There are three key characteristics of portfolios designed to meet investors’ longevity needs, according to Steve Deschenes, senior vice president and head of our client analytics and research team for The Capital Group, the parent company of American Funds.
Deschenes spoke with ThinkAdvisor at the Envestnet Advisor Summit in Chicago on Thursday.
“What’s the mental accounting the most retirees think about” as they plan for retirement, Deschenes said. His firm has conducted “a lot of research in the last year and a half with advisors and customers about their view of retirement,” he said, and has “developed a mental model for how people think about the appropriate risk buckets and asset buckets to manage their life in retirement.”
That research was used to create portfolios advisors can use to help their clients meet their longevity needs in retirement.
He said there are four key investment objectives or buckets. The emergency bucket covers investors’ immediate needs, “if the roof leaks or a kid needs to be bailed out.”
The basic bucket covers, naturally, their basic living expenses, while the lifestyle bucket provides for the “things people dream of,” he said. “Playing golf, sailing, traveling to Europe.”
Finally, there’s the legacy bucket. American Funds found that older people planning for retirement take a more disciplined approach to leaving a legacy, while younger clients imagine their legacy will simply be whatever’s left over, Deschenes said.
“Older retirees, people living in retirement at 75, 80, 85, they were beginning to really think about that,’ he said. Not only were they making financial plans to leave a legacy, but it was something that was emotionally important to them. “They worked hard to create this pile of money, now they get to leave it to their kids or their charities.”
He said that older retirees felt they had “cracked the code about how to live in retirement and they knew there was going to be money left over.”
Life expectancies have increased a third of a year every year for the past 50 years, Deschenes said. “We’re leaving a whole half generation longer than people just 50 years ago,” he said.
There are two schools of thought on longevity, he said. One scenario is that the increase in life expectancy continues and may even accelerate. Alternatively, while medical technology may be able to postpone death due to illness, eventually cells may reach the end of their functional lifespan.
“I have no idea which is right, but so far it’s been better to bet on the optimistic side,” Deschenes said.
American Funds built portfolios designed to meet investors’ longevity needs and stress tested them at various withdrawal rates, with and without inflation.
More robust portfolios had three characteristics, he said, “and they’re pretty intuitive.”
A low-cost portfolio is clearly important. “Costs are a direct deduction from results, so focusing on that matters.”
Another characteristic of a strong portfolio is when the manager is invested in it as well, he said.
Downside capture was the last characteristic. “If you evaluate a 20% market decline and your manager’s only down 10%, that’s a 50% downside capture,” he said. “That’s more important when you’re taking money out than if the market’s up 10% and you were up 12%. That’s a 20% advantage, but it’s more important to avoid the losses.” American Funds’ three portfolios – conservative, moderate and enhanced – are “geared to different levels of withdrawal” over at least 20 years. “They’re also geared toward the idea that at the end, your portfolio is likely – not guaranteed but likely – to be the same or larger than what you started with.”
He said clients “don’t want to eat into principal, and they don’t want to time it so their last check bounces on the day they die. That’s not attractive to people.”
Beyond their wish to leave a legacy, investors are concerned about unforeseen economic and political issues that could affect their income in retirement, like changes to Social Security or a default in public pensions.
He pointed to Puerto Rico as an example. “You’ve worked for 40 or 50 years to accrue this thing, you think it’s going to sustain you the rest of your life and it’s gone.”
He added, “If it was a broader scale issue – if it was California and Illinois and New York, we wouldn’t have the resources to bail everybody out. If we did try to bail them out, the taxes would go up so that it would be the same as if everybody was going to get a haircut.”
American Funds launched the portfolios in August, and they now have about $400 million in assets, Deschenes said. In November, Envestnet launched active-core portfolios using the same underlying research, he said.
— Read 5 Critical Issues That Will Make or Break an Aging America on ThinkAdvisor.