September 1, 2007 -

Recent trends suggest that Americans can look forward to spending more time in their "golden years." Not only has life expectancy increased considerably, but people are also retiring earlier than their predecessors did. While the prospect of a lengthy retirement may be a welcome one, it means that many investors must contend with a critical challenge: making their money last for an increasingly (and often unexpectedly) long duration.

Post-retirement life-cycle funds are one of many options for distribution planning in the mutual fund industry. These funds have generally fallen into two categories: conservative portfolios, dedicating between 25% and 40% to equities at retirement; and aggressive portfolios, dedicating between 55% and 65% to equities at retirement.

Each of these strategies presents challenges. While a portfolio heavy on fixed income may produce a savings shortfall (often referred to as "longevity risk"), an aggressive portfolio may be severely penalized if the equity markets experience large negative returns in the first several years of retirement (sometimes referred to as "sequence-of-returns risk"). In the latter situation, any withdrawals taken, compounded with negative returns, can exaggerate the depletion of a nest egg to the point where withdrawals cannot be sustained for the full duration of retirement. In short, either of these potential pitfalls may hurt investors' chances of making their money last.

Addressing this challenge—and building an effective investment solution for the retirement phase—involves moving beyond conventional product design. The focus of this new design should not be finding the level of equities that is always right for all investors in retirement. Rather, the focus should be meeting retirees' key investment objective: maintaining a sustainable withdrawal rate that keeps pace with inflation over an extended time period.

This focus requires an absolute shift in the goal-oriented investment mind set. Instead of traditional "relative-return investing," where the goal is to outperform a benchmark, the new paradigm requires "target-return investing," where the goal is to generate absolute returns that will fulfill an investor's spending needs in the face of zero, or reduced, income.

Investing for a target return may help investors get the best of both worlds: the low volatility of bonds and the return potential of equities. Target-return investing comprises the following:

Diversification

As with portfolios built for accumulation, portfolios geared toward retirement should continue to include exposure to a wide variety of asset classes and portfolio managers. Strategically diversifying in this manner can help reduce risk and increase return potential. Adding alternative asset classes-such as international small-cap stocks, emerging market equities, high-yield bonds and global bonds-to a portfolio may provide a further diversification benefit due to these asset classes' low correlations with traditional equities and fixed income. A retirement portfolio should also involve a variety of portfolio managers and asset management firms. Even the best portfolio managers can underperform from time to time, and manager diversification can help control risk and smooth out returns. Similarly, diversifying across a variety of asset management firms can help mitigate the risk that may occur when a single firm's investing style or investment philosophy is out of favor.

Exposure to Real Assets

In order to maintain consistent purchasing power, income received 20 to 30 years from now has to be worth the equivalent of today's income. That means an investor's income stream must rise in lockstep with inflation. To reflect this need, a retirement portfolio should include a dedicated allocation to real assets, which are sensitive to changes in inflation. Commodities, natural resource equities, real estate investment trusts (REITs) and Treasury Inflation-Protected Securities (TIPS) have historically exhibited higher correlations to inflation than traditional asset classes. A suggested mix for today's environment is shown opposite, including the four aforementioned inflation-sensitive asset classes.

Based on John Hancock Investment Management Services' current asset-class forecasts, the policy mix has a higher probability of sustaining an inflation-adjusted withdrawal rate over a lengthy time horizon than traditional balanced funds would. This is illustrated in the following two charts (click here).

Both show the hypothetical value of $1 million invested in three model portfolios, assuming the investor is taking annual withdrawals of 6% for 30 years (adjusted for a 2.5% rate of inflation). The green and orange lines depict conventional balanced funds, and the blue line depicts our suggested policy mix. The chart on the left represents the "most likely" market scenario based on our forecasts-meaning that 50% of the time, results were better than the outcome shown and 50% of the time results were worse. The chart on the right represents the "worst-case" market scenario, in which 80% of the time the results were better than the outcome shown and 20% of the time the results were worse. In both cases, our suggested policy mix produces the probability of a better result.

Finally, an effective retirement portfolio should allow for a considerable amount of active management, including the freedom to employ financial-engineering techniques. Instead of determining today what the right mix of equities or fixed income will be five, 10 or 20 years from now-which is exactly what many life-cycle fund providers are doing in setting their retirement funds' static allocations-the asset mix should be reviewed every year, or, in fact, multiple times per year.

Active management can add value to the portfolio by overweighting potentially undervalued assets, trimming back on overpriced assets or utilizing financial engineering (typically derivatives strategies) to protect or augment gains. Examples of the latter strategy include buying out-of-the-money puts on a portion of the equity portfolio in order to provide downside protection; buying futures on 20-year U.S. Treasury bonds in a falling-interest-rate environment or writing out-of-the-money calls in a flat market to generate income. Employing these strategies, in addition to maintaining a sound long-term asset mix, can help meet retirees' primary goal, which is making their money last. n

Bob Boyda is a senior vice president at John Hancock Investment Management Services. He can be reached at Bboyda@jhancock.com.

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