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July 31, 2013 at 01:01 PM
Institutional investors have been among the most successful investors in recent years. They have adapted to changing market conditions and have been able to meet client needs, while reducing risk. Let’s take a close look at how they’ve done it, and how their strategies can be applied to retirement income planning.
Today’s retirement landscape
Clients are facing several challenges in planning for retirement. First is market volatility. We all remember the dramatic swings over the past 10 years. Many investors are concerned the wave of volatility will continue.
There is also the challenge of longevity. An individual age 65 has a 50 percent chance of living into his/her mid-to late 80s and a 25 percent chance of living into his/her 90s.1 The challenges become even greater for couples: one has a 50 percent change of living until age 92. This means that there is a high probability that clients could have a retirement that lasts 30 years or more.
Finally, there is the impact of rising costs–inflation, health-care expenses and taxes. This can have a dramatic impact on clients’ standard of living in retirement.
So where should a client invest? It’s a balancing act. Investing too conservatively or too aggressively can have negative results. This is where we can learn from institutions.
Institutional investing
In the mid-1990s, institutional investors began to seek alternatives to traditional asset allocation to achieve clients’ goals. Increased volatility, lower yields and market correlation forced them to adapt. Below are some common strategies.
Liability-driven investing
This form of investing is most common among defined benefit pension plans. The risk for a pension plan is underperforming the liabilities, not just having negative asset returns. Most defined benefit plans have long liabilities, necessitating that they hedge the portfolio’s exposure to changes in interest rates and inflation. They use conventional fixed income, as well as inflation-linked and synthetic securities.
Alternative investments
Alternative assets are typically less correlated to the market. This can help dampen volatility. Alternative assets include derivatives, market neutral and global macro strategies.
Options
Options allow investors to buy or sell an underlying asset at a specific price on or before a certain date. They can improve a portfolio’s risk profile by hedging an investment in a related security. They include calls, puts, collars and spread options.
But what would happen if a client suffered negative returns early in retirement? Using the chart above, let’s look at a more aggressive asset allocation – 80 percent equities and 20 percent fixed income and a 30-year period. Assuming a 5 percent withdrawal rate, the probability of success starts off at only 64.3 percent. If, in the first year, market declines cause the account value to lose 30 percent, the probability of success drops to 17.9 percent. 