Dealing with longevity risk and sequencing risk for Australia’s retirees: the role of alternative assets
In a basic sense, retirement funding is about ensuring you have enough money to maintain a high standard of living after you are no longer working. However, there are more complex aspects to consider. Two of the most prevalent considerations are longevity risk and sequencing risk — economic hazards that can cause serious problems for retirees and those approaching retirement age.
In this article, we are going to look at these forms of risk in more detail and examine how alternative assets can offer a little more protection and certainty for retirees in Australia.
On the surface, longevity risk seems simple. As individuals live longer and life expectancy increases, retirees find that their savings need to last longer too. Retirement savings are finite and provide a certain standard of living for a set period of time. If retirees outlive this period of time, this is an example of longevity risk in action.
However, longevity risk is in fact a little more complicated than this. There are other factors involved that cannot be predicted. For example, increased life expectancy does not necessarily mean that all individuals will reach this milestone. Some individuals will live far beyond the current Australian life expectancy of 83 years, while others will, unfortunately, pass away years before this.
Another factor relates to personal circumstances. Retirees cannot assume that their costs and expenses will be uniform throughout retirement. Changes in healthcare needs or the financial situation of retirees or their family members may increase costs, putting extra strain on retirement savings. These factors combine to contribute to longevity risk.
Sequencing risk is a little different from longevity risk and refers instead to the timing of rises and falls in stock value within an investment portfolio. Many Australians invest in stocks and other assets as a way to provide income during retirement — whether in the form of a superannuation fund or another instrument. These investments are not guaranteed and may experience periods of decreasing value as well as growth.
This is normal for investors. However, sequencing risk occurs when the portfolio incurs losses at the wrong time; i.e. a time at which it will be difficult to recoup the loss. Basically, if a significant decrease in investment value occurs twenty years before retirement, the investor has a reasonable chance of recouping this — if it occurs only a couple of years before retirement, recouping the loss becomes much more difficult.
Investors also need to bear in mind that a loss will shrink their portfolio, and so their investments will have to work harder to get back to where they were before. Calculations from Invesco in the United States show that the portfolio will need to make an 11% return to recoup a 10% loss. When the loss increases to 20%, a 25% return will be needed — if 50% of the portfolio value is lost, a 100% return will be needed to break even. This underlines how disastrous a significant portfolio reduction can be as investors near retirement age.
Retirees can protect themselves against both longevity and sequencing risk with alternative assets. An alternative asset is essentially any asset outside of traditional stocks and shares, including classes as diverse as natural resources, infrastructure, and property, among others.
The idea is to achieve an element of redundancy within the portfolio. When traditional investments struggle, alternative assets may not be influenced by the same specific market forces, and may therefore provide a greater return and deliver more reliable levels of funding for the investor. For example, while the value of stocks and shares can fall or rise rapidly, the Australian property market generally exhibits aggregate growth over time and may add a more stable foundation to the investment portfolio ahead of retirement.
As longevity and sequencing risks work very differently, each requires its own specific approach. For longevity risk, illiquid assets tend to be the most suitable form of defence.
An illiquid asset is an asset class that cannot be redeemed before it reaches maturity. In some cases, investors can redeem the value of the asset before this date, but this is generally not an easy process. Illiquid assets will be priced on a periodic basis, often every quarter, and are designed to be held for the long-term, which makes them suitable as a protection against longevity risk.
Our friends at Stropro (www.stropro.com) have democratized access to these alternative assets, often also referred to as ‘structured investment products’, through their investment platform that curates deals from the world’s largest investment banks. They recently offered their clients the opportunity to invest in ‘Tech Infrastructure’ with a 7.00% p.a. fixed coupon, maturing after two years. This offer had an impressive 43% downside barrier, increasing certainty around risk and reward, and could even be tailored to the client to include capital protection guarantees. Therefore, it is clear that alternative assets could be very beneficial for retirees.
While longevity risk is a long-term consideration, sequencing risk requires more flexibility. This is because sequencing risk can rapidly deplete retirement savings and investments, and this will need to be recouped quickly — often in only a few years — if the risk is to be eliminated.
With this in mind, liquid alternative assets are better suited to protecting against sequencing risk. Investing in real estate or in publicly traded infrastructure projects provides access to these liquid assets, and a combination of liquid and illiquid investments may help retirees achieve the multifaceted defence they need to guard against both longevity and sequencing risks.
For retirees, it’s not necessarily about selecting a ‘catch-all’ investment that will provide a universal defence. Instead, it’s about a structured portfolio, in which different asset classes are hedged against each other to provide a wide-ranging safety net.
The team here at Futureproof has spent years examining the retirement funding landscape in Australia and have found that it repeatedly falls short when it comes to supporting retirees once they have finished work. This is why we are developing the Equity Preservation Mortgage™ (EPM) as a more viable funding option.
Sequencing risk and longevity risk are serious considerations for retirees, and so they are serious considerations for our team too. That’s why we’re adding structured products to the Equity Preservation Mortgage’s™ asset mix so that it is a diversified portfolio of liquid and illiquid assets. The aim is to create a resilient and reliable portfolio to serve as the foundation for post-retirement funding in Australia, and excitingly, the Equity Preservation Mortgage™ will do this while also allowing retirees to gain exposure to assets they would not normally have access to without a finance specialist managing their portfolio.
We are planning to launch the Equity Preservation Mortgage™ in 2023.