SAFT ON WEALTH: Bad years are bad news – accounting for sequence risk

October 29, 2015

Oct 29 (Reuters) – An unlucky sequence of bad investment
years at the wrong time can derail retirement savings and even
overwhelm decades of decent average returns.

Called “sequence risk,” it is the possibility that a bad
break, a poor run of years or an unusually poor year can have an
outsize impact on savings outcomes, even if savers are diligent
and consistent.

A saver might, for example, assume they’d earn a certain
average return over a planned 40-year working life and another,
perhaps lower, return after retirement. But hit some bad years
late in the accumulation phase and you can disproportionately
hit your overall returns. The same thing can happen if you hit a
bad year early in retirement, when the hit to accumulated
savings can be at its maximum.

The upshot may be that plans based on average return
assumptions understate the risks involved, and may cause nasty
shortfalls. As well, “glidepath” plans, the system of lightening
up on riskier investments as the saver approaches a retirement
target date, may not help very much with sequence risk.

“Sequence risk rears its ugly head wherever cash flows
matter – and we know cash flows matter both in the retirement
and accumulation phases,” Peter Chiappinelli and Ram Thirukkonda
of fund managers GMO wrote in an August paper on sequence risk.

“Current models of asset allocation – the most popular being
static, or predetermined, target date glidepaths – ‘know’ that
sequence risk exists, but behave as if there is nothing that can
be done to mitigate it.” (here)

GMO uses as illustration two retirees, one who started to
save in 1954 and one in 1967. Both worked and saved the same
amount – 9 percent of salary – in the same fund using the same
allocations. Both made identical returns of 8 percent annually
over the 40 years. Yet the one who started in 1967 ends with
$880,000 after 40 years while the older one ends with just
$590,000. The reason: the younger saver suffered through the
lackluster 1970s when she had little accumulated, but hit it
lucky when the market took off as she’d built up wealth in the
1980s. The older saver hit those same 1970s bad years just at
the wrong time: when he had already accumulated enough to make
the hit matter most.

TRANSFER OF RISK

One issue sequence risk raises is that the move to defined
contribution pension plans from defined benefit plans was a
great transfer of risk. Take a mixed cohort in a pension fund
and you can share out the lucky and unlucky years in a way in
which individual outcomes are blended to achieve one reasonably
acceptable average. That, however, is not how typical pension
systems now work.

The risk perhaps of a bad sequence is perhaps greatest
during the last 15 years of the accumulation phase and the first
10 years of retirement, when funds are being drawn out of the
large pool of savings with no cash going in.

Wade Pfau, a professor of retirement income at American
College, argues that the acceptable withdrawal rate, the
percentage of a portfolios’ final value that can be taken safely
over an expected 30-year retirement, varies hugely depending on
sequencing of returns. Using an asset allocation of 50/50 stocks
and bonds, the outcomes, and retirements, have been all over the
map.

Someone who retired in 1937, having borne the brunt of the
1929 crash and Great Depression, could safely take only 3.95
percent annually of the nest egg they had at retirement. A 1982
retiree could afford a 9.19 percent withdrawal
rate. (://retirementresearcher.com/sequence-risk-vs-investment-r
isk/)

So, what to do? While we are all hostage to our times to a
great extent, there are steps beyond a standard glidepath that
may help to minimize the risks of a particularly poor outcome.
GMO, as might be expected from a value investing specialist,
thinks using valuation as an input to asset allocation can help.
Rotating into cheap equity markets and away from ones with high
valuations produces lower drawdowns, or losses, two-thirds of
the time.

Looking at 40-year investment runs in markets going back to
1881, using a rather simple asset allocation and valuation
metric can have a meaningful impact, GMO says. The mean
portfolio at the end of the 40-year period was more than 13
percent bigger than it would have been using a classic glidepath
approach.

Sequence risk is one to guard against: the markets might,
just might, be efficient. But they certainly aren’t fair.

(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Dan Grebler)

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