“An increasing number of Australians are hitting retirement, but you need income and growth to allow them to achieve a desirable retirement lifestyle,” says George Walker, head of investment sales at Colonial First State (CFS).
Download full In Focus report, The perilous search for growth in retirement, as a pdf.
Unfortunately, in a quest for yield, many retirees have been rushing headlong into growth assets such as equities and property without properly assessing the risks. But a new growth-is-good-in-retirement paradigm is looking to add growth assets in a more considered way, and seeking to generate strong returns but also manage risks. Increasingly, that means incorporating assets such as global listed infrastructure and global resources into portfolios.
“We’re all grappling with a low-return environment,” Walker says. “That has challenged people’s thinking around traditional income-generating assets such as term deposits. You’ve got to look for different sources
of return without taking on too much risk.”
Challenging ‘income only’
Retirees have access to a number of income-producing assets, such as fixed income and term deposits. However, Australia’s government 10-year bonds are now yielding just 2.8 per cent, and term-deposit yields average below 3 per cent.
The prospect of rising official interest rates heightens the risk of significant capital losses in fixed income and other defensive assets. At the same time, the scourge of retirees – inflation – is threatening to accelerate
with the advent of ‘Trumponomics’.
“It’s a tough market environment,” says Veronica Klaus, general manager of investment consulting at Lonsec Fiscal.
Andrew Doherty, director of AssureInvest, which provides outsourced investment management services, says this outlook is challenging the traditional ‘go-to’ position that if a client is 65, they have got to immediately go to defensive assets to protect capital. “A number of things have changed,” he says.
One of the biggest changes is that Australians are simply living longer, which is increasing longevity risk – the prospect of retirees outliving their savings.
“A 65-year-old will have 30 to 40 years left,” Doherty says. “If they’re only in cash and bonds, they’ll run short of funds, depending on the outflows they have.”
Of course, retirees have been responding with their flight to equities and property. “But I fear they’re taking on more risk than is wise for their situation,” Doherty says, adding that Australian equities are now only fairly valued at a price/earnings ratio of about 15-16 times.
Klaus agrees the move into equities and property has “probably been for the wrong reasons. That’s exposed retirees to a lot more risk and a lot more volatility.”
But she says growth assets do have a strong role to play in retirement portfolios. Indeed, she says some research is showing that in normal market conditions a focus on income can give you a worse total outcome, and that maybe a better path is to focus on total returns and draw down on that. “That’s an option to look at when income
is so difficult to come by.”
The question is, how do advisers help clients build portfolios to enhance diversification and protect against inflation, while at the same time generating strong investment returns?
CFS’s Walker argues the answer is the inclusion of asset classes that provide strong returns and an inflation hedge in retirement portfolios.
An ‘obvious’ answer
Walker believes global listed infrastructure, which includes toll roads, airports, ports, utilities and railroads, fits this bill. In the 15 years to December 2016, the infrastructure index has delivered returns equivalent to CPI plus 8.2 per cent, with low correlation to other asset classes.
This class can also provide an inflation hedge, as about 70 per cent of assets owned by listed infrastructure companies are able to pass the impact of inflation through to customers, which benefits shareholders. “They’re able to increase prices in line with inflation over the medium-term, providing a stable and growing distribution yield over time,” Walker says.
But global listed infrastructure does have some risks around valuation and interest rate rises.
“I have a positive disposition to them but don’t have any infrastructure businesses in my portfolio
purely on valuation grounds,” Doherty says.
Klaus says: “We definitely think global infrastructure is an obvious asset class to think about including in retirement portfolios as a way of reducing inflation risk. But if you’re entering when markets are quite pricey, you need to acknowledge the volatility of that asset class might increase. It’s going to be difficult to generate any real alpha in it.”
Walker says, overall, listed infrastructure valuation multiples do look full by historic standards, but he says CFS is still able to identify relative value both between and within sectors and regions, “suggesting continued scope for successful active managers to create alpha”.
Global listed infrastructure is also seen as a ‘bond proxy’ and performance suffers when there are rate rises, as there have been in the past six months. US bond yields have surged from 1.4 per cent to 2.6 per cent in less than half a year. Walker argues that rising rates mean higher economic growth, which will help infrastructure sectors such as toll roads, airports, ports and railroads.
He also says the “degree and speed” of interest rate rises, rather than absolute interest rate levels, will determine the impact on infrastructure assets. “We would expect a relatively steady increase – say, a 1 per cent rise in interest rates over a 12-month period – to have a relatively benign impact on the asset class overall,” he says.
Another inflation hedge
The other growth asset class Walker believes advisers should consider incorporating into clients’ retirement portfolios is global resources, which should also perform well in an accelerating inflation environment. “Resource equities have not only protected against periods of high inflation historically, they have actually significantly increased purchasing power in most highly inflationary periods,” he says.
Walker concedes that resource equities are volatile and exhibit significant drawdowns in the short term, as they have in recent years, but he says that, over longer time frames, resource equities “have actually been remarkably effective at hedging inflationary risks. While strong inflation is not in our central scenario – having some global resources in the mix to hedge that risk is prudent, we think.”
Commodity prices and resource stocks rallied last year. Walker notes the CFS Wholesale Global Resources Fund’s custom benchmark, the Euromoney Global Mining Accumulation Index (75 per cent), and the MSCI All Country World Energy Index (25 per cent), returned 70 per cent over the 12 months to January 31, 2017.
He says that despite the recent bounce, the key resource names are still trading at a discount to historical levels, based their price-to-net present value.
AssureInvest’s Doherty agrees that companies such as BHP provide a good inflation hedge. “With growth picking up globally in the major economics and with China growing strongly, I see demand for commodities as quite strong,” he says. “If growth and inflation come out higher than expected, BHP and other global resource companies provide a good inflation hedge for portfolios.”
Klaus, on the other hand, says global listed resources is a low-yielding and highly volatile asset class, and she hasn’t seen much demand coming through for clients to have explicit allocations to it.
“Most clients we speak with typically prefer to have that kind of exposure managed by a fund manager,”
she says. “You’re not buying resources for yield, it’s more about valuations, growth perspectives and quality.”
Every allocation does its share
Klaus says that, in this environment, advisers need to consider how they get exposure to asset classes. Pure indices might be cheap, but active managers might be able to generate more alpha. “Active managers will be a lot more selective in the stocks they hold,” she says. “They’re going to look at the parts of the market that aren’t as expensive as others. If the market were to fall, they wouldn’t fall as much.”
Walker, Klaus and Doherty all agree, however, that in this complex environment, with the increasing need to incorporate growth assets into retirement portfolios, access to the right information is becoming vital.
“We found that planning advice practices had been so heavily focused on the accumulation phase that moving [to a scenario involving multiple objectives] resulted in a lot of personal biases (from both the adviser and the client) being incorporated into the portfolio structure, without due regard for all objectives, and the increased number of risks retirees were exposed to,” Klaus says, adding that Lonsec has created a specific retirement website for advisers.
“Clients need expertise and reliable experience in times of market complexity,” CFS’s Walker says. “In an ever more complex investment landscape, we find ourselves constantly bombarded with information, some useful, some not. Looking at asset classes and specific funds that have performed well through many cycles, and
the teams behind them, can help focus attention on the right expertise and the right information.”
Walker says that more advisers will find answers to the challenge of constructing retirement portfolios in this difficult environment through the inclusion of asset classes such as global listed infrastructure and global resources.
“They have got to be part of a well-constructed portfolio,” he says. “On their own, they aren’t silver bullets. But it’s really about making sure every part of the portfolio is pulling its weight.”
