Building Smarter Retirement Income Portfolios

BUILDING SMARTER RETIREMENT INCOME PORTFOLIOS

As baby boomers continue to pour into the ranks of the

retired, the need for investment advice has grown along with them. Retirement investors are becoming

LEE FREITAG Practice Lead, Retirement Solutions

increasingly focused on capturing consistent levels of income throughout retirement versus simply

Northern Trust Asset Management

maintaining large portfolio balances. Historically, a simple 60/40 portfolio would deliver the kind of asset

February 2021

growth and yield that could support an investor in

retirement. However, delivering consistent income is

becoming more difficult with increasing market volatility ,

expectations for lower returns across asset classes and lower

bond yields. The traditional approach of adding more fixed

income into the portfolio mix to generate income is no longer

as effective and comes with unintentional risks. Looking

ahead, it's important to consider the incorporation of

additional asset classes to help diversify the sources of

income generation and portfolio risk on the road to consistent

and persistent retirement income.

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A LOOK BACK AT WHEN 60/40 WAS GOOD ENOUGH

Let's look back at the historical returns for a traditional 60/40 portfolio and its typical components, the MSCI World and Aggregate Bond index, respectively. Going forward, there is a good likelihood that the 60/40 portfolio will not provide the returns ? and certainly not the income ? of days gone by. U.S. equities may be especially vulnerable from a return perspective given their decade-long run and current U.S. dividend yields are among the lowest in the world. Meanwhile, the "40" part of the 60/40 portfolio is at some risk of higher inflation and higher interest rates, which would pressure returns of an already-low yielding asset class. Investors may need to take on greater risk to get the same income. But they can prepare by focusing on broadly diversifying portfolios and focusing on higher yield-generating asset classes in a risk-controlled manner.

Exhibit 1: Market Returns: MSCI World & Aggregate Bond Portfolio and as building blocks of a 60/40 portfolio.

50% 40% 30% 20% 10%

0% -10% -20% -30%

3 Year Rolling Return

Dec-81 Dec-82 Dec-83 Dec-84 Dec-85 Dec-86 Dec-87 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19 Dec-20

MSCI World

BC Aggregate Bond

60/40 Portfolio

Source: Northern Trust

AGGREGATE BOND ALLOCATION: CHANGING CHARACTERISTICS

Over time, the yield on the aggregate bond index (as measured by yield to worst) has fallen precipitously over the past twenty years, from about 6.4% at 12/31/2000 to about 1.1% at 12/31/2020. This characteristic is one of primary concern for retirees wishing to generate current income during retirement. Secondly, over time, an allocation to aggregate bonds has become slightly more interest rate sensitive as the underlying allocations have unintentionally shifted toward a larger allocation to Treasuries that are also climbing in duration. Increasing duration by itself is not problematic, in fact longer duration bonds are, in fact providing greater returns (the yield curve is actually surprisingly steep).But yields in general are low ? even out the yield curve ? and some investors are concerned about the duration risk they now need to take to obtain a respectable yield. This can be clearly seen in Exhibit 2 below. Simply put, duration risk is rising as yields have fallen to historically low levels.

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Exhibit 2:

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

Agg Bond Characteritics Over Time

12/29/2000 07/31/2001 02/28/2002 09/30/2002 04/30/2003 11/28/2003 06/30/2004 01/31/2005 08/31/2005 03/31/2006 10/31/2006 05/31/2007 12/31/2007 07/31/2008 02/27/2009 09/30/2009 04/30/2010 11/30/2010 06/30/2011 01/31/2012 08/31/2012 03/29/2013 10/31/2013 05/30/2014 12/31/2014 07/31/2015 02/29/2016 09/30/2016 04/28/2017 11/30/2017 06/29/2018 01/31/2019 08/30/2019 03/31/2020 10/30/2020

Effective Duration

Yield to Worst

Source: Northern Trust

DIVERSIFICATION TO GENERATE INCOME

In this environment of diminishing yield ? and the falling yield-to-risk ratio - conventional approaches to portfolio construction will require some retooling. The first step is to revisit the importance of portfolio diversification beyond the traditional components of a 60/40 portfolio. Portfolio allocations should include asset classes that not only seek to provide strong returns over time, but can also address market risk, inflation risk and interest rate risk, among other risks. Furthermore, it's important to note that asset classes perform differently in different economic cycles, supporting the case for portfolio diversification, as it can be difficult to predict asset class relationships in future economic cycles.

