For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
A common misconception of income strategies is that they are somehow more risky than total return strategies. This appears to be a result of some significant historic failures of particular strategies but is not evidenced by the broader data. This is an important consideration for investors in drawdown, especially for the majority who are drawing more than the natural income from their portfolio.
We have repeatedly argued that the key risk for investors in retirement is sequencing risk. The impact of large falls in capital values, when a portfolio is in drawdown, can be very significant. Losses at any point in retirement will materially reduce how long the portfolio lasts. Losses are locked in by the need to be continually selling assets to fund income needs. This can be mitigated by only drawing the natural income, but this is simply not possible for the vast majority of retirees. The effect on the capital value of the retirement pot is the opposite of the pound cost averaging that is so beneficial during the accumulation phase.
It follows that mitigating the impact of market falls is a key objective of post-retirement planning. Many advisers hold between one and three years’ spending needs as cash, which does reduce overall portfolio risk, but has a significant negative impact on expected returns. Where the client is drawing heavily from the portfolio, the impact on expected returns and the life of the portfolio can be very material from this strategy. Holding cash reduces both upside risk and downside risk proportionally.
When considering funds or other investment products, not only is expected total return relevant, but the pattern of returns is equally important. A highly volatile strategy may be appropriate in accumulation, where weakness provides opportunity to invest at lower prices, but in retirement it might be inappropriate. In particular, downside volatility is especially important for post retirees.
The Sortino ratio is a measure of returns proportionate to downside risk or volatility. While the Sharpe ratio can measure return for a unit of volatility, the Sortino ignores upside volatility, which is obviously a good thing and considers downside volatility. Higher Sortino implies better downside protection, the key to a long and successful post-retirement investing journey.
This is where income strategies can come into their own. While investors are attracted to high returns, in drawdown this is not the whole story. When units are being encashed on a regular basis, Sortino ratio is at least as important. Well run income and value strategies are the majority of funds with positive Sortino ratios, e.g. better upside participation than downside in the IA 20-60% shares sector.
A simpler but equally important measure in this context is maximum drawdown. This only measures downside risk at a single point in time rather than over the whole journey. It does, however, provide a shortcut to seeing which funds are more suitable for a post retiree in drawdown.
People’s opinion of income strategies has been clouded by the impact of the Global Financial Crisis (GFC) where banks, in particular, did very badly. In most historic drawdowns, income and value strategies have been defensive.
The chart shows the MSCI World Value Index (blue) and MSCI World Growth Index (orange). In the three recent drawdowns value did marginally worse in the GFC but otherwise has proven defensive.
Source: Bloomberg Finance L.P and MSCI – 31/05/1994 – 21/05/2024
In conclusion, post-retirement advice is not only more complicated on the planning side but, on the investment selection front, additional metrics should also be considered, particularly for those clients who need to encash units over time. We would suggest using income strategies can be a good way of addressing this as many have been shown to have lower downside risk over time.
David Jane
Premier Miton Macro Thematic Multi Asset Team
