Solve the retirement income problem with deliberate portfolio construction

The world can be a highly unpredictable place and for some, investing can feel just as unpredictable. Perhaps this is the result of a major misperception that some people have about investing, the assumption that an investment should always increase in value in a straight line. But like life, nothing is that simple.

Investing is not just about achieving handsome returns; it’s also about the ability to manage risk. Based on where you are in your journey as an investor, the risks your capital face may be quite different. Pre-retirement, the largest risks are: you’re not saving enough, or your retirement savings have not sufficiently grown in the accumulation phase to provide you with enough income in retirement. Post-retirement, the greatest risks are: you may outlive your retirement capital (longevity risk), or adverse market conditions may negatively impact on your portfolio value in the decumulation phase (sequence risk). This article focuses on a solution for post-retirement.

Figure 1. The accumulation and decumulation phase for an investor

Source: Graviton, May 2020

In the accumulation phase investors are more concerned with maximising returns per unit of risk taken, with less focus on capital loss, since losses are not realised until a withdrawal is actually made. In the decumulation phase, the focus shifts to one of capital protection, whilst still maintaining a decent level of growth. Since withdrawals occur more readily in this phase, the risk of realising losses more frequently increases exponentially, especially in a low return environment. Thus, sequence risk is the danger that the timing of these withdrawals from a retirement portfolio will have a negative impact on the overall rate of return available to the investor if initial returns are poor. This can have a significant impact on a retiree who depends on the income from a lifetime of investing and is no longer contributing new capital that could offset losses.

So how does one go about developing a solution for this retirement problem? It starts with thinking of a solution that is deliberate in its outcome. For this, we advocate and adopt an absolute return investment philosophy. In simple terms, an absolute return philosophy focuses on the amount that an investment has earned. Also referred to as the total return, the absolute return measures the gain or loss experienced by an asset or portfolio independent of any market benchmark or other standard.

This philosophy leads to the construction of a portfolio designed to give a positive return regardless of the underlying market condition, and whatever asset class it’s invested in. To achieve this, we at Graviton feel it’s important to adequately define risk. For us, risk is not just volatility experienced in a portfolio as the market moves up and down, but rather the risk of permanent capital loss. This leads us to be highly capital-protection focused when thinking about a solution for a long-term income-drawing portfolio.

Expanding on this philosophy of absolute returns, we focus on how this is implemented in practice. We call this implementation “asymmetric returns”. At its most simplistic level, it means higher and more positive returns, and lower and fewer negative returns – achieved through active risk management. Besides reducing volatility in returns, asymmetric returns are designed to preserve capital and offer downside protection.

This asymmetric approach to investing is crucial when managing retirement assets, as it focuses on compounding sustainable positive returns and increasing the probability of achieving financial survival. It also limits the likelihood of investors switching to cash out of fear of continued negative/poor returns, by creating a smoother return experience and less participation in market downside. As depicted in the illustration below, applying the absolute return philosophy to the FTSE/JSE SWIX over the long term, whereby 67% of the upside and only 30% of the downside is captured, one does not need as much upside – resulting in a smoother return profile.

Figure 2. Asymmetric SWIX over the long term

Source: Graviton, January 2020

Building the living annuity solution

Having identified the appropriate approach we need to take in building a living annuity portfolio, we need to identify the correct starting point: defining the appropriate risk we are willing to take to achieve a specific outcome. In order to do this, we follow a protocol called risk budgeting, which is a relatively contemporary method to construct and manage investment portfolios. Instead of following a traditional asset allocation approach, a risk-budgeting asset allocation approach begins with identifying and quantifying the riskiness (volatility and correlation with one another) of each of the asset classes considered for the portfolio. Hereafter, once the risk budgets for each of the asset classes are set, an optimisation is executed to determine the total risk contributions of the assets to fit the overall portfolio risk budget.

The building blocks for the living annuity portfolio

Once the portfolio risk budget is determined, we identify the right building blocks that fit the risk budget of the overall portfolio and can deliver inflation-beating returns to retirees. Having a strong team of investment professionals conducting thorough valuations of asset classes across the board, combined with the ability to research asset managers throughout the industry is a powerful combination behind building a living annuity solution. Our research has identified that flexible equity, flexible property and flexible income strategies are most suitable to obtain an asymmetric pay-off profile, thus forming the core of our living annuity solution. These core funds are complemented with other strategies that serve a specific purpose, such as inflation-protection, liability-matching and explicit capital protection.

