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Sequencing risk and ways to manage it

'Sequencing risk' is the risk of experiencing poor investment performance at the wrong time, typically when the portfolio balance is at its greatest. In Jeremy Cooper’s Cuffelinks article last week, he highlighted that “our defined contribution (DC) system was never designed to provide retirement income, but just a lump sum to retire with.” In arriving at that lump sum to retire with, fund members must contend with sequencing risk, particularly late in their accumulation phase and early in the decumulation phase.

An example of ‘sequencing risk’

When good or bad returns occur can be almost as important as the size of the returns. That is, the sequence of investment returns, not just the average of those accumulated returns, is critical. And unfortunately, no one has come up with an approach to affect or determine, before the fact, the sequence of market returns.

Let’s consider two individuals who made net superannuation contributions of $10,000 per annum over a 20-year period. Let’s also assume that, over that 20-year period, the average investment earning rate on the savings of both individuals was identical, say 7% per annum. And finally let’s assume that the returns of each individual were identical in years 2 through 19 but individual 1 had a -10% return in year 1 and a +10% return in year 20 and individual 2 had the opposite returns, +10% in year 1 and -10% in year 20.

As individual 2 experienced the significant negative return in the final year, the time at which the balance was the largest (and closest to retirement), his account balance at the end was $402,634, $81,000 lower than the $483,636 balance of individual 1 (as individual 1 experienced the significant negative return early on, with a much lesser impact).

This risk of experiencing poor investment performance leading up to or shortly after retirement ranks alongside market risk, inflation risk, longevity risk and liquidity risk as key risks to manage to ensure savings are adequate for sustainable retirement income.

When are individuals most exposed to sequencing risk?

It can be extremely disheartening when poor investment performance comes at a time close to retirement, when an individual’s account balance may be close to a desired retirement amount. In addition to the losses, it can lead to actions that the individual would have preferred to avoid – working longer, reducing expenditures, possibly increasing investment risk to achieve higher asset growth. And it may be difficult for a person, once they have retired, to recover from poor investment returns or to buy securities at deflated prices.

The period of greatest risk is typically considered to be the last 10 years of the accumulation phase and the first 10 years of the decumulation phase (although some studies postulate that it begins earlier than 10 years before retirement). The sequence of returns during this period will have a significant impact on the sustainability of a retirement income, leading to an increase in the probability of ‘portfolio ruin’ post retirement.

Whilst few Australians buy an annuity on retirement, sequencing risk can be even more acute in countries where individuals must purchase an annuity at the time of their retirement. They may also be exposed to buying an annuity at a time when market prices for annuities have increased significantly due to reductions in future yields on securities that insurers use to back the annuities. For example, at present, some lifetime annuities in Australia are priced using a negative implicit real return.

How to mitigate the risk

There’s much good research on this topic but no perfect solution to mitigate the risk. And market timing is clearly not a viable option, even if it may have worked for some.

In considering their members’ best interests, trustees of large superannuation funds should consider how they can help members to manage sequencing risk. This might include segmenting members based on age and account balance, using target date funds, improving communication of the risk and provision of downside protection for members in the retirement risk zone.

How might individuals mitigate the risk, knowing there is no perfect solution?

  • Reduce the level of investment risk as retirement approaches. The aim is to lower the chances of significant losses on a retirement nest egg, but when should an individual start to de-risk? What are optimal levels of risk to accept? As most individuals’ superannuation savings will remain invested for many years after their retirement, should they de-risk as much as occurs in some target date funds? If they take too little risk they may end up with insufficient retirement income. With too much risk, poor returns can erode their savings and jeopardise the sustainability of their retirement income.
  • Increase the level of diversification in the savings portfolio.  But even with greater diversification, poor performance still can occur. Also, at times of stress in the markets, assets previously considered to be uncorrelated may follow each other down.
  • Buy annuities and/or deferred annuities. This can address post-retirement sequencing risk but doesn’t address pre-retirement sequencing risk. Also the market for annuities in Australia is still relatively small and individuals could be exposed to high annuity prices at time of retirement.
  • Spread contributions more evenly over a working life. Risk could be more evenly spread if contributions were high initially and decreased as one approaches retirement, but individuals would likely be reluctant to put more money into super when they are younger.
  • Adjust asset allocation over a working life. Higher exposure to growth assets in the early years than occurs with typical exposure levels by investing mostly in equities (or achieve even higher than 100% exposure using call options or gearing) when younger but switch to less volatile assets when approaching retirement.
  • Keep sufficient assets (about two years of expenditures) in a liquid fund. This would allow an individual to avoid the need to cash out investments after a significant fall in the markets, before markets have had time to recover. But this does not provide protection from risk on the balance of the portfolio.

