CPI plus three may not be optimal post-retirement

Asset managers and financial advisers need to think long-and-hard about the appropriateness of the post-retirement solutions they steer clients towards because the current preference for lower CPI ‘baskets’ reduces exposure to the assets classes that are needed to drive longer-term performance.

Harmonising risk and return

This observation, made during the second panel discussion, day one of the Glacier by Sanlam Gauteng Investment Summit 2024, had more than one member of the audience shifting nervously in their seats. The panellists had been asked whether low equity managers could harmonise risk and returns in today’s volatile markets. Low equity funds are fixed income portfolios that can take a maximum of 40% exposure to equities. 

Sandile Malinga, Co-head of Multi-Asset at M&G Investments, was first to step up to the podium. He said that answering the harmonisation question required figuring out how asset managers, and particularly those in the low equity space, balanced risk and return. Before rushing headlong into the discussion, Malinga offered some present day financial market context, trotting out the by now familiar refrain of high inflation and interest rates. PS, he outright ignored panel moderator Wade Witbooi’s plea to halt the ‘death by inflation’ theme that had dominated the morning sessions. 

“One of the challenges in doing what we do is to balance [valuations in line with] where we think the world is going to go,” Malinga said. He offered three slides to illustrate the difficult investment environment that low equity portfolio managers faced post-COVID, starting with a table of domestic asset class returns over 2023. He commented that asset class performances varied significantly based on the inflation outlook. In other words: “If you know when you are going into a low-, medium- or high-inflation environment the [asset allocation] game is done”. It is also important for asset managers to understand how far along the business cycle the economy is. 

Business cycles and the inflation, interest rate dilemma

The four stages of the economic cycle were introduced as expansion, peak, contraction and recovery. “There is a lot of angst about us being in a late stage of the cycle at present,” Malinga said, before turning his attention to when domestic and global central banks would begin cutting interest rates. To summarise his views, you need to have a clear view of the variability of returns through different business cycles and the outlook for inflation and interest rates. “There is plenty of opportunity for low equity managers to be tactical, depending on where you are in the economic cycle,” he said. 

The next part of Malinga’s discussion focused on how the exposure to asset classes in multi-asset, low equity portfolios ‘changed’ along with the aforementioned factors. “The bond that you pick is very important,” he said. “It is not just about choosing a bond; you must also think about where you want to be along the curve”. Equities are tough to evaluate too, with asset managers typically focusing on factors like sales growth; margin expansion; and which phase of the business cycle one finds oneself in. Malinga concluded that low equity fund management was about picking the right asset for the prevailing economic and inflation and interest rate outlook, of course, maintaining a diversified portfolio. 

Sumesh Chetty, a portfolio manager at Ninety One, took a somewhat confrontational stance. He said that based on recent performances, low equity fund managers had been unable to harmonise risk and return. “A lot of people have been hiding in cash over the last year or so; depending on the fund you invest in you can get anywhere between 7.5% and 9% without taking on a lot of risk,” he said. In his view, low equity funds should be able to deliver better returns than bonds, at far lower risk than high equity funds. Sadly, over the last couple of years, this has not been the case. 

Hiding out in diversified fixed income

“Low equity fund achieved lower risk than the bond market while delivering lower returns,” Chetty said. But counterintuitively, these lower returns were a consequence of low equity fund managers taking on too much risk rather than too little. One of the major issues with this fund category has been the extent of drawdowns during the COVID pandemic. “These funds are meant to protect you against the unexpected, but the average fund did not; we saw a drawdown of almost 9%,” Chetty complained. Investors have voted with their feet, shifting out of low equity into the apparent safety of diversified fixed income funds. 

Chetty then equated risk to capital erosion, saying that investors in lower risk portfolios were in a better position to ‘rebound’ following a market pullback than their higher-risk peers. “You have to think about risk very carefully,” he said. “Most low equity managers today tend to sit somewhere between 35% and 40% in equity without using the asset allocation flexibility that they are afforded to balance or harmonise risk and return”. This was an insightful ‘share’ because it must be tempting for portfolio managers to maximise exposures to the highest risk / return asset class that their fund mandates allow. 

Another important point is that you cannot simply toss ‘any old share’ into your 40% equity slot. “In environments where markets are generating a strong amount of beta, you have to think very carefully about the sort of equities that you include in your portfolio,” Chetty said. The secret sauce lies in identifying and incorporating quality businesses that have competitive advantages; dominant market share; phenomenal products and significant pricing power. The ‘name brand’ consumer goods, pharmaceutical and technology companies stand out as capable of weathering big market drawdowns. 

Bonds, cash and global equities for the win

Where should you and your clients go in search of low equity opportunity in the coming 12-months. Ninety One pointed out that SA cash looked fantastic, easily getting you to an inflation plus 4% hurdle. SA Bonds remain an important building block for the asset manager’s low equity funds too, with global equities and SA-listed shares with global exposure sweetening the return. “The opportunity set for multi-asset low-equity managers in South Africa is strong enough to continue generating inflation plus 4%,” Chetty concluded; but you must make appropriate asset class choices to deliver same. 

The final panel participant, Nico Katzke, Head of Portfolio Solutions at Satrix Investments, kicked off his participation by observing that many fund managers felt constrained by the low equity asset class mix. “In addition to capital preservation, low equity constraints force fund managers to be defensive,” he said, which many financial planners argue is the perfect approach for retirees. 

Katzke steered the discussion in a different direction by unpacking risk in the post-retirement context, and introducing the all-important investment term to the debate. “Your clients do not care as much about volatility as they care about limiting losses; the most important element to consider becomes term,” he said. Using fund return statistics going back to 2007, he illustrated that the biggest risk facing your clients was that of not taking sufficient risk. “You must hold asset classes that give you appropriate reward for the risk that you are taking,” Katzke said. Rejigging the aforementioned statistics to accommodate inflation showed the probability of losing money on a five-year or 10-year rolling basis moved close to zero, regardless of asset class. 

“The probability of your client losing money on a real basis effectively goes to zero for most of these asset classes; the return on the low-risk alternatives is 3% versus 8% to 9% at the other end of the scale,” he said. This observation was immediately tempered by the unfortunate truth that consumer price inflation (CPI) is not a true reflection of your client’s post-retirement inflation experience. 

Frequency of loss trumps volatility

The reality is that our client’s medical and other expenses often increase well in excess of CPI through their retirement years, which period nowadays often exceeds that estimated at the start of the financial planning process. Katzke concluded with some insights that may be worth exploring in a future newsletter. He pointed out that the return distribution for the South African bond index was almost identical to that of the SA low equity industry median. 

“We are asking our low equity fund managers to give us CPI plus three, and that is exactly what a bond holding gives you over the long-term,” he said. “We need to retrain our brains to think of risk from a frequency of loss rather than a volatility perspective”. 

Writer’s thoughts:

The mismatch between the official inflation number and the cost of living that retirees experience must give financial planners and their clients sleepless nights. How do South Africa’s CFP® professionals approach the CPI plus discussion with their clients? And how much real return is enough? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.