Challenges in strategic asset allocation for client retirement portfolios: Uncovering key issues

Asset allocation is one of the most discussed topics in investment management. Strategic asset allocation works like this: set your asset allocation appropriately, rebalance it back to strategic weights every year or two, and investors will be fine.

But does that hold true for retirement and income investors? It turns out that the set-it-and-forget-it strategic approach makes for a risky retirement. Let’s discuss.

First, some historical observations. The chart below shows the maximum 10-year rolling real drawdown of a US 60/40 (equity/bond) portfolio from 1900 through 2023. As we can see, there are many long periods, circled below in red, when the set-it-and-forget-it strategic portfolio investor experiences a real loss of between 25% and 55% of their wealth. In fact, as the chart shows, large real losses are more the norm than the exception for investors in this type of strategy.

Periods of large real loss are a problem for all investors because they reduce average returns. They are a particular problem for those approaching retirement and those in retirement because of the detrimental effects of losses on retirement income. Why?

What is the relationship between large losses and income in retirement? What do these periods of large real loss imply for managing retirement and income assets using an investment management approach predicated on strategic allocation? These are the topics we discuss next.

Significant periods of real financial decline pose a unique challenge for investors with an aversion to losses, individuals approaching retirement, and those already in retirement

Large losses in the years leading up to retirement reduce the fixed amount of capital that retirement incomes depend upon. Losses can, and do in fact, cause individuals to delay retirement and extend their working years to get back to the target level of retirement assets. This was the case for example during and after the global financial crisis (GFC) when it took many investors seven to ten years just to earn back their nominal losses from 2007-2008.

Other periods of loss even on the order of just 10% or 15%, which (as illustrated above) are common, can delay retirements by several years or require diminished retirement lifestyles, or both.

Large losses in retirement – or even just the likelihood of such losses in the future – decrease retirement income through the mechanism of having to conserve capital to preserve future income draws and ensure sufficient income over a couple’s lifespan.

Because of this, the critical objective of asset allocation for optimal retirement portfolios is minimizing exposure to large drawdowns as a first order priority while ensuring total returns sufficient to support income needs as a second order priority.

To the extent that investment management can reduce exposure to large loss, it can directly benefit those near retirement and in retirement with higher monthly incomes. As the chart above vividly illustrates, achieving better outcomes necessarily involves doing something better than the set-it-and-forget-it strategic approach.

Why does strategic asset allocation perform so badly for retirement investors? What are the key fundamental problems with managing retirement assets by the strategic allocation approach? That’s the topic of the next section.

Challenges in strategic asset allocation for retirement investors: Uncovering key issues

Problem 1: A long runway view to a short runway problem.

As we’ve discovered, there are very significant drawbacks to strategic asset allocation as an investment management approach for retirement investors. But why do portfolios managed in this way perform so badly for these investors? What is the central problem with this approach as it pertains to retirement?

The problem lies in the fact that strategic portfolios are not responsive to changes in asset dynamics – changes in expected returns, correlations, and risks. This is why strategic portfolios can get very risky very fast and they reliably result in frequent periods of large loss. Strategic portfolios essentially ignore market dynamics at their own peril. They do this because they are premised on the idea that things will work out in the long-run.

For a young, pre-retirement investors who are not averse to large losses and not drawing income, this may hold to some degree. Such investors have a long runway for compounding wealth. But for near retirement and in retirement investors, their incomes are very sensitive to both losses in the here and now and the likelihood of losses in the future. Their runway for withstanding losses is short and getting shorter every day. Losses have little time to work themselves out. For these investors, long-run income very much depends on avoiding large losses today, and everyday hereafter.

In a very real sense, managing by strategic allocation is the long runway round peg applied to the square hole that is the short runway, high-certainty income needs of retirement. It’s just not a good fit.

Problem 2: A risky solution to a problem that demands risk-management

A second major weakness of strategic portfolios in the retirement context is that in practice strategic portfolios either allocate to passive indexes representing each major asset class, or they allocate to funds that behave like indexes in down markets. That is, we find the emperor often has no clothes – there’s little in the strategic portfolio by construction or by dint of investment management that offers investors anything remotely resembling actual risk-management.

The failure to provide risk-management is a critical weakness of many strategic portfolios because, as we’ve discussed and as history shows us, reducing exposure to large losses is the critical requirement for short runway optimal retirement portfolios.

Lacking risk-management, which acts to reduce exposure to the securities in a portfolio exposed to large losses, strategic portfolios have, at best, limited suitability beyond younger, risk seeking investors. Portfolios that don’t limit exposure to large losses are a risky solution to a retirement problem that demands risk-management. Square peg meets round hole, again.

A Better Way

There is a better way to manage retirement assets for income. At Markin Asset Management we take the management of risks very seriously and actively seek to reduce exposure to large loss across all our multi-asset strategies. To learn about effective retirement strategies, read out article: Discover the Most Effective Strategies for Managing Client Retirement Portfolios with our Comprehensive Guide or feel free to contact us.

Conclusion

Periods of large real loss are a problem for all investors because they reduce average returns. They are a particular problem for those approaching retirement and those in retirement because of the detrimental effects of losses on retirement income. The critical objective of asset allocation for retirement portfolios is minimizing exposure to large drawdowns as a first order priority while ensuring total returns sufficient to support income needs as a second order priority.

Strategic portfolios perform poorly for retirement investors because of two major issues. First, they manage assets with a long runway view to the short runway problem of retirement income. Second, strategic portfolios offer a risky solution a problem that demands avoidance of large losses. There is a better way. Learn more about effective asset management strategies for retirement here.

About Markin Asset Management

Markin Asset Management is a diversified systematic manager that is active across alternative, multi-asset, and long-only equity strategies and funds. We seek to deliver outcomes that are aligned with the long-term goals of our investors. Our culture of combining quantitative and fundamental research, compute-intensive methods, and keenly focusing on the selection and management of risk exposures to enhance investor outcomes are distinguishing features of our firm. Markin is based in Rye, New York.