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Balanced portfolios for balanced risks

17 April 2018 | Garrett Harbron

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I was reading an article the other day about the looming retirement crisis in Europe. The gist was that many European investors may not be able to achieve an adequate retirement income, not because of inadequate savings rates, but because the returns many Europeans are earning are low – in some cases not even enough to keep up with inflation!

One explanation the article gave for such low returns was costs. We've written about the importance of costs before, so I won't go over that again (this time), but the other reason the article gave was that many pensions are allocated too heavily to low-returning bonds.

A good pension portfolio balances three different risks: shortfall risk; sequence of return risk; and longevity risk.

Shortfall risk is the risk that when the investor retires, his or her pension pot will be insufficient to provide a reasonable income during retirement. This is the biggest risk for early and mid-career investors. Shortfall risk is best countered by contributing more or earning higher returns.

The second risk is sequence-of-returns risk. This is the risk that the pension portfolio sustains a large loss right around the time the investor begins drawing an income, when the pension balance is at its highest (and therefore loses the most in pound terms from any percentage loss) and has little or no time to recover any losses. Sequence-of-returns risk is countered by a more conservative asset allocation, reducing the impact of any market decline.

The final risk is longevity risk. This is the risk that the investor lives longer than expected, increasing the money needed to provide an income in retirement. Longevity risk is countered in the same way as shortfall risk, either by contributing more or earning higher returns.

A heavy allocation to bonds addresses sequence-of-returns risk, but does little to reduce either shortfall risk or longevity risk. This means that contributions must be increased to offset these risks – substantially. To accumulate a pension pot of £500,000 over a 40-year career in a portfolio earning 2% per year (about what bonds are paying) would require contributions of around £8,300 per year. At a 6% rate of return, however, that same pension pot can be accumulated with contributions of only £3,200 per year – a significant difference.

Required annual contribution to accumulate £500,000

Required annual contribution bar chart

Source: Vanguard.

While a portfolio that's heavy on bonds may seem safer than one that incorporates equities, it only helps protect against one kind of risk, sequence-of-returns risk. A successful pension scheme must balance all three risks – shortfall risk and longevity risk, as well as sequence-of-returns risk. While increasing contributions is one way to mitigate these risks, with today's low interest rates, contributions have to be increased significantly to offset these risks in an all-bond portfolio.

Adopting a balanced portfolio, one that holds both equities and bonds, can increase returns compared to an all-bond portfolio. This helps mitigate shortfall and longevity risk without requiring increased contributions. Balancing your portfolio can help you balance your risks.

Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

Other important information:

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

The opinions expressed in this article are those of individual authors and may not be representative of Vanguard Asset Management, Limited.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

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