In building portfolios to weather various economic cycles, we can begin with asset class correlations, noting that while some evidence of high correlation exists among many risk asset classes, there are asset classes in the risk asset space, like natural resources, global real estate and high yield that exhibit somewhat lower correlation to other risk assets that will aid in building a diversified portfolio. Combined, these asset classes provide capital growth, downside protection, inflation sensitivity and opportunities to produce robust income.

Sparing an in-depth review of portfolio construction, we consider the following elements of a diversified portfolio and their specific contributions to meeting the following objectives:

1. Capital Growth

Clearly, broad equities, both U.S. and Non-U.S., are well-positioned to be the main driver of returns in any growth portfolio. But they also contribute the most to volatility over time, so intentionality of these components is critical.

2. Risk Mitigation

From a risk asset perspective, high yield is often overlooked, with its strong contribution to risk mitigation relegated to a secondary role in the portfolio. Our research into global high yield indicates that it captures 55% of global equity upside and only 33% of the downside. This is a meaningful diversification benefit for any portfolio.

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3. Inflation Sensitivity

While inflation continues to remain low, portfolios should be on the look-out for flare ups in inflation which may meaningfully impact investors' purchasing power. Natural resources and TIPS allocations respond well to inflationary pressures. Natural resources show high inflation betas which are analogous to leveraged exposure to inflation, where a small allocation in a portfolio can provide inflation protection more broadly across the portfolio.1 While inflation is low now, further government stimulus may ignite it, so considering inflation-sensitive asset classes is important.

4. Interest rate risk

Utilizing key fixed income components with intentional duration that stabilize fixed income portfolios over time to minimize unintentional interest rate sensitivity. Portfolios should consider the combined effect of marrying short and long duration elements to achieve intentional portfolio duration and be mindful of duration drift over time.

5. Income delivery

While we want to stabilize portfolios via interest rate risk reduction, portfolios need to capture robust levels of income through stronger, more persistent yields obtained by intentional allocations to different fixed income allocations. Also, it's important to include other asset classes that offer diversified sources of yield, such as high yield fixed income and other higher dividend yielding equities ? namely infrastructure and global real estate ? to contribute to yield generation.

Exhibit 3 below illustrates a diversified portfolio that seeks to improve upon a traditional 60/40 portfolio by considering an allocation not constrained by the traditional "60/40" while considering improved opportunities for yield capture. Each asset class, as proxied by a market index, represents an intentional allocation designed to address risks mentioned above. Furthermore, it's not helpful to anchor expected portfolio returns to the past to get a sense of return and yield expectations ? we must extrapolate from the current environment to get a sense of what we may expect. To that end, we use the Northern Trust 10-year Capital Market Assumptions to forecast return in order to contrast these two portfolios.

Gaining more income requires taking on more risk. In today's environment, there's just no way around that. However, through a diversified approach we can limit the additional risk that needs to be taken. As shown below, the globally diversified portfolios has the potential to increase the income to 3.2% - a 1.1% jump in yield over the traditional 60/40. And it is able to do so by slightly increasing the risk level (as measured by standard deviation) from 9.1% to 10.3%. This is a reasonable increase in risk to capture greater yield generation (in addition to a higher total return potential).

