“The four most dangerous words in investing are ‘This time it’s different.’” – John Templeton
Unfortunately, when it comes to investing, what you don’t know can hurt you. Risk management has continually evolved over the years, and a little-known risk called “sequencing risk” is getting a lot of attention lately, as baby boomers seek a better quality of retirement. Basically, sequencing risk is the Murphy’s Law of investment returns and can wreak havoc on your retirement plans if you are not aware of what it is and how to protect yourself.
If we look at the annual returns of any investment over many years, we will note that the returns vary from year to year. We may have two investments that each produce an “average” annual return of 10%, but one may achieve a return that varies between 8-12% per annum, whereas another investment may have returns that vary from -20% to +20% per annum. The problem is that we usually don’t know what the order, or “sequence”, of these annual returns will be. When most people consider their investments, they focus on the average return of the investment, and ignore the actual realised path of returns i.e. the sequence of returns.
So, what is sequencing risk?
Sequencing risk is the risk that your retirement savings will be subject to the worst returns at the worst possible time, namely in the five years preceding your retirement. It is in these years when your super balance is very high, and your future contributions are minimal, that you are most exposed to sequencing risk. This risk is especially high right at the point of retirement, when you cease contributing to your savings and start drawing on them for living expenses. Even if you have achieved a good average rate of return over the last 30 to 40 years, if the last few years of returns before you retire are particularly poor, your final super balance will suffer dramatically. For example, many people had to shelve retirement plans when the GFC wiped out a large chunk of their retirement nest egg, but they should never have been exposed to this risk in the first place. It is not a matter of if, but when, this will happen again.
In order to protect against sequencing risk, investors must control volatility and the risk of large drawdowns once they enter this critical phase just prior to retirement. By age 55-60, the balance of your super savings at retirement is almost entirely dependent upon your investment returns, not on your contributions.
Let’s assume you have invested a portion of your super funds in the share market.
Balanced or default super investments contain a large weighting to equities, typically 60% or more of total holdings.
Equities are an extremely volatile asset class, subject to substantial drawdowns, or bear markets. As an example, if we look back to 1929 for the US market, we see that there have been 25 bear markets, or one on average every 3.5 years. In other words, the chances of having a large chunk of your super savings subject to a bear market in the last five to ten years of your super accumulation is very high. The average drawdown experienced across these 25 bear markets was an equity market decline of more than 35%, with the least severe being the textbook definition of a bear market (i.e. -20%) and the worst being the Great Depression at -86%.
Other growth assets, such as real estate, can also suffer significant declines in value, and investors should expect that all growth assets will produce a significant annual or multi-year loss periodically.
The problem is that whilst significant periodical losses are a virtual certainty, the timing of these significant losses is practically impossible to predict, so if you are nearing retirement and have a large amount of your assets in shares and/or real estate, retirement may be further away, and a lot less comfortable, than you think.
Three factors will determine whether your super does its job and funds a comfortable retirement.
Assuming your contributions do not change, the following factors determine whether your superannuation balance is sufficient to fund your retirement:
- the average rate of return your investments achieve;
- the volatility of the returns (which determines the compound return through time, with higher volatility resulting in lower compound returns); and
- the sequence, or order, of returns.
Considering these facts, it is clear that the only solution for those nearing retirement is to re-allocate a substantial amount of their super savings away from equities and into much more conservative investments to avoid this extreme sequencing risk.
But reallocate to what?
Especially now, when cash returns are so low (and falling), and the low yields on bonds make them very risky? Do you buy precious metals—well, they are more volatile than shares! What about bricks and mortar—but do you really want to be trying to sell properties to fund your day-to-day retirement expenses?
One possible answer for an increasing number of those in or nearing retirement is to re-allocate some of their equities, cash, and property holdings to other more sophisticated sources of return. In other words, cast a much wider net and incorporate additional sources of return that are lowly correlated to equities – investments that have historically provided returns similar to growth assets, and yet do not suffer from the substantial drawdowns that equities experience during bear markets.
As an example of sequencing risk, let’s consider two hypothetical couples, Murphy and Marge, and Lucky and Lucy.
Both of these couples retire at different times—but at exactly the same age, with exactly the same balance in their super—$1,000,000. They invest in the exact same portfolio with the exact same average and compound annual return, and the exact same volatility. They also both draw $50,000 per year, indexed to assumed inflation at a rate of 3%.
Unfortunately, for Murphy and Marge, they fall prey to sequencing risk, experiencing a horrible period of returns right at the point when they retire, i.e. just as they stop contributing and start drawing down their savings. Poor Murphy and Marge. After saving diligently for their retirement over their entire life, they end up destitute by the age of 80. This is not a pretty picture. According to the Society of Actuaries, there is a 45% chance that either the husband or wife of a married couple will live to age 90 (and an 18% chance that one of them will live to 95).
Now let’s consider Lucky and Lucy:
Lucky and Lucy don’t have a care in the world. At age 89, they are drawing over $100,000 in annual income and have a portfolio worth over $4 million (in nominal terms). Why did they do so well? The answer is that we just simply flipped around the sequence of the returns. The fact is that Lucky and Lucy received the exact same returns and volatility as Murphy and Marge – just in the reverse order. What a huge difference the order of returns made! The point is, none of us know in what order our range of possible returns will arrive in the future. What does the next five years look like for the share market or the property market? Ask 50 experts and you will get 50 different answers, in a fairly wide range. The bottom line is that the only way to manage sequencing risk is to dramatically reduce the volatility of your investment portfolio by shifting money out of growth assets and into more conservative assets. This will produce a less volatile range of returns, providing you with much more certainty over your financial future.