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3 Keys to Picking Active Retirement Investments: American Funds

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The key to a well-funded retirement is seeking out equity investments that have been more resilient during market downturns.

“Market downturns can be particularly harmful to retirees because they are drawing regular income from their portfolios and, without a salary to make up for losses, they could suffer serious setbacks,” states a new American Funds report.

The report, Key Steps to Retirement Success: How to Seek Greater Wealth and Downside Resilience, has identified three critical factors for selecting retirement investments that both generate strong returns to address longevity risk and also have the downside resilience to address market risk.

“After years of investing during their working lives, millions of baby boomers are beginning to draw on these savings for their retirements,” said Rob Lovelace, portfolio manager and senior member of Capital Group’s management committee, in a statement. “The needs of these investors change as they move from growing their nest egg to living off of it – protecting their savings against market downturns while continuing to build wealth becomes even more important.”

According to the study, American Funds suggests looking for funds that meet these three criteria:

  1. Low downside capture ratio: A downside capture ratio measures how a fund has fared relative to the market during downturns. According to the study, funds that were most frequently in the best quartiles of downside capture in the period under review tended to outpace indexes more often in withdrawal scenarios.
  2. Low expense ratios: The study also found that funds that had the lowest expense ratios tended to outpace indexes in withdrawal scenarios. The study says that “this tendency makes sense, as funds with lower expense ratios have a lower bar to clear to beat indexes.”
  3. High manager ownership at the firm level: “If managers are invested in their own funds, their interests are better aligned with an investor’s,” the study states. According to American Funds, investment firms whose managers had invested more dollars into their funds also tended to outpace benchmarks over the long term.

“By seeking active managers who keep fees low, have their own money in the fund and do a better job of limiting the impact of market downturns, investors who are nearing or are in retirement are, we believe, well-positioned to outpace index returns and build sustainable retirement income,” Lovelace said in a statement. The study found that actively managed equity funds that met these three criteria historically generated more wealth for retirees compared with index portfolios.

To determine this, the study examined four Morningstar category groupings: U.S. large-cap funds, foreign large-cap funds, Moderate Allocation funds (consisting of a mix of U.S. stocks and bonds) and World Allocation funds (composed of a mix of global stocks and bonds).

After accounting for regular withdrawals, the study found that funds sharing the three critical factors collectively outpaced indexes over the last 20 years, a period that includes the dot-com bust and the 2008 financial crisis.

The same was true when looking at rolling 10-year periods within that same time frame.

To translate what these success rates look like in dollars, the study tested hypothetical portfolios.

The study used a hypothetical 65-year-old retiring with $500,000 in savings in 1995, with a plan to withdraw 4% initially each year (increasing by 3% annually to account for inflation) as its base. 

According to the study, a portfolio with a half-and-half allocation between Moderate Allocation funds and World Allocation funds sharing the three factors would have generated 85% greater wealth than a blended index after 20 years.

The study looked at another hypothetical portfolio situation designed to represent an investor’s typical large-cap equity bucket – a 50% allocation to the select U.S. large-cap funds and a 50% allocation to the select foreign large-cap funds.

Compared to an index blend consisting of an equal allocation to the S&P 500 and MSCI All Country World ex USA indexes, this hypothetical portfolio generated 44% greater ending wealth than the index blend after accounting for withdrawals.

In both hypothetical scenarios, the investor would have been able to withdraw a total of about $537,000 over the 20-year period and still have almost $1.7 million left over.

— Check out Top 10 Mutual Fund Firms Most Trusted by Advisors: Cogent on ThinkAdvisor.

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