Those in the Retirement Risk Zone would benefit most from targeted investment advice.
The Retirement Risk Zone is the 10-year period before and after retirement (assumed to retire at age 65 years).
It is the 20-year period when the greatest amount of retirement savings is in play, and subsequently, risk is at its highest. It is a very important period for retirement planning.
The Retirement Risk Zone is the worst possible time to experience a large negative return. 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 that loss.
Therefore, the value of good advice and a well-constructed portfolio aligned with one’s investment objectives is of most value during the Retirement Risk Zone.
Impact on timing of market losses
If a large loss occurs during the Retirement Risk Zone it will result in less money in retirement and raise longevity risk (the risk of running out of money in retirement).
The risk that the order of investment returns is unfavourable is referred to as 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.
Once an investor needs to take capital or income from a portfolio volatility of equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives.
It is untrue to say that volatility does not matter for the long term when cashflows are involved. For further discussion on this issue see this Post, Could Buffett be wrong?
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.
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.
Materiality of Market Volatility in Retirement Risk Zone
Research by Griffith University 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.“
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.
Managing Sequencing Risk
Sequencing risk is largely a retirement planning issue. Albeit a robust portfolio and a suitably appropriate investment approach to investing will help mitigate the impact of sequencing risk.
Two key areas from an investment perspective to focus on in managing sequencing risk include:
The Retirement Goal is Income
The OECD’s Core Principles of Private Pension Regulation emphasis that the objective is to generate retirement income. This is different to the focus on accumulated value. A key learning from the Australian Superannuation industry is that there has been too greater focus on the size of the accumulated balance and that the purpose of superannuation should be about income in retirement.
An important point to consider, 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.
The OECD recommends the greater use of asset-liability matching (LDI) investment techniques.
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 and secure level of income in retirement.
This is aligned with a Goals Based Investment approach.
A greater focus on reducing downside risk in a portfolio (Capital Preservation)
This is beyond just reducing the equity allocation within the retirement portfolio on approaching retirement, albeit this is fundamentally important in most cases.
A robust portfolio must display true portfolio diversification, that helps manage downside risk i.e. reduce degree of losses within a portfolio.
This may include the inclusion of alternative investments, tail risk hedging, and low volatility equities may also be option.
The current ultra-low interest rate environment presents a challenging environment for preserving portfolio capital, historically the role of Fixed Income. Further discussion on this issue can be found in this Post, which includes a discussion on Tail Risk Hedging.
This article in smstrusteenews highlights the growing issue of capital preservation within the Australian Self-Managed Super Fund (SMSF) space given the current investment environment.
Meanwhile, this article from Forbes is on 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. Longevity annuities could be used to complement the Goals-Based approach, 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.
For a more technical read please see the following papers:
- 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
The case for a greater focus on generating retirement income is provided in this Post, summarising an article by Nobel Laureate Professor Robert Merton. He argues strongly we should move away from the goal of amassing a lump sum at the time of retirement to one of achieving a retirement income for life.
The concepts in Merton’s article are consistent with the work by the EDHEC Risk Institute in building more robust retirement income solutions.
Lastly, a recent Kiwi Investor Blog Post, The Traditional Diversified Fund is outdated – greater customisation of the client’s investment solution is required, provides a framework for generating greater tailoring of investment solutions for clients.
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