This article is a follow-up to our ongoing series on living annuities, which focuses on how to maximise a pensioner’s chances of drawing an inflation-hedged income for life.
One of the key discussion points emanating from our advisor engagements on this topic has been the use of so-called bucket strategies in managing the asset allocation of living annuities. In our May 2019 article, we reviewed bucket strategies and some academic material published on this topic. We would encourage you to review this article for background. One of the key conclusions from our article was that bucket strategies introduce portfolio management risk, and advisors using these strategies should actively guard against these pitfalls. This article unpacks the above conclusion.
What are the key investment risks for a living annuity portfolio?
In our earlier research work on designing investment portfolios for living annuities, we concluded the following:
- For a given level of starting income, the success probability of a living annuity is strongly driven by the real return of the portfolio.
- The real return of a portfolio is, in turn, strongly driven by the asset allocation and the manager alpha (outperformance of the benchmark).
- Contrary to popular thinking, the biggest asset allocation risk for an annuity is underexposure to growth assets (such as local and offshore equities), as you need growth assets to provide an inflation-protected income over a 30-year term.
- Once an annuity portfolio has the correct asset allocation, reduce volatility as much as possible through diversification and selecting investment managers/strategies with an inherently low volatility signature.
With these four conclusions as background, how can the investment strategy for a living annuity go wrong? Broadly speaking, the following are the three most common mistakes made:
- Selecting an incorrect long-term strategic asset allocation (typically maintaining too low an average equity exposure in the annuity);
- An unintended tactical asset allocation trap (basically falling in the classic “buy high and sell low” trap under pressure); and
- Incorporating unnecessary volatility in the portfolio.
How prone is a bucket strategy to these investment pitfalls?
Let us investigate the implementation of bucket strategies against these common pitfalls.
1) Selecting the appropriate long-term strategic asset allocation
This is a critical area to get right, and arguably where bucket strategies are most prone to errors and present some risk to advisors and pensioners.
A bucket strategy’s behavioural advantage could lead to a poor investment outcome. The focus is on securing the next three or four years’ income in fixed income instruments to manage the pensioner’s emotions and behaviours. But this makes a bucket strategy prone to overexposure to fixed income assets.
The table below gives an example of how this can easily happen in practice. It highlights an initial asset allocation for a 5% initial income living annuity where the first year’s income is in the money market and the next three years’ income is in multi-asset income funds. The remainder of the assets are invested in multi-asset high equity funds.
Table 1: Initial asset allocation for a typical bucket strategy
| Average asset allocation | ||||
|---|---|---|---|---|
| Portfolio allocation | Domestic fixed income | SA equity | Offshore equity | |
| Money market | 5% | 100% | 0% | 0% |
| Multi-asset income | 15% | 100% | 0% | 0% |
| Multi-asset high equity | 80% | 40% | 40% | 20% |
| Total net exposure | 52% | 32% | 16% | |
From the table you can see the problem quite clearly. Although at first glance this portfolio appears acceptable (80% invested in balanced-style funds), on a look-through basis this living annuity only has 48% exposure to local and offshore growth assets. This contrasts with what our living annuity research suggests for a 5% initial income annuity, which is closer to 70% equity exposure. Such a strategy introduces risk to the pensioner and advisor, as it materially increases the failure probability of this annuity.
This is an important discipline that will quickly highlight if a portfolio suffers from ‘fixed income drift’.
2) Rebalancing a bucket portfolio regularly
One of the implications of using a bucket strategy is that the annuity income is only drawn from the fixed income assets in the portfolio. The fixed income assets therefore need to be replenished periodically by selling equity assets and purchasing fixed income assets with the proceeds.
A lot of material has been published in international financial planning journals about various rebalancing strategies, but this article is not about the merits of different strategies. However, we would like to highlight that, unless rebalancing is done in a systematic way (i.e. at fixed, regular intervals), it effectively becomes a type of tactical asset allocation and can jeopardise the success probabilities of an annuity portfolio.
The typical trap with rebalancing is when:
- You delay switching growth assets into fixed income assets after the equity market has run hard (greed); or
- After a market crash you switch more growth assets into fixed income assets than is required to fund the income (fear).
As with the normal ‘fear/greed’ trading cycle, this type of behaviour destroys value for a pensioner and should be avoided at all cost.
Figure 1: A typical rebalancing trap
3) Avoiding short-term asset allocation mistakes
At first glance it appears that tactical asset allocation is one area where bucket strategies should do very well. After all, they are designed to temper investor emotions and they are very effective at nudging the pensioner to ‘stay the course’ with their asset allocation, and not get distracted by short-term market noise.
However, there are situations where an advisor would knowingly tilt the asset allocation of an annuity away from the ideal long-term strategic asset allocation. A classic example of this is when the investment is originally made for a new pensioner client. The negative implications of a market correction early on in an annuity’s lifetime (known as sequence of return risk) are well documented. An early market correction significantly reduces the future success prospects of an annuity, and it dents the pensioner’s confidence in their new financial advisor, possibly leading to a severing of the advice relationship.
The most effective way to deal with both issues of pensioner trust, as well as sequence of return risk, is to phase in the investment at inception. This involves deliberately investing an annuity into a fixed income-heavy portfolio at inception, to protect against an early market crash. The pensioner’s retirement capital is then phased into the target asset allocation at regular intervals over a period of twelve to thirty-six months.
Figure 2: A typical phasing-in strategy
The risk with this strategy, however, is that the phasing-in strategy is ignored or significantly delayed. This is a real possibility when market conditions are choppy and there is apprehension to phasing into growth assets. This could leave a pensioner overexposed to fixed income assets for a number of years.
4) Avoiding unnecessary portfolio volatility
On face value, bucket strategies don’t appear to deal directly with portfolio volatility. However, bucket strategies are often implemented using specialist mandate funds (i.e. single asset class mandates) as opposed to multi-asset funds, which makes them prone to not achieving maximum diversification.
A common example is with offshore exposure in annuity portfolios. In our earlier research work on living annuities, we identified offshore equity exposure as a key piece of the diversification puzzle. Including an offshore exposure of between 25% and 35% makes a significant difference to the portfolio’s volatility signature and improves the success rate of an annuity. Ignoring offshore assets and investing a living annuity 100% in South African assets increases portfolio volatility unnecessarily and reduces the annuity’s success probabilities.
Conclusion
Bucket strategies are frequently used by advisors because of their behavioural finance benefits. They do, however, come with some portfolio construction risks that an advisor should recognise and manage proactively.
- Always run a look-through asset allocation report on a bucket portfolio to verify that the net asset allocation makes sense.
- Use a structured portfolio rebalancing algorithm that is immune to market emotions to avoid falling into a market-timing trap.
- Phase-ins are very useful tools when investing the retirement capital of a new pensioner client during uncertain market conditions. But remember to stick to the phase-in plan and do not get distracted by market events.
- Always search for opportunities to reduce portfolio volatility. In particular, look for opportunities to use funds with lower volatility styles and do not forget the diversification benefits of offshore exposure in living annuities.