In their newest whitepaper, Ned Davis Research demonstrates how even a simple, low turnover implementation of tactical asset allocation can improve performance and reduce risk.
The biggest risk that many retirees face is that their savings will not be able to support their income needs in retirement.
Ironically, the wealth management industry has traditionally focused on a different problem — asset allocation. Clients are routinely “risk profiled” and assigned to categories such as “conservative,” “moderate,” “balanced” or “growth.” Their asset allocation is matched to their risk profile, not their income needs. This wasn’t such a problem in the past. But the current low interest rate environment has created a situation where the gap between the portfolio required to meet a retiree’s income needs and a portfolio designed to suit a retiree’s stated risk preferences is arguably as wide as it’s ever been.
The secular decline in interest rates has also resulted in convergence between the returns of stocks, bonds and cash. This has provided a tailwind for the asset allocation/risk profiling approach since client portfolios have enjoyed similar returns regardless of asset allocation.
Convergence across asset allocation returns has arguably made risk management less important. But a world in which most asset classes deliver similar returns is the exception, not the rule. Risk management will be critical should asset class returns diverge.
At the same time, the risk that retirees may run out of money has been increased by longevity gains and retirees’ costs of living rising faster than CPI. Americans are living longer and so their investment horizon is also getting longer. Consequently, retirees should consider a larger allocation to growth assets. True, such a portfolio is more volatile. But then it is arguably less risky if the retiree is focused on creating an inflation-adjusted income stream in retirement. This income stream can be enhanced by a tilt toward companies with sustainable and growing dividends.
A larger allocation to growth assets increases retirees’ exposure to sequencing risk — the order of investment returns matters if you are making regular withdrawals. We believe that sequencing risk can be managed using tactical asset allocation. We provide an example of how a Ned Davis Research (NDR) tactical asset allocation modeling process can be combined with a larger allocation to growth assets to manage risk in a retirement portfolio.
Sources: Ned Davis Research.