The potential impact shouldn't be underestimated.
Milliman analysis shows that for a retiree with $500,000 earning a steady benchmark return of CPI1 + 3.5% will run out of money in just over 30 years assuming they draw down $26,000 each year, increasing with CPI. Now, if a 19%1 portfolio loss were to happen in the first year of retirement, that same retiree will run out of money almost a full decade earlier than they expected.
1 CPI has been assumed to equal 2.5%, the midrange of RBA’s consumer price inflation target of 2-3%.
2 -19% is the return in 2008 on Morningstar’s Multisector Australian Category Average Index for Balanced funds.
There are three drivers that create sequencing risk:
- A significant downturn has a much larger negative impact on a big retirement balance than a small one.
- Older investors usually don't have the same amount of remaining time in the market as younger investors who can fully benefit as the market swings back up.
- Retirees drawing a pension are spending their savings after its value has dropped.
This puts them on the back foot because they have a lower amount of savings available to even be able to benefit from a market recovery when it comes along.
The retiree risk-return conundrum
Retirees are naturally risk averse.
Studies show that the average person feels the pain from a loss twice as much as the pleasure they feel from a financial gain. However, retirees can be five times more sensitive to losses, yet few have the luxury of avoiding any risk at all within their portfolios.
A popular way to manage sequencing risk (and ‘de-risk’ portfolios), is to invest in safer assets such as cash rather than shares. However, while it can minimise the chance of experiencing a big market downturn, the result is also often much lower returns.
Interest rates around the developed world have been cut to record lows, meaning 'safe' assets such as cash and bank deposits are in fact, often returning less than the rate of inflation.
Retirees also need healthy investment returns to fund decades in retirement. The average 65-year-old man is now expected to live to 84.7 years and a woman the same age to 87.3 years, according to the Australian Institute of Health and Welfare.
This puts many retirees in a bind. They need growth but can't risk a major downturn in their early years of retirement. And while it’s been over a decade since the global financial crisis, major market downturns have historically struck more frequently.
Managing sequencing risk
Managing sequencing risk while generating strong investment returns is crucial.
Portfolio diversification is a popular strategy that attempts to do this but the global financial crisis revealed the limit of its effectiveness. The following graph shows that most major asset classes simultaneously fell, with major share markets losing about half their value.
'Bucketing' is another strategy you might be familiar with, where money is placed into different accounts to fund different lifestyle components.
For example, a 'cash' bucket can fund day-to-day expenses, while a 'shares' bucket can fund longer-term expenses. The problem here is that share markets don’t necessarily recover before the cash bucket runs dry. It took equity markets 4.6 years to recover from the global financial crisis in 2008 and 7.9 years to recover from the 1970 downturn.
A newer strategy to manage sequencing risk, which Milliman has helped pioneer globally, applies proven techniques from the insurance industry, which manages the risk of a significant market downturn and market volatility through exchange-traded futures and options. This maintains their exposure to potential high-growth assets such as shares while ‘hedging’ any losses against potential market downturns. In the past, this approach required significant scale, but it is now more commonly available for all investors to access through a variety of structures.
This approach to managing risk certainly helps when markets are slowing, or where there might be an extended downturn. Risk and return trade-offs remain, nonetheless. In more buoyant market conditions, the hedging strategy can also lessen the overall return. Making sure you have enough money in your retirement, is personal to each investor. We are not all the same and there is not one magic number for everyone.
Truly managing risk always comes at a cost and each investor must assess the potential price (upside and downside) relative to their personal situation, their retirement goals and aspirations.
Milliman is a global actuarial firm that provides investment advisory, hedging and consulting services across AUD $215billion in assets (as at 30th September 2019). Milliman’s SmartShield Portfolio series provides the ability to turn Milliman’s risk management strategies on or off as markets or client circumstances change. It can be accessed via HUB24 and other platforms.
For more information please go to advice.milliman.com or contact us at firstname.lastname@example.org
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