Figure 3. Building blocks for achieving desired outcomes in a living annuity portfolio

Source: Graviton, May 2020

Another aspect to identifying the right building blocks is being able to determine the style (value, growth, quality, momentum, duration) that a fund demonstrates. This is a crucial step in ensuring sufficient diversification within the solution, as we do not want a portfolio of funds that all move in the same direction at the same time.

Enhancing asymmetric and uncorrelated returns

Taking phase one further, skilful and robust manager research also leads us to identify unique strategies and opportunities that exhibit powerful asymmetric characteristics, which are outside the realm of traditional long only investments, such as smooth bonus funds and alternatives, for example hedge funds.

Using hedge funds

Due to their relatively weak correlation with other asset classes, hedge funds can play an important role in reducing risk and enhancing yield, i.e. improve portfolio efficiency. Unlike long-only funds, they are able to utilise additional tools that can be used to improve their performance. These tools include leveraging (borrowing money to enhance returns), short- selling (selling assets viewed as overpriced to make a profit from the eventual fall in the share price) and access to a variety of derivatives. Effectively, what this means is that for the same level of risk as a long-only fund, a hedge fund can be expected to generate a better return.

Using other alternatives

Capital protection and achieving a smoother return profile are one side of the objective; the other is enhancing returns to ensure sustained growth over the long term. Private equity, mezzanine debt, unlisted (private) credit and unlisted property offer opportunities to generate significant returns which are not dependent on the movements within the publicly traded market. This is largely due to their illiquidity premium – the reward investors expect because they cannot quickly sell these assets. Also, these assets are not subject to short-selling which could artificially depress their value by speculators. Think of these as finding diamonds in the rough, whilst everyone else is going to the store to buy their diamond at a premium. As a division within Sanlam Investments, Graviton can gain preferential access to these opportunities for its retail clients in the living annuity solution – subject to administrative and legislative rules being met.

Using smoothing techniques

A key component of developing a solution to address the sequence of return risk is to reduce the volatility that negative market shocks can have on a portfolio. One method for achieving this is by “artificially” smoothing out the return profile. In the ideal living annuity, a fund which has unique mechanics to achieve this objective is required.

One key feature of this fund should be that it never incurs a capital drawdown, i.e. protects capital in all market environments. An investor will therefore never experience the market volatility normally associated with more aggressive balanced funds.

Portfolio construction

Good portfolio construction is like building a house. In order for that house to stand for a really long time, it needs to have a good foundation and structure. Similarly, portfolio construction for the retiree must ensure the portfolio can meet the purpose of protecting capital in all market conditions, whilst achieving growth and providing an income for life.

Our starting point for constructing the ideal portfolio for a retiree is identifying the potential loss a portfolio could experience by analysing its distribution of returns. For this we use Value at risk (VaR) which is a statistical measure that quantifies the level of financial risk within a portfolio over a specific time frame. This metric is most commonly used by investment and commercial banks to determine the extent and occurrence ratio of potential losses in their institutional portfolios. Conditional Value at Risk (CVaR), also known as the expected shortfall, is a risk assessment measure that quantifies the amount of tail (excess) risk an investment portfolio has. CVaR is derived by taking a weighted average of the “extreme” losses in the tail of the distribution of possible returns, beyond the Value at risk (VaR) cut-off point. CVaR is therefore used in our proprietary portfolio optimisation for effective risk management with the aim of achieving less losses in the range of return outcomes, for a more stable and consistent return distribution.

Figure 4. Using CVaR to optimise the portfolio achieves less tail risk and a more consistent distribution of positive returns.

Source: Graviton, May 2020

To put the above more simply, ultimately what our portfolio construction wants to achieve is a narrower range of return outcomes with less loss and more consistent positive returns.


A retiree’s portfolio needs to be tailored to where they are in their investment journey. Using VaR and CVaR analysis to understand the risk this investor is exposed to is critical for managing capital preservation. Ensuring a retiree’s portfolio is populated with asset classes or strategies geared towards asymmetry assists in managing downside risk and helps smooth the investor’s experience.

Being deliberate and creative about the methodology and tools used in portfolio construction is critical in finding the solution that greatly assists retirees in managing their financial outcomes. We believe this solution firmly places a retired investor in a better position to combat sequence and longevity risk through advanced portfolio construction techniques. Applying our investment skills in ways that we have not done before has led us to a solution that can provide more certainty in a world of new and challenging investment problems.