Sunday, November 4, 2012

The Sequence of Returns Risk

11:03 PM


When things don't go according to plan

The sequence of returns risk is the risk of incurring low or negative investment returns in the early years of retirement and the erosion of the asset base caused by withdrawals, making it is difficult to recover even if you have strong returns in the following years.

In other words, if you incur a couple of years of low or negative returns while taking withdrawals,
your ability to make up losses in future years even with strong investment returns is greatly diminished.

This is more acute with equities, which are more volatile than fixed income investments -- equities' higher expected returns come at the price of taking more risk. Investment returns from equities have greater variability, with large swings from one year to the next.

The following chart illustrates the volatility of returns of various asset classes.
The blue line represents annual returns on cash and money market investments over the last 20 years.
Returns are low and predictable. The red line shows annual returns for a bond portfolio. Less stable returns from year to year, but still fairly consistent.
The green line shows returns of the S&P/TSX Total Return Index, representing Canadian stocks. This green line zigzags wildly each year going from good to bad.

The returns in the above chart do not take into account fees and come from Canadian indices for cash, fixed income and equities.



If you're invested heavily in equities at the onset of retirement, timing is everything. If you're unlucky and start at a time when the green line goes south, your portfolio may never recover and you will run out of money faster than if you get decent investment returns.

Sequence without consequence

Consider these three possibilities of getting an average 7% return:

  • Level: 7% each year
  • Lucky: returns of -10%, 7%, 27.2% each year repeated every three years
  • Unlucky: returns of 27.2%, 7%, -10% each year repeated every three years

If you take no withdrawals, you'll end up with the same balance. The order in which you earn the return does not matter: you'll end up with the same amount of money.

This is good news during the accumulation phase in view of retirement. Years of negative returns will be made up with good years and you'll earn the average of the asset class you are investing.


 

Where sequence matters

When you take withdrawals sequence greatly matters. In our example, starting with $100,000 and taking $10,000 per year, the lucky order will let your assets last 21 years, while the level return will go for 17 years. However, the unlucky sequence will only last 14 years.

 

What you can do

Of course you can't know whether your retirement will start on a year with good investment returns. So these are a few strategies to consider in order to minimizing or avoiding the sequence of returns risk.

Reduce exposure to equities

While keeping some of your assets equities is essential to boost long-term returns, retirement is not the time to bet the farm. Having a significant portion of your funds invested in fixed income will damper the impact of an undesirable sequence of returns.

No equities

Having no equities will make the problem disappear, but creates another one: without the strong average returns of equities, you may not earn enough investment income to fund your retirement.

A moderate amount of risk is the trade-off required to earn these higher expected returns, while keeping the bulk of your assets in less volatile and risky assets, for example fixed income.

Invest conservatively and diversify

Lowering exposure to equities is a sensible approach, but you can also imnprove your odds on the equity portion of your portfolio by investing in companies that are not speculative. If you can't afford the consequences of bets that don't pan out, then you should stay away.

A diversified portfolio that closely follows the index will work best to take away company-specific risk, so your exposure is only to market risk.

Stay invested

If you suffer low or negative returns, stay invested. You can't throw the towel or know ahead of time what will happen next.

Time horizon

Look at your time horizon for the investment. If it's only a few years, equities may not be a good fit because you don't have time to make up losses. If it's for a longer term, such as 20 or more years, you'll live through a few bull and bear markets and earn the average return of that asset class.

Spend conservatively

Spend conservatively during the first few years of retirement and minimize your withdrawals. If you earn poor returns, low withdrawals will not deplete your assets as much and you'll be left with enough funds for the rest of your retirement.

Adapt spending

If you have a year with negative returns, take less for the following couple of years to help minimize losses and keep as much money invested to earn more investment income when markets recover.

Get an annuity

An annuity will not only eliminate the sequence of returns risk, but also the longevity risk. Consider annuitizing part or all of your assets. Partial annuitization works best if you plan to leave money to your estate.

Segregated fund with income

Some insurance companies offer a "guaranteed minimum withdrawal benefit" (GMWB), which is an option to provide an income for life, usually between 3% and 5% per year of the capital invested in the product.

The amount upon which the withdrawal rate is based is usually reset every few years, so if there are good investment returns, the income can grow (but never decline). You can read more about it at the end of this recent blog post.

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