In theory, a portfolio of risk-free bonds with coupon and redemption amounts that match the target income, such as US Treasuries, can offer a stream of inflation-adjusted income payments in retirement which are relatively low risk.

Practically, however, retirees will likely prefer to take some investment risk with the goal of being rewarded with higher income over time, especially given the current low level of yields.

Evaluate post-retirement solutions consistently

US Treasuries are effective tools to consistently and fairly compare all post-retirement solutions based on how much additional investment return they seek to provide and how much relative risk they intend to take.

By definition, the matching US Treasuries portfolio is aligned to the income target of the post-retirement solution. Therefore, two post-retirement solutions with different income targets – such as based on different time horizons – will each need different US Treasuries strategies. This approach is used to calculate relative performance, so comparing the relative performance of different strategies versus their matching US Treasuries portfolio is consistent and fair.

For example, the volatility of the difference in performance between the target portfolio and matching US Treasuries portfolio provides a consistent risk measure to evaluate different solutions. We call this risk measure ‘Income Relative Risk’ – it is similar to the tracking error metric often used for actively managed portfolios; the only difference is that rather than using a market benchmark to compare performance, we use the least risky way of achieving the target outcome.

Assess solutions against objectives

To evaluate ongoing performance more effectively, we should also include measures that relate more directly to the specific objectives of each post-retirement solution.

For example, consider a solution that withdraws a fixed amount of income each year regardless of market performance. In this case, evaluating historical variability in the income delivered isn’t helpful. However, a key risk would be: how long can the solution provide the income (often referred to as ‘risk of ruin’)?

The reverse is true for a solution that targets a particular time horizon to deliver the income and adjusts the amount withdrawn each year depending on performance. Here, volatility of income is relevant and, in particular, the key risk is the income falling below a level required to sustain the individual’s retirement.

As a result, to assess the underlying investment strategy requires monitoring how it is performing versus the appropriate metrics that directly relate to the specific objectives – income volatility versus risk of ruin.

Case Study 1: Income for life – providing variable income for the whole of a participant’s lifetime

The target income is set based on life expectancy at age 65. So, for each year, we need to multiply the initial income by the probability of surviving to that age. As the probability of living longer is lower, we see a declining income profile. In addition, an adjustment to the income paid is needed each year, depending on market performance to target income for life.

Who this suits

This type of solution will appeal to participants who don’t want to run out of money but are comfortable with some variability in income. As the income declines quite significantly in later ages, this solution might be best paired with an annuity once the participant reaches an age where any future declines in income are unacceptable.

Case Study 2: Fixed payout – target fixed payments for an uncertain amount of time

A fixed payout strategy provides the same income regardless of underlying investment performance. This means the length of time that the income is provided will vary depending on the investment performance. The projected income can be calculated using the portfolios’ expected returns.

Who this suits

This solution will appeal to participants who value the stability of the income they will receive above the length of time they may receive it. This might be for planning purposes, or for behavioural reasons, yet are comfortable with some (low) risk of running out of money.

With conventional metrics not relevant to evaluate, compare and monitor post-retirement vehicles, a portfolio of US Treasuries aligned to the target income – combined with specific performance metrics that directly relate to the objectives – should be used as a sensible and realistic benchmark to assess the risk and reward of different solutions.

Click here to learn more about the considerations and solutions there are when planning for a post-retirement investment portfolio.

IMPORTANT INFORMATION

Investment involves risks. This material is issued by Schroder Investment Management (Hong Kong) Limited and has not been reviewed by the SFC.