The retirement risk zone (also known as the ‘conversion’ phase) is commonly defined as the final 10 years of working life (the ‘accumulation’ phase) and the first 10 years of retirement (the pay-out phase or decumulation).
This period is right before and right after you retire.
Importantly, it is this 20 year period when the greatest amount of retirement savings is in play and, subsequently, risk is at its highest.
This can be thought of along the lines of the death zone when climbing Mt Everest. The risky time is the final ascent, clambering over the Hillary Step, on the way to the summit of Mt Everest. However, once at the summit risks remain on the decent and until below the death zone when the ability to breathe becomes easier.
The summit in terms of retirement savings is generally reached at age 65, this is when the amount saved will be the “peak” in savings accumulated. It is here when accumulated wealth is at its largest. Albeit, from an investment perspective, risks remain heightened over the first 10 years of the pay-out/decumulation phase.
The Retirement Risk Zone, the 10 years either side of retirement, is the worst possible time to experience a large negative return given this is when the greatness amount of money is at stake. Risks to portfolios are heightened at this stage.
It is a very important period for retirement planning.
During the Retirement Risk Zone two factors can potentially combine to have a detrimental impact on the standard of living in retirement:
- The portfolio size effect (what you do when the largest amount of your money is at risk matters); and
- the problem of sequencing risk (how much you lose during a bear market (20% or more fall in value of sharemarkets) may not be anywhere near as important as the timing of the loss, again, especially during the Retirement Risk Zone).
To explain, sequencing risk, is the risk that the order of investment returns are unfavourable, resulting in less money for retirement.
Sequencing risk impacts pre-and post-retirement i.e. the retirement risk zone.
Cashflows, investments in and withdrawals out of the retirement savings plan, add another dimension to sequencing risk.
Sequencing Risk can be viewed as the interaction of market volatility and cashflows. The timing of returns and cashflows matters during both the accumulation of retirement savings and in retirement. This impacts on longevity risk.
This is where Warren Buffet could be wrong in recommending people maintain high equity allocations for the longer term. As noted in my previous Post, Could Buffet be Wrong? “once an investor needs to take capital or income from a portfolio volatility of the equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives”. This is sequencing risk at play for those planning for retirement. This is also why many US Endowments do not hold large equity allocations.
It is untrue to say that volatility does not matter for the long term when cashflows are involved.
A brief explanation of interplay between the timing of returns and cashflows is provided below.
The portfolio size effect and sequencing risk have a direct relationship to longevity risk.
For individuals, longevity risk is the risk of outliving ones’ assets, resulting in a lower standard of living, reduced care, or a return to employment.
Or put another way, longevity risk is the likelihood that superannuation savings will be depleted prior to satisfying the lifetime financial needs of the dependents of those savings.
One way longevity risk manifests itself is when an investor’s superannuation savings is subject to a major negative market event within the Retirement Risk Zone.
The point to take away: the size of your portfolio, order in which returns are experienced, and timing of cashflows into and out of the retirement savings account have an impact on accumulated wealth and ultimately standard of living in retirement.
The basic conclusions. First, it is better to suffer negative returns early in the accumulation phase.
Secondly, it is better to suffer negative returns later in retirement.
Materiality of Sequencing Risk
In short, the research finds that the sequence of returns materially impacts peak accumulated wealth (terminal wealth) and heightens the probability of running out of money in retirement (longevity risk). The research backs up the two conclusions above.
The Griffith University research paper mentioned below “finds that sequencing risk can deplete terminal wealth by almost a quarter, at the same time increasing the probability of portfolio ruin at age 85 from a probability of one-in three, to one-in-two.“
Terminal wealth is “peak” accumulated savings in our Mt Everest example above.
Based on their extensive modelling, investors have a 33.3% chance of not having enough money to last to aged 85, this raises to a 50% chance due to a large negative return during the Retirement Risk Zone.
They also note “It is our conjecture that, for someone in their 20s, the impact of sequencing risk is minimal: younger investors have small account balances, and plenty of time to recover …… However, for someone in their late 50s/early 60s, the interplay between portfolio size and sequencing risk can cause a potentially catastrophic financial loss that has serious consequences for individuals, families and broader society.”
This is consistent with other international studies.
For those wanting a more technical read please see the papers that have been drawn upon for this Post:
- Griffith University = The Retirement Risk Zone: A Baseline Study poorly-timed negative return event
- Retirement income and the sequence of-returns By: Moshe A. Milevsky, Ph.D., and Anna Abaimova, for MetLife
Managing Sequencing Risk
The combination of the portfolio size effect, sequencing risk, and longevity risk combine to form a trinity of investment issues that need to be managed inside the Retirement Risk Zone.
