From risk to resilience: Building portfolios for retirement

The prospect of retirement is both exciting and daunting. Advances in healthcare and higher living standards have resulted in people living longer than ever before, enjoying extended retirements can span multiple decades.

This increased longevity brings its own set of challenges, particularly the need to ensure that one’s savings last throughout these golden years. Adding to this complexity is the inherent volatility of financial markets, which can make it difficult to plan for the long-term.

How we think about retirement

As the only mutual financial institution focused on graduate professionals, PPS is able to gain unique insights into their retirement needs. Professional retirees tend to outlive the average South African by more than 10 years, meaning their retirement horizon can stetch between 30-40 years. To help tackle this, our approach focuses on three key risks:

1. Longevity risk – the possibility of outliving your savings.

2. Inflation risk – the gradual erosion of purchasing power over time.

3. Sequencing risk – the impact that the order of investment returns can have, especially when you’re making regular withdrawals.

To better understand and plan for these risks, when it comes to building portfolios for retirement, we simulate 1 000 possible future scenarios. Each simulation projects monthly investment returns over a 50-year period, using a combination of realistic return expectations and the relationships between different asset classes (known as a covariance matrix). These simulations help us stress-test the portfolios under a wide range of conditions, ensuring a high likelihood of achieving returns that outpace inflation over time.

Understanding sequencing risk

Sequencing risk is especially important when it comes to building portfolios for retirement. Even if long-term returns are strong, experiencing a few poor years early on, especially while making withdrawals can significantly reduce the longevity of a portfolio.

Imagine two clients with the same return over 31 years. Client A experiences three consecutive years of -10% p.a. at the start of retirement, while client B only encounters the same negative returns 28 years into retirement. Client A has only R1.2 million remaining, compared to Client B who has R16.7 million. While the order of returns may have minimal impact during your accumulation years, it can be critical in retirement, where retirees are effectively forced sellers during downturns.

*For illustrative purposes only.

To manage this, it’s crucial to focus on reducing the potential for large losses in difficult market conditions. We achieve this by carefully selecting and blending funds in a way that aims to cushion against sharp downturns while still delivering inflation-beating returns over time.

Returning to Client A, if the downside risk was protected, a better outcome could have been for the portfolio to deliver -6% p.a. over the first 3 years instead of -10% p.a. That small improvement in downside protection could have resulted in client A ending up with 145% more capital after 31 years.

*For illustrative purposes only.

Having an absolute return mindset when building portfolios for retirement

When markets underperform, portfolio managers pursuing relative returns strategies can offer their clients both good and bad news. The bad news is that they have lost money. The good news is that they have not lost as much money as everyone else. However, by implementing an effective absolute return strategy, you can offer clients only good news: they have not lost money.

When clients are still saving for retirement, periods of negative returns can be tolerated as there is usually still ample time to recover and the additional savings during that period is being invested at depressed prices. This luxury does not exist for retirees.

It is therefore imperative to have inflation targets when building portfolios for retirement. The key in achieving this is diversification, which can provide lower volatility without materially sacrificing returns. Our approach to achieve this is by combining flexible, specialist and alternative strategies within our Retirement Income Solutions to ensure clients have the maximum probability to reach their goals in retirement.

The specialist equity managers provide growth, addressing longevity risk, while fixed income specialist managers address sequence risk. Flexible strategies allow managers to be nimble during periods of market volatility which can add significant value to clients, both to capture upside by finding opportunities and on the downside by reducing exposure to vulnerable asset classes. Lastly, hedge funds provide uncorrelated returns which further adds diversification.

Creating a financial plan for your clients approaching retirement requires you to address a long list of variables. While some of these are unique to each client, there are elements that you can address across your practice. Providing your clients with solutions that addresses the issues that most clients will face can add great value to both your practice and your clients.

*Estimated growth, with all distributions reinvested