In a recent insights update, AMP Capital said that as the end of an individual’s working life approached, the usual approach would be to gently wound down the proportion of growth assets like equities in your portfolio and lift the defensive assets like bonds and fixed income.
The aim was to eventually hit something like a 50:50 split between growth and defence that could fund a comfortable and stable income across a long and happy retirement.
However, it noted that near-zero interest rates had changed that.
“Suddenly, the traditional approach is not working – bonds and fixed income are no longer capable of playing the role they once played in a retirement portfolio, leaving investors searching for income,” AMP said.
“So, what can take their place? One option is real assets like property and infrastructure, which show some of the same characteristics that make fixed income attractive to retiring investors.”
AMP noted that investing near retirement is different from investing during the earlier parts of working life.
This is because as retirement approaches, an investor’s ability to tolerate downturns in the market is reduced. This is known as sequencing risk and refers to the idea that younger people have more time to ride out market volatility.
“In retirement, most people rely on account-based pensions in superannuation and pay no income tax, raising the attractiveness of refundable franking dividends,” AMP said.
“Inflation risk plays a bigger role in retirement as consumption spending is subject to rising prices, but there are no longer inflation-linked wages to offset this. It’s what financial markets might call an asset-liability mismatch.
“Liquidity is also a bigger factor in retirement than during a working life as people need to be sure they can get access to funds rapidly in case of events like health emergencies. And finally, natural human behavioural biases often play a bigger role as people faced with market volatility, and no wage income can be tempted to make decisions to switch away from growth assets, often at precisely the wrong time.
“Most retirement planners handle these risks through reducing allocations to growth assets and lifting exposure to defensive assets.”
AMP noted that real assets might be the answer to addressing the kind of stable, predictable income that retirees need while also offering equity-like growth.
Infrastructure and real estate
Institutional investors have long recognised the attraction of infrastructure as an asset class.
AMP pointed out that infrastructure has some of the benefits that an investor in or nearing retirement might want, including stability, income, inflation protection and diversification, taking into account the risks of infrastructure investing, including regulatory, liquidity and operating risks.
These features are a result of the fact that infrastructure assets often include essential services – water, power, schools, hospitals and roads. This essential nature means they enjoy consistent levels of demand and are less susceptible to economic cycles.
“Many infrastructure assets are also monopoly businesses either through regulation or high barriers to entry in the marketplace. This means they are free from the competitive pressures faced by many other businesses,” AMP said.
“In terms of yield, a hallmark of many infrastructure assets is their consistent long-term income, with revenues often being underpinned by regulation or long-term contracts. That gives the investors a very high level of visibility and certainty around future cash flows.
“Many infrastructure assets offer a hedge against inflation with revenues linked to inflation, which may occur through built-in price rises under contractual arrangements or through a regulatory framework.
“Diversification is also a feature of infrastructure as most assets show little correlation to other asset classes.”
Real estate is another sector that shows little correlation to other asset classes and can behave very differently throughout the cycle.
Not all real estate is the same, according to AMP. Commercial real estate performs very differently from the residential market.
“Commercial real estate historically offers a higher yield than residential real estate, which can be useful for investors nearing or in retirement. The commercial sector also benefits from longer lease terms than residential. Generally, retail leases are between three and five years while office and industrial leases are longer than five years and sometimes longer than 10 years,” AMP said.
“This provides a nice certainty of income for investors. Leases are a contractual obligation between landlord and tenant and often come with annual increases that are linked to CPI, allowing income to keep pace with inflation.
“Income growth from real estate assets generally provides support for an asset’s value, taking into account the risks of investing including regulatory, liquidity and operating risks.
“A fourth class of commercial real estate is also emerging in Australia – grouped under the label alternative real estate, including multi-family, build-to-rent residential, and assets like medical centres and data centres. Alternatives are 55 per cent of the US real estate investment markets but only around 5 per cent in Australia, so there is opportunity for growth in these sectors domestically.”
Economic impacts
But whilst real assets may offer an alternative approach in portfolios, AMP noted that it would be important to understand how different real assets behave in different economic conditions.
It observed that the COVID pandemic had been the biggest influence recently – and the different ways that the pandemic affected assets are illustrative.
“Real assets that depend on patronage for revenue were badly affected. Airports and hotels saw a dramatic decline in people travelling during the pandemic. Shopping centres were also badly affected with many people under stay-at-home orders. Offices also suffered,” it explained.
But these are short-term effects. There is little evidence that people won’t travel again as lockdowns are lifted – and we think shopping centres will almost certainly return to pre-pandemic traffic levels.
“And even in the short term, many assets did well. So-called non-discretionary retail – stores like supermarkets, hardware and liquor – did very well during the pandemic. The industrial logistics sector also did very well as people switched their spending to online and tenants decided to hold increased inventory locally in response to disruptions in global supply chains,” it said.
AMP said that this shows the short term and long term can play out very differently.
“While airports depend on patronage, public-private partnership assets like schools, hospitals and justice facilities often have availability-based revenues that are paid as long as the asset is available for use, regardless of the extent to which they are used,” it observed.
“Regulated assets like water and power companies are always in demand as people need water and power every day, regardless of economic conditions.
“Meanwhile, communications infrastructure like mobile phone towers and fibre optic networks saw booming demand during COVID as we all worked from home and tuned in to streaming services. Investors seeking diversification can consider all these different economic drivers.”
