The great majority of individuals in or nearing retirement age may seek to retain some exposure to investment markets to provide the opportunity for growth to support a sustainable income stream. This investment market exposure is typically achieved via multi-asset funds or model portfolio solutions investing principally across equity and bond markets in a range of countries. The rationale is that investing across a range of asset classes and geographies limits exposure to the risk and return fortunes of any particular asset or market, a classic approach to diversification.
Investment diversification can support higher risk-adjusted returns through several channels: geographic, asset class, and currency. In this paper, we explore the role played by diversification in the context of advising clients to take a regular distribution from a diversified (equity and bond) portfolio that aims to sustain their income throughout retirement. We use the experience of a significant and sustained fall in investment markets in 2002, 2008 and 2022.
In addition to considering these historical results, we discuss briefly the potential implications for the strength of risk management effects in the future. We argue that extending the idea of diversification to encompass complementary risk management techniques such as dynamic hedging may help manage sequence risk and improve the resilience of the retirement income plans that advisers create for their clients.
Key discussion points include the following.
- Benefit of geographic diversification within equities: How investing across different geographic markets within the listed equity asset class can be limited
- Benefit of equity diversification with bonds: The correlation between equities and UK government bonds
- Benefit of currency exposure: The impact of the movements in the exchange rate between US dollars and Sterling for a UK investor during three market stress events
- Diversification summary: A strong case in favour of enhancing the risk management for retirees decumulating invested funds
- Dynamic hedging: A technique that changes the balance of investment exposure between cash and an investment portfolio in response to prevailing measures of market risk
- Dynamic hedging performed historically: Analysis of the performance of a dynamic hedging technique on a reference equity index