Allocating Retirement Portfolios

Morningstar's Peng Chen

The Insured Retirement Institute issued an important report this week based upon retirement risk analysis by Peng Chen, president of Morningstar’s global investment management division.  The report appears in the August edition of IRI’s monthly newsletter, Insight. The two biggest investors face, according to the report, are longevity risk and market risk. “The average 65-year-old retiree can expect to live another 20 years, and record numbers are expected to live past the century mark,” Chen said in his analysis, adding that roughly half of retirees may live longer than their life expectancy. “Fortunately investors and advisors have access to effective tools to combat these risks,” according to Chen. “[I]nvestors can mitigate both longevity and investment-performance risk with a carefully constructed combination of longevity-insurance products…which offer investors a guaranteed income stream and traditional assets, such as ETFs and mutual funds.”

The five factors identified by Chen that determine how to allocate a client’s portfolio are as follows.

  1. Age: Investors should increase their allocations to income annuities as they get older, from about 50% of an average 65-year-old’s portfolio to close to 60% by age 75. Allocations to deferred annuities with guaranteed benefits should decrease with age.
  2. Finance Market Risk Tolerance: Conservative investors should have a higher allocation to longevity insurance. Conservative investors may want approximately 60% of their portfolios in guaranteed products, while aggressive investors may want just 30%.
  3. Wealth v. Retirement Expenses: Retirees with a high ratio of wealth to non-covered expenses have no need for longevity insurance. Retirees with a wealth-gap ratio around 20 should allocate 40% of their assets to annuities.
  4. Risk Preference Toward Longevity: Investors who believe they’ll likely live a long life should allocate 65% of their portfolios to guaranteed products. Investors who think they’ll live a short life should keep an allocation of 35%.
  5. Bequest Goal: Investors who want to leave an inheritance to their loved ones need less longevity insurance. Their annuities allocations should favor deferred annuities with guaranteed lifetime withdrawal benefits, while investors who want to spend all of their assets in retirement should use income annuities.

“The burden on retirees to finance their own retirement spending is growing,” Chen concluded. “Most investors can avoid an extreme outcome by allocating a portion of their portfolios to insurance products that offer a guaranteed income for life. But, advisors and investors have to be careful in how they determine the proper allocation to these products.”


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