Mitigation of sequencing risk is critical across the retirement risk zone.
Sequencing risk is largely a retirement planning issue. Albeit a more robust portfolio and a suitably appropriate investment approach to investing will help mitigate the impact of sequencing risk:
- A greater focus on generating retirement income earlier
In my mind, a greater focus should be placed on positioning retirement portfolios for generating income in retirement at the later stages of the retirement accumulation phase i.e. at least 10-15 years out from retirement.
This is achieved by using asset-liability matching techniques as recommended by the OECD. This is not just about increasing the cash and fixed income allocations within the portfolio but implementing more advanced funds management techniques to position the portfolio to deliver a more stable level of income in retirement.
The investment knowledge is available now to achieve this and these techniques can improve the outcomes of Target Date Funds.
This is also consistent with the OECD’s Core Principles of Private Pension Regulation that emphasised that the objective is to generate retirement income.
The central point is, without a greater focus on generating Income in retirement during the accumulation phase the variation of income in retirement will likely be higher.
Therefore, it is important to have coherency between the accumulation and pay-out phase of retirement as recommended by the OECD.
I have highlighted the OECD recommendations in a previous Post.
2. A greater focus on reducing downside risk in a portfolio
This is beyond just reducing the equity allocation within the retirement portfolio on approaching retirement, albeit this is fundamentally important in most cases.
From this perspective Target Date Funds would be an appropriate default option for KiwiSaver, as I have previously outlined.
A more robust portfolio must also display true portfolio diversification, that helps manage downside risk i.e. reduce degree of losses within a portfolio.
This includes the inclusion of alternative investments. Portfolios should be built more like US endowments as I outlined in a previous Post.
An allocation to Alternatives have also been shown to improve the investment outcomes of Target Date Funds.
The inclusion of low volatility equities may also be option.
The article from Forbes is of interest in managing sequence of returns in retirement, and recommends amongst other things in having some flexibility around spending, maintaining reserve assets so you don’t have to sell assets after they fall in value, and the use of Annuities.
Many argue that sequencing risk can be managed by Product use alone.
My preference is for a robust portfolio, truly diversified that is based on the principles of Goals-Based Investing, and is therefore using asset-liability matching type strategies. I would complement the Goals-Based approach with longevity annuities so as to manage longevity risk. This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.
Sequencing risk is currently a growing and present danger given it has been a long time since both the US and New Zealand sharemarkets have incurred a major fall in value. Hopefully, sequencing risk is getting some consideration in investment decisions being made today.
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Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.
Background – Understanding Impact of returns and Cashflows
It is hard to believe, but two investors might both experience “average” returns of 8 per cent over a 20-year period and yet have materially different balances due to sequencing risk.
The 20-year periods would occur at different times, yet the “average” return is the same.
Nevertheless, the sequence of returns to generate an “average” return over the 20 year periods can result in different accumulated wealth.
This reflects there is a difference between time weighted returns and dollar invested returns. The time weighted return assumes you held the same investment over the time period. A dollar weighted return takes into consideration that money goes in and comes out of a savings account and each dollar earns a different return given the period it is invested for. Dollar weighted returns impact on accumulated wealth.
Although the sequence of returns is crucial, so too are the timing of Cashflows into (deposits) and out (withdrawals) of a savings account.
To appreciate this, it is important to understand the impact of market volatility, it is hard to recover a dollar lost from a negative market movement. For example, if your portfolio falls in value by 40%, it’s takes a 67% return to recover your loses e.g. you have $100, this falls in value by 40%, wealth falls to $60, to get back to $100, the portfolio must recover 67%.
When there are cashflows not every dollar will experience the same return e.g. a dollar withdrawn after a 50% fall will miss out on any subsequent recovery in market prices, which can take up to six to ten years.
Therefore, the introduction of cashflows can also result in different outcomes for investors. This is why the pulling of funds out of markets following a large fall (draw-down) early in the accumulation phase can have a detrimental impact on accumulated wealth at the time of retirement.
The sequence of returns and cashflows matters during both the accumulation of retirement savings and in retirement.
During accumulation cashflows are going into the savings account and the account balance is growing. Therefore, each dollar invested has a different investment return.
In retirement, cashflows coming out of the portfolio will gradually reduce the capital base, therefore, investors will be better off if returns are stronger at the start of retirement, as the account balance will be larger and growing, meaning cashflows out will not reduce the capital base as much when returns are poorer in the earlier years of retirement.
For those wanting a more technical explanation, along with some great charts and graphs, this article by Challanger will be of real value.