How to use multi-asset index funds for retirement planning

Introduction

Pension planning has become increasingly complicated over the past few decades.

We have seen the demise of defined benefit schemes and the rise of defined contribution, where scheme members bears all the investment risk themselves, as well as the responsibility for securing their optimal retirement outcomes.

As part of this, the need for implementing sensible, secure strategies both in the accumulation phase and the decumulation pathways has become more important.

What sort of investment strategies work best for long-term retirement provision? Are there any particular investment plans that can be put in place for moderately risky investors who want to maintain an income through their investments in retirement?

How can you maintain a well-diversified portfolio without diversifying too much, or too little; without incurring high costs and ending up with a complicated bundle of investments?

Multi-asset funds that combine a variety of indices can be beneficial for both accumulation and decumulation strategies.

While they will not be appropriate for every client, the following feature, by Mohneet Dhir, multi-asset specialist for Vanguard Europe, outlines how this style of investing – as detailed by the company's own Life Strategy range – can help long-term planning.

For most investors, having sufficient funds to meet their goals is the ultimate aim of long-term investing.

Whether it is saving for a child’s education, purchasing a home or saving for retirement, many clients are looking for the reassurance that they can meet their objectives when they seek the help of a trusted financial adviser.

For advisers, the challenge is choosing an asset allocation, or combination of assets, that will give clients the best chance of meeting their goals, based on reasonable expectations for risk and return as well as the investor’s objectives, constraints, age, income, time horizon and attitude to risk.

Indeed, there is a large body of evidence to show that a portfolio’s asset allocation – the percentage of a portfolio invested in various asset classes such as global equities and bonds – determines the overwhelming majority of its long-term performance and return variability¹.

However, the appropriate asset allocation will be very different for a client with 30 years of saving ahead, compared with one who is looking to achieve a short-term goal.

That is why all-in-one funds, such as life strategy style funds, offer a range of risk and return profiles with different allocations to global equities and bonds, designed to align with different investors depending on their objectives and attitude to risk.

Determining the asset mix

Generally, a multi-asset approach to portfolio management, and having a range of portfolios to choose from, allows for advisers to manage their clients' changing lifestyle needs over time.

For example, Vanguard's own LifeStrategy Funds offers five different asset allocation mixes, ranging from 100 per cent equities down to 20 per cent equities and 80 per cent bonds, meaning advisers have the option of transitioning clients to a more appropriate asset mix over time without being prescriptive and allowing for a change in circumstances.

Broadly speaking, clients with longer-term horizons may be better suited to either 100 per cent or 80 per cent equity allocations, while those with a shorter time-frame, such as those in or approaching retirement, may be more suited to a 40 per cent or 20 per cent equity allocation, with global bonds making up the majority of the portfolio.

The rationale behind an increasing allocation to bonds is the trade-off between human capital and financial capital. Individuals in the early stages of their careers have high earning potential, or human capital, and are likely to have only a marginal amount of accumulated financial wealth.

Human capital, or future income from work, is a bond-like asset: investors earn a regular salary similar to a bond’s coupon. This bond-like human capital helps to diversify equity risk in financial assets.

In practice, this translates to younger clients being able to take on more financial risk because they have more time and capacity to recover from financial losses.

As careers progress, human capital reduces and, generally speaking, financial wealth increases. The theory dictates that as clients approach retirement and their human capital reduces, they should increase their exposure to fixed income and decrease the allocation to risk assets.

In other words, the mix between equities and bonds gradually inverses over time with global bonds accounting for most of a client’s market exposure in retirement.

This approach of reducing equity market exposure over time is a popular one and supported by a large body of research², and offers a strong framework from which advisers can model a client’s long-term investment strategy.

That said, it is broad and generic, ignoring multiple other specific factors that define the optimal portfolio mix for a particular investment objective.

For example, the nature and magnitude of the investment goal itself, the client’s individual circumstances and subjective preferences or attitudes toward investment risk can each put different demands on the portfolio at different times.

Strategic asset allocation

Once an adviser has established a framework for a client’s portfolio by aligning the asset mix with the client’s long-term goals and objectives, the next step is maintaining that asset allocation through different market environments (for as long as the allocation remains in line with the client’s objectives and risk profile).

That is why strategic or target-allocation funds maintain a consistent, predetermined exposure to stocks and bonds through time and market events with the help of periodic rebalancing back to the initial asset allocation.

Alternatively, a tactical asset allocation strategy actively, or opportunistically, adjusts a portfolio’s asset allocation based on short-term views.

