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

Welcome to Firstlinks Edition 433 with weekend update

There’s this story about a group of US Air Force generals in World War II who try to figure out ways to protect fighter bombers (and their crew) by examining the location of bullet holes on returning planes. Mapping the location of these holes, the generals quickly come to the conclusion that the areas with the most holes should be prioritised for additional armour.

  • 11 November 2021

Why has Australia slipped down the global super ranks?

Australia appears to be slipping from the pantheon of global superstar pension systems, with a recent report placing us sixth. A review of an earlier report, which had Australia in bronze position, points to some reasons why, and what might need to happen to regain our former glory.

Welcome to Firstlinks Edition 431 with weekend update

House prices have risen at the fastest pace for 33 years, but what actually happened in 1988, and why is 2021 different? Here's a clue: the stockmarket crashed 50% between September and November 1987. Looking ahead, where did house prices head in the following years, 1989 to 1991?

  • 28 October 2021

How to help people with retirement spending decisions

Super funds will soon be required to offer retirement income strategies for members in decumulation. With uncertain returns, uncertain timelines, and different goals, it's possibly “the hardest, nastiest problem in finance".

Tips when taking large withdrawals from super

You want to take a lump sum from your super, but what's the best way? Should it come from you or your spouse, or the pension or accumulation account. There is a welcome flexibility to select the best outcome.

“Trust your instinct” Hamish Douglass in conversation with Sir Frank Lowy AC

Sir Frank shares his story, including his journey from war-torn Europe, identifying opportunities, key character traits necessary for business success, and the importance of remaining paranoid yet optimistic.

Latest Updates

Investment strategies

Charlie Munger and stock picks at the Sohn Conference

The Sohn Australia Conference brings together leading fund managers to chose their highest conviction stock in a 10-minute pitch. Here are their 2021 selections with Charlie Munger's wisdom as the star feature.

Interviews

John Woods on diversification using asset allocation

All fund managers now claim to take ESG factors into account, but a multi-asset ethical fund will look quite different from a mainstream fund. Faced with low fixed income returns, alternatives have a bigger role.

SMSF strategies

Don't believe the SMSF statistics on investment allocation

The ATO's data on SMSF asset allocation is as much as 27 months out-of-date and categories such as cash and global investments are reported incorrectly. We should question the motives of some who quote the numbers.

Investment strategies

Highlights of reader tips for young investors

In this second part on the reader responses with advice to younger people, we have selected a dozen highlights, but there are so many quality contributions that a full list of comments is also attached.

Investment strategies

Four climate themes offer investors the next big thing

Climate-related companies will experience exponential growth driven by consumer demand and government action. Investors who identify the right companies will benefit from four themes which will last decades.

Investment strategies

Inflation remains transitory due to strong long-term trends

There is momentum to stop calling inflation 'transitory' but this overlooks deep-seated trends. A longer-term view will see companies like ARB, Reece, Macquarie Telecom and CSL more valuable in a decade.

Infrastructure

Infrastructure and the road to recovery

Infrastructure assets experienced varying fortunes during the pandemic, from less travel at airports to strong activity in communications. On the road to recovery, what role does infrastructure play in a portfolio?

Economy

The three prices that everyone should worry about

Among the myriad of numbers that bombard us every day, three prices matter greatly to the world economy. Recent changes in these prices help to understand the potential for a global recovery and interest rates.

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.