The theory that underpins retirement investing is to create an asset allocation over time that changes with the shifting objectives over an investor’s lifecycle.
The theory underpinning lifecycle investing is summarised by Ibbotson, Milevsky, Chen & Zhu (2007) in the research publication, Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance.
The investment lifecycle can be broken into three phases: an accumulation phase, a preservation phase, and a decumulation phase.
During the accumulation phase, investors convert a portion of their income into capital based on a 'contribution rate'. While during the decumulation phase, investors convert a portion of their capital into income based on a 'withdrawal rate'.
Growth bias
In the accumulation phase, portfolio objectives typically have a growth bias and aim to maximise portfolio value. This is a function of initial size, contribution rates, and capital growth in real terms.
In the decumulation phase, portfolio objectives typically have an income bias and aim to maximise portfolio durability. This is a function of initial size, withdrawal rates, and capital preservation in real terms.
Durability means that a portfolio can support a level of withdrawals that can adequately fund a retirement income stream over an expected time horizon.
For accumulation, the portfolio construction approach is known as an “asset-optimised” approach. This aims to maximise return for a given level of risk that is consistent with an investor’s risk profile (primarily defined by attitude to risk).
The key driver of an accumulation portfolio’s outcome is risk and return. The key variables for constructing an asset-optimised portfolio are assumptions regarding long-run risk, return and correlation assumptions of each asset class in the portfolio.
For decumulation, the portfolio construction approach is known as a “liability-relative” approach.
This aims to ensure that the market value of a portfolio broadly matches the present value of future withdrawals to be funded by that portfolio over time. The key driver of a decumulation portfolio’s outcome is volatility, interest rates and time horizon.
The key variables for constructing a liability-relative portfolio are assumptions regarding future withdrawals, discount rates and time horizon.
Key risk factors
The key risk factors for accumulation portfolios are, in order, low returns, volatility, liquidity and longevity.
The impact on portfolio value of these risk factors can be mitigated by regular contributions, known as pound cost averaging.
The key risk factors for decumulation portfolios are, in order, longevity, liquidity, volatility, and low returns.
The impact on portfolio value of these risk factors can be exaggerated by regular withdrawals, known as pound cost ravaging.
The opposite ranking of these risk factors illustrates their different impact on accumulation and decumulation strategies.
Furthermore, the combined impact of these risks on the sequence of returns is described as 'sequencing risk', which is the combined effect of 1) the sequence of portfolio returns; and 2) the impact of any contributions or withdrawals.