It aims to exploit perceived inefficiencies or temporary imbalances among different asset or sub-asset classes. Studies have found that while some tactical strategies have added value, on average, most tactical strategies have failed to produce consistent, or durable, positive excess returns³.

When considering the potential inclusion of a tactical asset allocation strategy, advisers should be mindful of the risks and obstacles that can outweigh any theoretical benefits. Tactical strategies can limit transparency, typically increase cost and potentially complicate management and oversight⁴.

It is optimal therefore, to provide target-allocation funds with periodic rebalancing as a good starting point for most investors, to maintain a straightforward portfolio and keep clients on track to meet their goals.

However, advisers will need to periodically reassess their clients' objectives, risk tolerance and progress towards achieving their goals, to ensure the target-allocation fund continues to suit a client’s circumstances.

By using a target-allocation fund as the core portfolio, a financial adviser can achieve low costs and a high level of risk control in the investment portfolio, while also having the flexibility to invest in more specialist indices or actively managed funds.

Using target-allocation funds within a core-satellite investment approach gives advisers the chance to add value for their clients in a risk-controlled way.

Regularly rebalanced

A key benefit of investing client assets in such funds is the regular rebalancing feature offered by some providers.

Keeping savers on-track to meet their goals is heavily dependent on maintaining a disciplined approach to asset allocation. Without regular intervention, the mix of assets will naturally drift over time and can result in unnecessary risk-taking, which could come back to bite at a later date.

This effect, known as portfolio drift, is common during normal market cycles, but can become more acute during times of increased volatility.

For example, the chart below demonstrates the effect of portfolio drift by comparing a regularly rebalanced portfolio with a non-rebalanced portfolio over the course of just under 60 years.

Both portfolios begin with an initial allocation of 60 per cent global equity and 40 per cent global bonds, but as time goes by, the non-rebalanced portfolio drifts closer to 80 per cent equities, owing to the outperformance of stock markets relative to bond markets over the period.

The key point here is that the risk profile of the non-rebalanced portfolio has increased significantly, as we know equity markets are more volatile than bond markets.

So, while it may seem counterintuitive to sell outperforming assets to buy underperforming assets, it is important to acknowledge the objective of rebalancing is to mitigate the risk of portfolio drift and unintended exposure to one asset class over another.

After all, higher-returning assets are also typically higher-risk assets and could become big detractors further down the line. Rebalancing can go a long way towards avoiding unwanted and unintended portfolio risk.

LifeStrategy Funds are rebalanced daily, based on cash flows and target weights, while also taking into account market volatility to be as cost-effective as possible. Each market the funds invest in are assigned specific drift thresholds that are variable dependent on the level of current market volatility.

For example, when the March 2020 Covid-19 sell-off hit asset prices, the rebalancing thresholds were moved slightly wider than they would be under more typical market conditions, to avoid rebalancing in the wrong market direction.

Broad diversification at low-cost

For long-term savers, another key factor in achieving their goals is keeping costs low.

There is a wealth of research to support the case for low-cost index investing⁵, with low-cost funds tending to outperform higher-cost funds, which is true for both active and index strategies.

For clients concerned about costs, it is worth looking at those funds which can provide investors with a low-cost access to a broadly diversified portfolio of global stocks and bonds.

There has been some debate about the effectiveness of the traditional multi-asset portfolio of stocks and bonds, particularly around the role of bonds in a changing economic environment as yields rise.

However, it is important to remember that high-quality bonds offer value beyond returns – they act as a stabiliser, which is particularly important for those clients nearing retirement and who want to minimise volatility.

After the Covid-19 sell-off in March 2020, for example, the LifeStrategy 40 per cent equity fund took only five months to recover to its maximum value between the beginning of January and the end of February 2021, while the 80 per cent equity fund took 10 months to fully recover⁶.

The 20 per cent equity fund recovered in only four months, further demonstrating the value of high-quality bonds as a volatility dampener.

In early retirement, clients generally require a balance of reliable income as well as protection against inflation over the long term.

Within a typical multi-asset index approach, a 40 per cent equity portfolio could offer those clients with perhaps 20 or 30 years to plan for in retirement a means to offset some inflationary risk and continue accumulating in early retirement, depending on their risk profile.

At the same time, a greater allocation to global bonds can defend against market volatility and provide greater portfolio stability.

In summary any long-term investment objective is more likely to be achieved by adhering to our four investment principles, including the setting of clear goals, staying balanced across asset classes and markets, keeping costs low and maintaining discipline.

Each of these principles is critical to a successful long-term savings plan.