And finally, individuals could choose to defer retirement or save more! That is, an individual could target a retirement funded ratio – a Defined Benefit (DB) concept – of greater than 100%, where a target is set greater than expected requirements. This provides a buffer where, faced with one or two years of poor investment performance around retirement, the retiree would have a greater chance of funding the desired post-retirement lifestyle.

Use of a target funded ratio approach could also lead an individual to consider whether it is necessary to take as much risk close to retirement. More employer sponsors of DB funds are doing this as their funded ratios improve towards 100% or more.

To summarise, dealing with sequencing risk is important for people who generally want to save enough to have a retirement income greater than the age pension. Besides considering actions whilst they are approaching retirement or shortly thereafter, individuals need to take some steps at a younger age – start earlier, save more, lower their risk as assets grow, understand their retirement objectives and the consequent saving needs.

Kevin O’Sullivan is Director, Actuarial & Benefits Consulting at Russell Investments.

 

 

3 Comments
michael armitage
March 07, 2015

Great article outlining sequencing risk and challenges given current rate environment and negative real rates for life annuity.
As we have seen in the US - target date or lifecycle 1.0 - de-risking of portfolio may prove to be limited in capital protection. For example, 2010 target date funds experiencing -25% returns in 2008.
Further, de-risking a portfolio from growth increases longevity risk in the portfolio. With retirement typically lasting +25 years, growth will need to remain in the portfolio in order to maintain income in retirement.
Further, Life-cycle approaches that determine asset allocation based upon age and not valuation seem to be illogical.
Instead, why not manage the risk associated with growth assets - instead of straight de-allocation from growth?
Various strategies are available from lower risk equity portfolios, collar strategies, and more explicit risk management overlays.
An approach that is dynamic in letting the long growth exposure maintain more full exposure in benign environments and reduces net. beta exposure in more volatile and/or downward moving markets seems to be straight forward and easy to communicate to clients.

As a hedging strategy - there is always a cost involved - NO free lunch.
However, for the investor within the "Sequencing Risk" hot zone - the willingness to sacrifice some part of the upside for downside protection is attractive.

Challenging times need innovative solutions , luckily there are solutions available that have been used in other markets and Australia with success.

Aaron Minney
March 08, 2013

A good article Kevin. I would only suggest that two years in liquidity is not enough for the market to recover? Even with the recent bounce our equity market is still below the 2007 peaks. Historically, when there has been a fall in the Australian equity market, it has not recovered the loss in 40% of cases. If you take the dividends out to spend, this failure to recover increases to 60%. Even over five years, almost 1 in 4 market price declines have not been recovered.
Retirees need to protect their income from market volatility for longer than two years.

Brian Bendzulla
August 28, 2014

Fantastic to see this covered besides longevity risk in retirement. NetActuary has developed a calculator that uses the past 60 years experience to evaluate, in conjunction with retiree circumstances, what is the optimal growth/defensive mix. Its much like you would do for setting TTR - hunt through all the combinations to see the optimal setting. It's not just "is it two years cash bucket right". What one wants is cashflow/liquidity to cover retirement income payments - may have a term annuity that supplies large amounts of cash flow for a small initial sum, from dividends, from rental income etc The setting for someone where Age Pension is a large percentage of required retirement income would be very different to someone who has no such entitlement. It would also be very different depending on the size of assets versus what is the desired income. Comes into its own for the middle group that need to draw down capital over the years.

Rule of thumbs are fine from the mass market - but if you want to do better for your client - it needs analysis.

 

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