By Paul Resnik and Peter Worcester
Over the last few years we’ve seen a growing number of strategies adopted by advisers to engage investors in their money decisions. One that has an intuitive appeal is sometimes termed the ‘Bucket Shop’ approach as it can be applied to meet older investors’ needs.
Conversations between advisers and their clients are typically constructed to develop a list of financial goals which are in turn placed within time frames: short term (in the next few years); medium term (in the following half dozen years or so); long term (ten-years plus); and estate planning (what goes to family and philanthropy).
Many of those advisers I’ve spoken with view the different stages – short-medium-long term – as three, or in some cases four different buckets, filled with different investment approaches with different tolerances to risk attached to each bucket.
For each stage, however, there’s likely to be at least different capacities for loss. In the case of education funding for instance, in the absence of alternative sourced monies, the investor may have little flexibility in taking on the uncertainty that typically follows increased equity risk exposure. Capacity is clearly the issue that changes with context, not risk tolerance.
Evidence and experience tell us that risk tolerance is the one consistent factor in each risk bucket.
Of course the practical challenge is in managing the various portfolios if monies are actually put aside to match the goals as the assets in the bucket deplete. At any time, one ‘stage’ may become over full because the asset mix has outperformed expectations or a bucket may be rapidly emptying because something unexpected like a surprise tax liability occurs.
So what’s the best way forward?
There are several options. All have their benefits and drawbacks. And at the back of almost everyone’s mind is the fear of series or sequence risk. Sequence risk is the concern that the client’s outcomes may be horrific if they invest the majority of their monies just before the markets correct and they need to withdraw relatively large amounts of money soon after to meet their financial needs.
Sequence risk is probably overstated. For every time a portfolio is de-equitised and the markets confirm the wisdom of that action, the opposite will occur. The portfolio will not fully participate in a positive correction. As most retirees don’t have sufficient investable funds to meet their preferred lifestyle, sub-optimal outcomes are generated.
Option 1: Run a generic portfolio and keep back three or four years of assets in cash and liquid assets to meet short-term needs. There is an intuitive validity to this approach but it may lead to lower overall performance because the portfolio is likely to see-saw with changes to the proportion of growth assets over time. For smaller investment pots the four years cash allocation will likely result in underexposure to growth assets. If the market booms during an underexposed term then the aggregate return over time will be diminished, perhaps significantly.
Option 2: Weight the portfolio to higher distributing assets such as ungeared property, higher yielding shares and higher yielding fixed interest. The limited universe of income generating assets fundamentally alters the risk profile of the portfolio itself and could likely lead to underperformance. Maximising income at the expense of total return is unwise. A better objective would be to maximize total returns, subject to your client’s risk profile. Then, if the income received in insufficient for a client’s needs in a particular year, then draw down some capital. This delivers a better outcome for the client.
Option 3: Add warrants and guarantees of income, minimum income payment periods, protection against inflation, first or second death continuity and return of capital in agreed percentages. These can be either added as riders or offered through complementary products such as annuities, which would be considered a defensive asset. It is a challenge to map an annuity at the commencement of the portfolio, and over time, to the client’s risk tolerance. Many experts argue that these guarantees cost more than they are worth, and are generally not a good idea. Their argument is that if you want guaranteed returns, invest in cash. Over the next few years we can expect a rush of funds offering what we might call ‘retirement alpha’.
Option 4: Aggregate the portfolio into one. Run the growth asset exposure consistent with the client’s capacity for loss, time horizons (needs), and risk tolerance. If the client is a couple, their agreed risk tolerance must be considered. If clients have a low risk tolerance, discourage them from looking at account values too regularly. There’s necessarily less personalisation to specific needs in this approach but at least the portfolio can be run sensibly.
Many advisers argue that this approach is likely to deliver the best result over time. The key to clients staying with their portfolio over time is that they should not be surprised by market performances. Advisers should work hard to frame investors’ expectations.
The conversation between adviser and client still involves an exploration of priorities, what’s necessary to have and what’s preferential. The outcome is essentially an individual plan for time-based goals from one bucket.
Individual needs and circumstances and professional judgment should lead to the selection of the ‘best’ option. Whichever is chosen, rigorous note taking is required to keep compliance officers, the regulators and ultimately the courts at bay. However carefully the initial suitability work is, the markets and individual circumstances will invariably lead to sub-optimal outcomes in some cases.
Each strategy should be ‘scenario tested’ for good, average and poor possible returns and the results compared against the range of probable client circumstances. The general rule prevails that advisers should undertake due diligence on all parts of the product and service chain, including retirement portfolios. Once the strengths and weaknesses of each has been understood then the remaining two provisos are that the adviser should work to mitigate the weaknesses in the plan and to fully explain what might go wrong so that the client can give their informed consent.
About the authors Paul Resnik is a co-founder of FinaMetrica, which provides best-practice psychometric risk tolerance testing tools and investment suitability methodologies to financial advisers in 23 countries. Paul has been in the financial services industry for more than 40 years. He has founded financial planning, asset management, life insurance, consulting, recruitment, conference, wrap and financial planning software businesses. He has a detailed understanding of the financial services industry supply chain and personal financial planning.
Peter Worcester has spent nearly 40 years working in the financial services industry. He is an actuary, has been a director of several financial planning firms, and has been an investment manager with several firms. He was a key witness for the Joint Parliamentary Committee investigation into Storm Financial. He is committed to continual improvement in investment outcomes for clients.