Diversification trumps income generation in retirement accounts

As duration-driven returns dry up in a low-interest rate environment, portfolio managers are turning toward higher yielding fixed-income assets, and to active management within the fixed-income space, says Darragh O’Dowd, head of portfolio solutions at Irish Life Investment Managers.

O’Dowd said these allocations can definitely insulate a retirement portfolio’s duration exposure.

Healthier retirees and longer lifespans are changing the way portfolio managers think about pre- and post-retirement investing, he said. Constructing portfolios that accommodate longer retirements is all about balance — both in terms of the portfolio’s ability to deliver a sufficient return and its ability to manage the potential for material losses.

But he cautioned that the ability of an asset to generate income doesn’t necessarily mean it belongs in a retirement portfolio.

“It is very often the case that income-generating assets have the type of characteristics that you’re looking for in a post-retirement portfolio — more stability, less potential for drawdowns,” he said. “For those reasons we would see a place for those types of investments within an overall diversified post-retirement portfolio. But it’s more for the stability and diversification they bring to the overall portfolio, and the protection that they offer, as opposed to necessarily the incomes that they’re generating.”

Within fixed-income investments, he likes high-yield bonds, sovereign emerging market debt and alternative credit, particularly given the low yields Europe has experienced over the last 10 years and which are now being seen in North America.

As for equities, O’Dowd looks for defensive allocations and strategies that provide explicit protection through the use of options, or implicit protection with lower exposure to pro-cyclicals like consumer discretionary, technology and banking.

“This is what we think is appropriate for the post-retirement decumulation phase,” he said. “We favour having lower allocations of those types of sectors, and higher allocations to sectors like utilities and pharmaceuticals that maybe have more stability in terms of their overall return profile.”

He favours adding equities strategies that offer downside protection, given that traditional investment-grade fixed-income assets will not provide the same level of protection that they have historically.

O’Dowd said infrastructure and stimulus spending in the U.S. could pave the way for attractive equity returns. In fact, the benefits of massive U.S. spending could be global in nature.

“Obviously it’s going to help more in terms of U.S. and their economic growth,” he said, “but we see it as something that’s going to help global equities.”

O’Dowd said the infrastructure stimulus package introduced by the Biden administration could add a half to 1% growth to the U.S. economy next year.

“I definitely think that’s an attractive place to be invested,” he said.

He also likes emerging markets for higher-risk post-retirement portfolios, both in terms of equity and debt.

“They definitely have a place,” he said. “In terms of equity, we would have seen emerging markets deliver quite strongly last year, and at the start of this year.”

When it comes to retirement outcomes for clients, O’Dowd said advisors need to be focused on making sure the money-weighted rate of return is as close as possible to the time-weighted rate of return.

“That differential is essentially what sequencing-of-returns risk is,” he said. “And how do you structure a portfolio to make sure that you’re limiting that sequencing-of-returns risk? It’s about diversification.”

He said portfolios must have diversification across and within asset classes, as well as across regions, sectors, economic factors and investment styles.

“All of these things help us to manage sequencing risk and to take the element of luck — or bad luck — out of the equation, and make sure that people have more certainty in terms of planning for their retirement.”

O’Dowd said investing for retirement today requires considering low interest rates, high equity valuations, high global debt levels leading to inflation concerns, and interventionist central bank policies.

“Despite these challenges, we need to make sure that the portfolios we construct are positioned to deliver strong returns, positioned to protect against potential inflation, [and] positioned to deliver a sustainable income and manage sequencing-of-returns risk,” he said.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.