It is a truism that our primary aim is to assist investors protect and grow their wealth. But the biggest threat to this goal might be something you’re not aware of.
You have probably read dozens of articles discussing the longevity risk facing Australians. And they are correct. With life expectancy for the average 65 year old Australian at 84.1 years (male) and 87.0 years (female), we are at real risk of outliving our retirement savings.
You have probably also heard about Australia’s rising dependency ratio. The proportion of the non-working population to the working-age population is inexorably rising. Public finances are already under immense strain and the pension is unlikely to be a viable option for most retirees.
However, neither of these risks is the biggest risk facing Australian retirees. That title belongs to ‘sequencing risk’. While many professionals stress and fret about average rates of return, it turns out that rate of return (at least by itself) is not the key driver of retirement outcomes. Rather, it is the sequence of these returns that is the primary driver of investment success.
What is sequencing risk?
The definition of sequence risk is hotly contested. Unfortunately, many commentators restrict its application to investors in drawdown phase only – but it is important at all stages of the investment life-cycle.
Consider the following case study (and I am indebted to Basu, Doran and Drew, article ‘Sequencing Risk: A Key Challenge to Sustainable Retirement Incomes’, for the example):
Michael commenced work at the age of 25 in 1972 on $41,552 (2012 dollars). His earnings increased by 4% real p.a and he saved and invested 9% of his earnings until retirement at 65 in 2011. Based on the actual returns of a typical ‘balanced’ portfolio from 1972 to 2011, Michael would have accumulated $4 million in retirement savings. Not bad.
However, if we were to swap the order of the annual returns of Michael’s portfolio to optimise the outcome (worst annual results in early years, best results in later years); Michael’s portfolio would have been a massive $17.4 million. Conversely, if the worst possible order of returns were achieved, the portfolio would have been just $1.4 million. Clearly, even before entering drawdown phase, the sequence of returns plays an enormous role in investment outcomes. This divergence is equivalent to an average annual rate of return differential – over 40 consecutive years – of a whopping 9.5% p.a.
So how can you manage sequencing risk?
The primary tool is whole-of-life, or lifecycle investment strategies. At their simplest, these strategies maximise exposure to growth assets in early years, then gradually transition to more capital-stable, fixed-interest offerings in later years. Risk is effectively taken off the table as the funds at stake grow and retirement approaches.
However, care must be taken with how this strategy is executed. An excessive move to cash (and some forms of fixed interest) will yield insufficient returns. This, of course, leaves the investor exposed to longevity risk. The key is to generate a diversified portfolio of investment offerings that generate a decent yield, without sacrificing that critical capital stability.
Chris Andrews is the Vice President, Head of Funds Management at La Trobe Financial.