1 Mladina, Pete: How Real are Real Assets, October 2018

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Exhibit 3:

Globally Diversified Portolio

MSCI USA IMI GR USD MSCI ACWI Ex USA IMI GR USD S&P Global Natural Resources TR USD FTSE EPRA Nareit Global TR USD S&P Global Infrastructure TR USD BBgBarc US HY 2% Issuer Cap TR USD BBgBarc US Long Credit TR USD BBgBarc US MBS TR USD BBgBarc US Trsy Infl Note 1-10Y TR USD Morningstar US Cash T-bill TR USD

3.1% 2.0%

8.2% 9.9%

22.1%

25.3%

21.6%

2.5%

2.5% 2.8%

60/40 Portfolio

40% 60%

MSCI World Agg Bond

Return2 Risk2 Current Yield33

Globally Diversified Portfolio

5.6 10.3 3.2%

60/40 Portfolio (MSCI World / Agg Bond) 4.9

9.1

2.1%

2 Northern Trust 10 Year CMAs 3 Northern Trust Index Characteristics

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YIELD CAPTURE

Where does the additional yield come from? In Exhibit 4, we lay out the current yields for the components that make up each portfolio, clearly indicating the diversified sources of intentional yield that, when combined, produce higher yielding portfolios. Again, in this instance, it's important to understand the current yield environment to see where yield is coming from today, versus where it came from historically. In Exhibit 4, we see strong yields from high yield (5.7%), U.S. long credit (3.6%), U.S. MBS ( 2.9%) and the three real asset categories: global real estate (4.1%), global listed infrastructure (3.5%) and global natural resources (3.7%). As a comparison, the Aggregate Bond index reports an annualized yield of just 2.4%. It's also worth noting that the globally diversified portfolio includes global equities but only U.S. bonds. Why is that important to retirement investors? Global equity diversification has been shown to reduce volatility vs. just a U.S. equity mandate while U.S. retirement investors' cash outlays are denominated in U.S. dollars, so paying for them via yield from U.S. bonds has traditionally been the simplest, most cost-efficient way to effect those transactions. In the globally diversified portfolio, that can be achieved via the high yield, long credit and MBS allocations. and to some extent, after currency conversion, the yields from the global real asset categories which need to be considered in a low yield environment.

Exhibit 4:

7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0%

Yields as of 12/31/20

5.7%

3.7% 4.1% 3.5% 1.8% 1.5% 2.3%

3.6% 2.9%

2.4%

0.5%

Source: Northern Trust

CONCLUSION

The current market environment has created challenges for those constructing portfolios aimed at generating retirement income. Lower yields for the foreseeable future will require the consideration of new ways to provide income to meet client spending needs in retirement. Portfolios constructed with a broader set of asset classes can help to diversify the inevitable increase in portfolio risk to meet income goals. As more people are set to retire in the coming years, consistent and stable retirement income - while maintaining a reasonable risk level - will be critical to their long-term financial success and prosperity. A properly constructed portfolio taking intentional risk across all asset classes, while delivering meaningful levels of income, will likely lead to strong outcomes for current and future retirees.

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NORTHERN TRUST RETIREMENT SOLUTIONS

As one of the largest managers of retirement assets in the United States, our team has deep expertise in developing innovative answers to challenges faced by many plan sponsors, retirement advisors and individual investors. We take a consultative approach to addressing the needs of individual investors while offering a suite of solutions aimed at improving retirement outcomes.

Please contact the Northern Solutions Group at NorthernSolutionsGroup@

NORTHERN TRUST ASSET MANAGEMENT

As a leading global asset management firm, our investment expertise, strength and innovation have earned the trust and confidence of the world's most sophisticated institutional and individual investors.

With $1.1 trillion in total assets under management,4 and a long standing history of solving complex challenges, we believe our strength and stability drive opportunities for our clients. Our comprehensive asset class offering includes passive, factor-based, fundamental active and multi-asset class solutions that are available in a variety of investment vehicles.

IMPORTANT INFORMATION

For use with Institutional Investors/Financial Professionals Only. Not For Retail Use.

The information contained herein is intended for use with current or prospective clients of Northern Trust Investments, Inc. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor. Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of Northern Trust and are subject to change without notice.

This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions. Past performance is no guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by Northern Trust. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise.

Northern Trust Asset Management is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Belvedere Advisors LLC and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

? 2021 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.

4 Asset under management as of December 31, 2020.

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