Designing a simple path to achieving retirement income objectives
Part 2: Introducing Asset Liability Management strategies and how it can be applied to balance income certainty and longevity protection in the retirement phase.
Previously we discussed the potential benefits of protection strategies in managing flexibility and capital protection during the early phase of retirement. At this time, access to capital and limiting the impact of drawdowns due to market volatility are both a high priority. As a brief recap, we explored the role protection strategies can play in protecting or reshaping return distribution to target a desired cash flow profile in a decumulation portfolio.
As members age, they tend to prefer increased certainty in investment returns, and are more averse to putting their capital at risk. While a degree of flexibility is still desirable, tighter control of return distribution and increased vigilance for capital protection can be beneficial for investment strategies for older retirees. In this article we’ll look at Asset and Liability Management (ALM), and how it can be applied to a portfolio to balance income stability and longevity protection in the retirement phase.
Asset Liability Management (ALM) Strategies
As a strategy that supports delivery of a cash flow profile with protection from the negative impacts of market volatility, Asset Liability Management (ALM) is an important solution for delivering certainty in a decumulation portfolio. A prudent ALM approach targets appropriate and expected cash flows, taking into account the underlying potential for volatility in an investment portfolio.
Using ALM principles to guide the decumulation process also makes it easier to manage other investment ‘trade-offs’. For example, it enables a clear focus on the goal of balancing the investment income and capital drawdown for cash flow. An ALM process can be combined with a framework for assessing the relative ability of potential investments to deliver the cash flows required.
To remove all investment risk, the ALM process could match all cash flows with government bonds, however, this would limit potential returns and might result in lower payments to the member. Taking some investment risk – combined with an ALM approach and managed appropriately – can deliver higher expected returns to maximise retirement payments while still providing income security.
Some investors take a passive ‘set-and-forget’ approach to an ALM strategy with the aim of capturing a risk premium over time. In our view, following a more dynamic ALM-aware investment approach is more effective and forms the solid base on which to build a decumulation strategy. This involves consideration of current opportunity sets across a range of assets while matching portfolio exposures to the target cash flow profile.
Introducing ALM techniques to secure cash flow and longevity protection
One way super funds can tighten the return distribution in retirement for members is to move away from an asset-only allocation approach and introduce an ALM strategy by integrating annuitisation into the overall retirement income product design.
Inclusion of annuitisation into the retirement income strategy enables a super fund to embed a guaranteed return stream with no volatility of income, as part of the overall retirement income strategy. Integrating this type of annuitisation should be funded from the defensive part of the portfolio to ensure the risk profile of the overall retirement income strategy remains consistent. The proportion of the portfolio that is annuitised can be refined depending on member preference and current conditions such as interest rates.