Solving the Lifetime Income Challenge: Hedging the Sequence of Returns Risk with Absolute Return Funds
October 12, 2009
Previously, we saw how the sequence of returns your portfolio experiences after you’ve retired can affect your nest egg.
We reviewed how robust returns early in retirement could help afford a steady stream of income and a substantial legacy. We also saw how disastrous returns early on can cause your portfolio to run out of money while you still need distributions.
To guard against this latter scenario, we considered a hedging strategy that could limit losses and gains and still provide income throughout retirement. One way to achieve this hedging strategy is with Putnam Absolute Return Funds. The funds seek to provide a targeted return and limit losses in a down market.
Hedging the Sequence of Returns Risk with Absolute Return Funds
2008 was a year of extraordinary market volatility. Though not yet an official fund category, the 17 absolute return funds tracked by Morningstar did manage to limit losses to just over 10% last year, based on average return.
That may have disappointed those who expect absolute return strategies to deliver positive returns even in seasons when most global asset classes are plunging.
But on the whole, they succeeded in limiting losses in 2008 to less than that generated by a wide variety of asset classes.
While absolute return strategies cannot guarantee positive results over an investment cycle, they do have a lower risk profile. This means they could help limit losses in a down market.
Past performance is not indicative of future results. Indexes are unmanaged and used as a broad measure of market performance. It is not possible to invest directly in an index. The asset class categories are defined as follows: U.S. bonds: Barclays Capital Aggregate Bond Index; Treasury bills: BoA ML 3-month T-Bill Index; Absolute Return Funds: the average 2008 annual returns of 17 absolute return mutual funds as identified by Morningstar in its 7/14/09 article, “What’s so absolute about absolute return funds?”; balanced portfolio: Portfolio comprised of 60% stocks, 30% bonds, 10% cash; U.S. stocks: S&P 500 Index; international real estate: MSCI REIT Index; international stocks: MSCI EAFE Index; commodities: Goldman Sachs Commodity Index; emerging markets: MSCI Emerging Markets Index. Performance is not indicative of the performance of any specific investment. Results for longer time periods may differ from results shown for 2008.
By contrast, relative-return funds, or strategies that closely track benchmarks, are almost certain to lose value when the markets they track plummet. Because absolute return strategies target the U.S. Treasury bill rate and have unconstrained investment flexibility, they have at least the possibility of earning positive returns in any market.
For this reason, absolute return funds can be an important component of a hedging strategy that seeks to limit the risk in the sequence of returns during retirement. We believe these strategies should play a central role in lifecycle investing and in retirement portfolios in general – where wealth preservation and volatility dampening are so vital.
Absolute Return Strategies as part of Lifecycle Funds:
Putnam RetirementReady Funds
Putnam has designed a series of RetirementReady Funds that are unique in the industry. They incorporate both absolute return and more traditional asset allocation strategies with a money market component. They seek to maximize capital appreciation during a person’s early years of saving and to reduce volatility and preserve capital as one approaches and starts retirement.
Obviously, absolute return strategies cannot guarantee the positive results they aim for over an investment cycle. However, they do have a lower risk profile and should help limit losses in a market downturn.
Asset allocation decisions may not always be correct and may adversely affect fund performance. The use of leverage through derivatives may magnify this risk. Leverage and derivatives carry other risks that may result in losses, including the effects of unexpected market shifts and/or the potential illiquidity of certain derivatives. International investments carry risks of volatile currencies, economies, and governments, and emerging-market securities can be illiquid. Bonds are affected by changes in interest rates, credit conditions, and inflation. As interest rates rise, prices of bonds fall. Long-term bonds are more sensitive to interest-rate risk than short-term bonds, while lower-rated bonds may offer higher yields in return for more risk. Unlike bonds, bond funds have ongoing fees and expenses. Stocks of small and/or midsize companies increase the risk of greater price fluctuations. REITs involve the risks of real estate investing, including declining property values. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. Additional risks are listed in the funds’ prospectus.
Money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other governmental agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in this fund.
Each RetirementReady Fund has a different target date indicating when the fund’s investors expect to retire and begin withdrawing assets from their account. The dates range from 2010 to 2050 in five-year intervals, with the exception of the Maturity Fund, which is designed for investors at or near retirement.
The funds are generally weighted more heavily toward more aggressive, higher-risk investments when the target date of the fund is far off, and more conservative, lower-risk investments when the target date of the fund is near. This means that both the risk of your investment and your potential return are reduced as the target date of the particular fund approaches, although there can be no assurance that any one fund will have less risk or more reward than any other fund.
The principal value of the funds is not guaranteed at any time, including the target date.
