Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 53

Bill & Ted’s (Not So) Excellent Sequencing Adventure

In the world of investments the start of a new year is a time of heightened activity, as performance data from the previous year becomes available. For example, balanced options (between 60% and 76% in growth assets) have, on average, generated an annualised return of 7.1% p.a., net of investment fees and tax, for the ten calendar years to 31 December 2013. This equates to a real (after-tax) return of 4.2% p.a. over the period. Given a typical real return objective of 3– 4% p.a. over rolling multi-year periods, this result for the ‘average’ balanced super option would seem highly satisfactory from a pure investment perspective.

An in-depth review, however, finds only one calendar year (8% in 2007) was close to the annualised average of 7.1%. More commonly, high return years (e.g., 16.3% in 2013) were balanced by low return years (e.g., -19.7% in 2008). How ‘average’, therefore, are long-term average returns? How closely do they match returns as experienced by individual members? More importantly, does it matter if they don’t?

Peeking under the hood of a retirement projection

To answer these questions let’s look at a real-world scenario incorporating actual returns over the 2004 to 2013 period. We examine a hypothetical example of two super fund members, William and Edward. Both turned 55 on 1 January 2014 and both intend to retire in ten years at age 65. Their circumstances are identical: super balance of $215,000 on 1 January 2014, and income of $85,000 escalating at 4% p.a., on which employer super guarantee contributions (as currently legislated) are paid, with no further contributions. For ease of computation, non-investment related fees and insurance premiums are ignored in this example.

Seeking advice, both men discover that they should aim for a retirement super balance of $430,000 in real (2013) dollars. The advisor’s projections indicate that if their respective super options generate an annualised return of 7.1% p.a. and inflation matches the average for the last ten years, they should retire with super of $432,000 in real dollars.

Rather than the average 7.1% p.a. return, let’s model outcomes with year-to-year variability based on the historical sequence of calendar returns from 2004 to 2013.  We’ll change only one factor: re-ordering this sequence such that Edward’s returns are ordered from worst to best over the period, whilst William’s are a mirror image, with his worst return in year ten.

The results for this modelling exercise are depicted below:

HC Snip1 140314

HC Snip1 140314

The red path shows how Edward and William’s super would have grown if the returns from 2014 to 2023 matched exactly those from 2004 to 2013 in size and chronological order. However, once we change the return sequence as described above, both end up with retirement balances significantly different to the projection of $432,000, and some $55,500 different from each other. Why?

The answer is sequencing risk – the risk to an individual’s wealth of receiving the worst returns in their worst order. Both Edward and William experience a -19.7% return once in their final ten years before retirement. It is William who is affected to a far larger degree. He experiences his worst return (-19.7%) at the point of maximum portfolio size, decimating his year 10 starting balance of $503,000. Edward’s -19.7% return year occurs off a starting balance of $215,000.

William’s worst return year also coincides with his largest cash flow into superannuation, with some $12,800 of net nominal contributions made in his tenth year, compared to some $7,000 in Edward’s first year. These aspects of sequencing risk have come to be known as the ‘portfolio size effect’ [Basu and Drew, 2009]: sequencing risk increases with the magnitude of dollars at risk, reaching its zenith at or near the end of an investment time horizon.

The above example demonstrates that returns as experienced by individuals are cash flow sensitive and path dependent. Both the timing of cash flows and the order of returns matter in producing the final dollar outcome (terminal wealth) from which a retirement lifestyle is funded.

Investment risk and sequencing risk are related, but not the same thing. It is simultaneously possible for an individual to achieve an investment return objective over an entire investment horizon (as with the 7.1% p.a. ten year annualised return) and not meet a terminal wealth objective (the unfortunate William) due to the order of returns on their particular path to retirement.

Ramifications for superannuation

Sequencing risk creates a particularly troublesome dilemma in retirement planning. At its core, sequencing risk is a function of portfolio volatility: reduce it and you mitigate the sequencing risk effect. Do this by down-weighting growth assets and you might not have the growth engine you need to combat inflation and longevity risk through a retirement of uncertain length. Getting the balance right is a very delicate dance, and a challenge for the entire superannuation sector.

Many MySuper funds have implemented lifecycle strategies that periodically de-risk members once in the retirement risk zone. These developments are in their infancy, with their effectiveness hobbled by operational complexity and regulatory constraints. They are a mass-personalised solution, segmenting members into groups that de-risk together along a pre-determined ‘glidepath’, not an individualised response to sequencing risk. Enhancements continue to be made in this area.

Financial planners can help individuals negotiate their personal retirement risk zone, focussing clients on achieving wealth objectives and income goals, incorporating superannuation into the totality of financial resources available for retirement.

Sequencing risk will be a sizeable challenge for SMSFs, which tend to have a significant weighting to Australian shares that pay tax-advantaged franked dividends. Whilst this might boost after-tax returns in the accumulation phase, portfolio volatility may be dominated by equities. A tendency to defer the sale of assets with unrealised capital gains tax liabilities until in pension mode further exacerbates the problem. In short, SMSF trustees might inadvertently be allowing the tax tail to wag the sequencing risk dog.

 

Harry Chemay is a Certified Investment Management Analyst and a consultant across both retail and institutional superannuation. He has previously practised as a specialist SMSF advisor, and as an investment consultant to APRA-regulated superannuation funds. The example used in this article appears for illustrative purposes only, and is not intended to be taken as personal or general financial advice.  


 

Leave a Comment:

     

RELATED ARTICLES

Picking winners: the origins of the specious

A better approach to post-retirement planning

An insider's view of the last financial crisis

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Latest Updates

Retirement

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.