside the usual income, impacting the asset allocation mix. 

Coombs says: “The old notion of transferring more into bonds as you get closer to retirement is probably out of date now. I actually think that now it’s inappropriate to have a rule of thumb, it will increasingly depend on the individual, and obviously the adviser is crucial to that conversation.

"But I think in general, investors may need to have more in equities, and we could be at the stage where for some investors there is a need to treat retirement as part of the accumulation phase.

"And from an income point of view, because the pot of assets is to be owned for longer, inflation considerations come into it much more. You need to think about protecting the spending power of the income generated to protect the current lifestyle.”

The old notion of transferring more into bonds as you get closer to retirement is probably out of date now.David Coombs, Rathbones

Alex Funk, chief investment officer at Schroders Investment Solutions, says: "On the income portfolios we have here, on some of them the target income yield might be 5 per cent but it is certainly the case that you have to monitor the capital side now much more so than in the past. It can’t just be take the income and deplete the size of the pot any more.” 

He adds that even within equities there is an increased need to diversify. Funk says that a portfolio constructed solely with retirement income in mind would likely be very exposed to companies that pay a very high dividend, but perhaps have relatively low growth prospects. 

In a portfolio where capital appreciation from equities is also necessary, this is likely to mean that retirement portfolios in future have exposure to a wider range of equities and investment styles, such as having both growth and value equities, whereas in the past a client in decumulation would be expected to have very little exposure to growth stocks, Funk says.   

Inflation

The challenge is that higher inflation increases the level of income needed to maintain one’s lifestyle, while also eroding the capital value of the pot in retirement.

Obviously the longer the timeframe in which the client is in decumulation, the greater the risk that the assets in the retirement pot will be eroded by rising prices by the time the client comes to draw some of the income for retirement spending. 

And as retirements typically last longer now, the challenge presented to advisers is to operate a portfolio that has the right assets to grow in line with inflation in future, while also producing sufficient income to enable the client to retire today.

You have to monitor the capital side now much more so than in the past.Alex Funk, Schroders Investment Solutions

And the greater the prevailing level of inflation today, the greater the need to invest in assets that can pay a high yield today, even if those assets offer little long-term growth potential. 

Funk says one way to square this circle is for clients to take income from capital gains.

He says quite often they will target a “natural income” of 3.5 per cent, that is the income generated from the dividends on the equities and interest payments from the bonds, while clients needing a greater level of income than this can sell some of the growth investments they have made and which rise in value. 

For example, if one owned a US tech stock, and it rose by 10 per cent, one could sell some of the holding to provide an income today, while retaining the rest of the holding to capitalise on future share price gains.  

Regulatory changes

Fahad Hassan, chief investment officer at Albemarle Street Partners, says that in addition to the demographic factors, regulatory changes have created new challenges for advisers with clients looking towards retirement.

He says: “Pensions freedom has exposed income investors and retirees to challenges historically reserved for actuaries and large annuity providers. Chief among them is inflation.

"Rising inflation not only undermines the buying power of investment income, it also impedes the portfolio returns. Investors risk wealth destruction as central banks try to contain inflationary forces.

"Higher policy rates cause a repricing of all asset classes. As the cost of money is ratcheted up, longer dated bonds and growth equities initially suffer the largest losses. Investors can mitigate these risks by owning shorter dated government and corporate bonds and allocating to value equities."

Hassan adds: "Portfolios will also benefit from owning high-quality sources of income such as infrastructure funds. As rates continue to rise however, the risk of a recession rises and value equity exposures should be trimmed.

Investors risk wealth destruction as central banks try to contain inflationary forces.Fahad Hassan, Albemarle Street Partners

"Rising policy rates give investors the ability to de-risk portfolios by allocating to cash and short-term bonds. This opportunity should not be ignored as it could protect portfolios from more meaningful drawdowns, which could endanger longer term outcomes.”

Nalaka De Silva, multi-asset investor at Abrdn, says the new priority for clients in retirement means alternative assets may come more into play, particularly as bonds may be less suitable in portfolios where growth is also a requirement, and where inflation is rising. 

His view is that a multi-asset portfolio built with retirement income in mind needs to have more alternatives in portfolios, with exposure to assets such as infrastructure and other alternative income products such as music royalty funds, as these offer an income higher than bonds and may have an income stream that rises with inflation. 

He would view those assets as alternatives to bonds in portfolios. He has also reduced his equity exposure over recent months in order to invest more in those alternative asset classes. 

david.thorpe@ft.com