28th July 2014

Fidelity: 3 threats to retirement income

The outlook for markets remains broadly well-supported by a backdrop of increasing growth, subdued inflation and accommodative central bank monetary policy. However, this also comes with some potential threats for a retirement portfolio. With that in mind, I’ve highlighted some ways to protect portfolios from three of the key risks faced today.

1. Global growth is unsteady

I remain positive about prospects for global growth, but since recovery never happens in a straight line, it makes sense to include some lower-risk options in portfolios to see your clients through bumps in the road.

The most obvious risk to investment portfolios is that – despite largely encouraging headlines – global growth remains unpredictable. The slowdown in China has created a ripple-effect, particularly in broader emerging markets, and looks set to continue as the country’s government rebalances its economy. At the same time, events in the Ukraine and the current situation in the Middle East have reminded investors of the risk of geopolitical unpredictability, and have the potential to continue for some time to come.

We did see a small bounce back this spring for the US, where data was weak in the first part of this year, largely due to poor weather. But even here, in this powerhouse of the global economy, the benefit of the recovery is yet to be fully felt by the consumer – and until this happens, the reliability of growth is unassured. Closer to home, growth in the UK appears on the right track, but these conditions could change. Factors like the Bank of England’s loose monetary policy or the current housing boom contribute significantly to the UK recovery, so any change in direction could have a detrimental impact.

Against that backdrop, it makes sense to diversify portfolios across different regions to protect against the risks posed by the growth outlook for individual countries. The overall risk profile could be reduced by making slight cuts to holdings in more growth-focused assets like global dividend stocks. Instead, more traditional, longer duration income generating assets – like investment grade bonds, for example – could boost income, while adding an element of capital preservation and balancing risk.

2. QE tapering comes with various side effects

When building portfolios to draw an income at retirement, think carefully about the impact changes in monetary policy will have on each asset class held.

Early in 2013, when the Fed hinted at plans to taper its quantitative easing (QE) programme, market volatility increased as investors worried about the impact. While the policy was never going to last forever, uncertainties about the timing and repercussions of its rollback were problematic. Now that tapering is underway, markets are clearer about the end of QE, but it is affecting different income assets in different ways.

For example, as tapering began at the start of this year, we saw a sharp fall in emerging market debt (EMD). The flipside of this poor performance was that yields on EMD were forced up to an attractive level. It made sense to take advantage of the price weakness to lock in an attractive income stream for the future.

3. The hunt for yield may have gone too far in some regions

The quest for income in an environment of scarcity is pushing many investors further up the risk spectrum. Protecting a retirement portfolio from the threat of lower yields needn’t mean missing out on assets that should do well during the recovery phase of the economic cycle.

While the tapering of QE may result in a small boost to developed market government bond yields at some point in future, many income investors continue to take a greater amount of risk in the hope of achieving higher yields.

High yield bonds have seen strong performance this year, particularly in Europe. As a result, the strength of these assets now means that valuations are starting to look stretched relative to their fundamentals.

Yields have been driven down by continued high demand for income. The fact that Greece’s largest bank, the CCC-rated Piraeus Bank, was able to issue a €500m bond at a yield of just over 5% (when US CCC-rated corporate bonds are currently yielding 7.5-8%) suggests that the reach for yield may now have gone too far in Europe.

On the other hand, we continue to see opportunities in both US and Asian high yield bonds. I think that ‘hybrid assets’, which offer potential for both capital growth and income, like US and Asian high yield bonds or loans, should continue to do well in this environment.

Likewise, investments in infrastructure not only provide an attractive level of income, but also diversification benefits due to low correlations with more traditional assets and some protection from inflation.

Mitigating against the threat to retirement income

Many savers at retirement are seeking stable and sustainable income from their investments. In an environment of low yields, uncertain growth and QE tapering, the benefits of diversification are all too apparent. As each of the threats I discussed centres on the impact of asset class decisions, it is important that the solutions you offer your clients can follow a flexible approach that is able to take advantage of the opportunities unpredictable markets can offer.

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Retirement, Investments