For many retirees, 2022 was an incredibly tough year as high inflation increased the cost of living and rapid interest rate hikes caused asset prices to fall.
But Morningstar Investment Management’s chief investment officer for Asia Pacific, Matt Wacher, says this shift has created a far more positive footing moving into 2023.
“Coming into this year, we have higher yields and lower valuations, helping you with the three measures of retirement success: 1. cash flow stability, 2. source of withdrawals, and 3. likely ending account value,” Wacher says in the Morningstar Investment Management 2023 Outlook report.
Wacher points to “a wildly better environment for retirees”, partly thanks to higher bond yields.
The appeal of higher yields
As with elite sporting teams, every asset in a portfolio plays a role. While some are more defensive players, others press forward to attack – but they need to work together to achieve results.
Throughout 2020 and 2021, Wacher says the defensive portion of a portfolio was not well placed to do its role, with both stocks and bonds falling last year.
“Historically low yields meant that bonds could provide little resistance to broader economic stress,” Wacher says.
“That has clearly changed – and it has big implications for retirees. Not only have the long-term prospects improved for equity markets, now the defensive portion of portfolios has a genuine prospect of providing some ballast.”
He says higher yields are especially relevant to retirees, reducing the “capital gains hurdle” they need to jump and allowing them to lean more heavily on the income component of their total return.
“This is most pronounced in bonds, which retirees tend to have a higher allocation toward, where we can now deliver income in excess of the so-called 4% safe withdrawal rate (which remains a good rule of thumb, despite its weakness).”
While not expecting a smooth ride in 2023, Morningstar experts say the fall in the price of global equities and bonds has improved the outlook for investors.
“Taking a longer-term perspective, the 2022 downturn has set the stage for a much-improved long-term investing environment,” says Philip Straehl, global head of research and investment management at Morningstar Investment Management.
Straehl notes 10-year US real yields are at their highest level since 2009, offering meaningfully positive return prospects after inflation, while equity market valuations are significantly better than in late 2021.
“Considering the improvements in equity and fixed income valuations over the course of 2022, our valuation models suggest that the 60/40 portfolio stands to deliver a return after inflation of 3.6% over the next two decades. This is a 1.6% improvement from a year ago.”
The importance of cash flow
Wacher stresses the importance of retirees thinking about total cash flow, whether that’s generated from an asset delivering high levels of income or by reducing the capital of an asset.
“The ongoing debate about an income-approach versus a total-return approach continues, but in our mind it misses the point,” Wacher says.
“After-tax cashflow is most important—not necessarily how you achieve it.”
He highlights the advantages of the valuation-driven approach to investing followed by Morningstar.
“It means you focus on buying assets at a low price, boosting the cash flow generating prospects in a manner that can also keep overall risks lower (buying a low-priced asset carries less ‘valuation risk’).
“If done correctly and consistently, this can offer the best prospect for achieving your goals in retirement.”
For retirees taking an income approach in 2023, Wacher notes there is a far wider range of assets delivering yields above 4%.
This avoids the problems of a year ago, when it required elevated levels of risk to achieve the same levels of income.
“Some of the same challenges apply, though, with some higher-income assets exhibiting no growth in income (a risk in the face of inflation) and potentially elevated credit risk.”
For those favouring a total-return approach, Wacher says there is likely to be a greater tailwind from yield generation, potentially avoiding the need to sell part of the portfolio periodically to meet retirement needs.
“With a total cash flow mindset, one of the upsides to this approach is that you can potentially access lower-yielding assets at lower prices, which could add to your cash flows over time.”
Consider the risks – and opportunities
Wacher says despite the good news on yields, retirees need to carefully consider further downside risks.
He highlights sequencing risk, or the risk a big decline early in retirement wipes out a big part of the nest egg.
“By the same token, there is a key conundrum between sequencing risk and longevity risk. That is, we don’t really know how long we need our capital to last for, so retirees do need to maintain some level of growth assets to ensure their savings can last,” he says.
Wacher says higher yields impact both the equity and fixed income assets in a portfolio.
“Notably, improved defensive characteristics from bonds can provide more scope to actively pursue those assets with the best prospects in the growth portion of portfolios. And those assets look very different today than they did a year ago.
“Said simply, the opportunity set has shifted, so there could be value in portfolio adjustments. By the same token, volatility can be used within a retirement portfolio to position for future outcomes.
“The key is timeframe—and this is even more relevant for those in retirement.”
Thinking long term
In times of uncertainty, the obvious temptation is to tighten the wallet.
But Wacher cautions that short-term thinking can be the enemy if retirees believe they need to act more cautiously than is required over the long run.
“Specifically, we want to preserve capital, but not to the extent that you can’t live life,” he says.
He suggests splitting the nest egg up into short-, medium- and long-term buckets.
“The longer-term bucket would naturally carry more risk (typically via stocks), which will move higher and lower but will top-up your shorter-term buckets over time,” Wacher says.
“The beauty of doing this is that it works really well with a valuation-driven asset allocation. This means favouring cheaper assets that are fundamentally attractive, which can often take a while to harvest but tend to have higher yields.”